|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||January 4, 2013|
At long, long last, Congressional leaders and the President this week did what they should have done over a year ago: address the serious tax issues involved in the U.S.'s "fiscal cliff". And, so far, the early reviews from the stock market have been quite good.
Stocks soared Wednesday, the first trading day after the cliff deal was announced. Under the agreement, the Bush-era tax cuts will remain in place permanently for all but those individuals earning $400,000 or more and couples earnings $450,000 or more (they will see their tax rates rise from about 35% to about 40%).
The agreement also leaves capital gains and dividend taxes at 15% for most people. Those rates will rise to 20% for individuals making $400,000 or more and couples making $450,000 or more. Without an agreement, dividends and capital gains would have been taxed as ordinary income, however, so those increases are quite minor in comparison. The deal allows the temporary payroll tax cut to expire, however, so payroll taxes will jump from 4.2% to 6.2%.
Of course, our legislators have by no means completed a reorganization of the country's fiscal house. Far from it. In fact, they were more like a contractor who "finishes" a home renovation a year after it was supposed to be done, while leaving half the roof unshingled and an entire room missing. That's because the agreement reached this week fails to address the budget-cut side of the fiscal equation, meaning that major issues like Medicare and entitlement reform -- and the debt ceiling -- were kicked down the road a few months. Those battles will be waged soon, and are likely to be ugly.
Nonetheless, the market's strong reaction to the fiscal cliff deal is a study in expectations. Investors expected little from U.S. leaders, so even a half-done job was met with much relief. Hopefully the deal made on tax rates will give corporations the clarity they need to put their sky-high cash levels to work, by hiring more workers and spending on capital improvements.
Just what impact the cliff deal will have on the economy remains to be seen. What we do know is that, since our last newsletter, several areas of the economy have continued to show improvement. A new report from the Commerce Department showed, for example, that real personal income rose 0.8% in November. Part of that may have been a bounce-back following Superstorm Sandy, but the gain was still significant and greater than analysts had expected. As a result, real personal consumption expenditures jumped 0.6% for the month, while at the same time the personal savings rate rose from 3.4% to 3.6%
The manufacturing sector, meanwhile, expanded in December, according to the Institute for Supply Management. The group's manufacturing index, which had fallen just slightly into contraction territory in November, indicated that the sector expanded slightly in December. The survey's employment sub-index also made a nice jump.
The housing market also continues to improve. New residential home sales rose 4.4% in October, according to the Commerce Department, and are now about 17% higher than they were a year ago.
Since our last newsletter, the S&P 500 returned 1.1%, while the Hot List returned 3.0%. So far in 2013, the portfolio has returned 3.2% vs. 2.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 179.7% vs. the S&P's 45.9% gain.
Strong Gains, Despite Headwinds
For the stock market and investment world, 2012 was a year marked by fear and trepidation. From the European debt crisis to the fiscal cliff, individual investors continued to find reasons to steer clear of equities. Yet, despite all the fears, the market notched some strong gains, and the Hot List fared even better. The portfolio gained 20.0% vs. the S&P 500's 13.4% gain, meaning it has now beaten the index in 7 of its 10 years since inception (including the partial 2003 year). Through the end of 2012, the portfolio had more than quadrupled the index's gains.
So, with 2012 now officially in the rear-view mirror, this week I'd like to take a deeper look at the Hot List's performance, and the performance of my other guru-inspired portfolios, to see what lessons we might take from the year. Overall, the 14 ten-stock portfolios averaged a 12.5% gain for the year. Six of the fourteen beat the S&P. The 20-stock versions of these portfolios fared better, averaging gains of 15.8% for the year. Eight of the fourteen beat the S&P. Here's a look at a few of the notable strategies' performances (with returns through the end of 2012).
The Hot List: Our flagship portfolio had a very nice bounce-back year, outperforming the S&P 500 by more than 6.5 percentage points after a rough 2011. As I've noted many times, you don't have to be right on much more than 50% of your picks to do quite well in the market, and the Hot List showed that in 2012. It was accurate (meaning it made money) on 53.8% of its picks, which was enough to post that 20% gain for the year. The portfolio was about 19% more volatile than the broader market, with a beta of 1.19, but the extra volatility proved worth it.
Among the biggest winners for the Hot List were small-cap financial firm Altisource Portfolio Solutions, which gained about 14% while in the portfolio from Jan. 20-April 13, and then jumped nearly 30% during a second stint from June 8-Aug. 31; Aeropostale, which gained about 34% from Jan. 1-March 16; and Western Digital, which gained 21.1% in only about five weeks after the portfolio snatched it up on Nov. 23. The portfolio did have some sizeable losers, with Body Central Corp. tumbling 44.2% from March 16-May 11 and for-profit education firm Apollo Group falling 46% from July 6-Oct. 26. But it also found a number of other winners in the 10% to 20% range, helping it post that strong 20% gain for the year.
The 20-stock version of the Hot List fared even better than its smaller counterpart, gaining 22.1% to beat the index by nearly 9 percentage points. Since its 2003 inception, the 20-stock version has averaged annualized gains of 10.1%, while the 10-stock Hot List has averaged 11.1% per year. Both of those easily beat the S&P 500's 3.8% annualized return over that same period.
The Benjamin Graham-based Portfolios: The 10-stock Graham portfolio was our best performer in 2012, returning 33.8%. The portfolio made money on 66.9% of its picks, and did so with a bit more volatility than the broader market (beta of 1.14). As it has for much of the past few years, the Graham-based portfolio is currently the top long-term performer of all the individual guru10-stock portfolios we track. Since its July 2003 inception, it has posted annualized gains of 13.7%, far outpacing the 3.8% annualized returns of the S&P 500. The portfolio has beaten the index in eight of the 10 years of its existence.
In 2012, the Graham-based model found some of its biggest winners in the retail and energy sectors. They included oil and gas driller Helmerich & Payne, which jumped 22.8% while in the portfolio from May 11-December 21; True Religion Apparel, which gained 21.1% in just one month in the portfolio this fall; and Walgreen Company, a 20.9% gainer during its one-month stint in the portfolio in July and early August. Several of its other picks also produced strong gains over short periods. GameStop Corp. gained nearly 18% while in the portfolio from October 26-November 23; energy firm HollyFrontier Corp. gained nearly 17% over the same one-month timeframe; and in the week-and-a-half between when it picked up Deckers Outdoor Corp. (Dec. 21) and year-end, Deckers shares jumped nearly 17%.
The 20-stock Graham-based portfolio also had an excellent year, returning 31.9%. Since its inception (also July 2003), it has fared even better than the 10-stock Graham portfolio, averaging annualized returns of 16.6%.
It's remarkable that the Graham strategy continues to work, nearly 65 years after Graham detailed it in his classic book, The Intelligent Investor. But the types of variables that the strategy looks at -- valuation metrics like the price/earnings ratio and price/book ratio, and debt-related metrics like the current ratio and the relationship between net current assets and long-term debt -- are variables that get to the heart of good business and good investing. The fundamental concept behind the strategy -- invest in financially sound, stable firms whose shares are cheap -- is timeless. That's why the Graham model has worked so well, and why I think it will continue to post strong returns over the long haul.
The Warren Buffett-based Portfolios: The second-best 10-stock performer in 2012 was the portfolio inspired by Graham's protege, Warren Buffett. The Buffett-inspired portfolio gained 15.1% for the year, while being only slightly more volatile than the broader market (beta of 1.06). It was accurate on more than 63% of its picks. The Buffett-inspired portfolio has beaten the S&P in five of its nine years (not including 2003, since its inception date was less than a month before the end of that year).
The Buffett-based model tends to hold on to stocks for longer than many of my other models, like Buffett himself does. And in 2012, one of its top performers was discount retailer The TJX Companies, which it held for the entire year while the stock gained more than 30%. The portfolio also notched nice gains on two stocks that it held from March 16-July 6: Monster Beverage Corp., which gained 23.3%, and Raven Industries, which gained 21.0% (though Monster was a loser when it rejoined the portfolio from Aug. 3 through year-end). It also found some impressive shorter-term winners, like USANA Health Sciences (which gained about 25% from the start of the year until it was sold on Feb. 17) and Aeropostale Inc. (which gained more than 30% from the start of the year until it was sold on March 16).
The 20-stock Buffet-based portfolio also had a solid year, gaining 15.9%. It has beaten the S&P in six of its nine years.
The Motley Fool-based Portfolios: The Fool-based 10-stock portfolio had a rather remarkable run of beating market in each of its first nine years. But in 2012, that run came to an end. The portfolio did make positive gains, but its 4.7% advance was only about a third of what the S&P 500 gained. The portfolio got hit hard by a handful of stocks in 2012, including Adams Resources & Energy, which fell 36% in just one month (April 13-May 11); Richmont Mines, which tumbled about the same from the start of the year until it was sold in April; and MarketAxess Holdings, which fell about 24% from March 16-July 6.
It did find some nice winners, including lululemon athletica, the yoga-focused sporting apparel store. The portfolio picked up the stock way back in November 2009. In 2012, it gained about 28% before it was sold in early July. That made for a total gain of more than 350% from that late 2009 purchase date. Another big winner was Altisource Portfolio Solutions, which gained 23.8% from Jan. 20-March 16, then rejoined the portfolio from May 11-Aug. 31 and jumped another 48.5%. Those types of gains helped keep the portfolio in the black for the year, but weren't enough to catch up to the broader market.
Still, the Fool-based portfolio is one of my best-performing 10-stock portfolios over the long haul, averaging gains of 13.0% since its July 2003 inception. And, the 20-stock Fool-based portfolio had quite a good year. It nearly doubled the S&P's gains, returning 24.2%. Those are signs that the strategy is still working quite well, and that the 10-stock portfolio's underperformance in 2012 was due to some stock-specific issues rather than any sort of long-term problem.
The Top 5 Gurus Portfolios: The Top 5 Gurus portfolios had a strong 2012, building on their stellar long-term track records. The 10-stock portfolio gained 25.5%, nearly doubling the S&P 500's gain and bringing the portfolio's annualized return since its 2003 inception to 14.2%. It has now beaten the S&P in 8 of its 10 years.
Interestingly, the portfolio (which uses the top two picks from five of my best-performing strategies) was accurate on only 48.5% of its picks throughout the year. It found some big winners, though, which helped it post those strong gains for the year. Among them: Latin American steel firm Ternium, which gained 35% from the start of the year until the portfolio sold it on March 16; Altisource Portfolio Solutions, which gained nearly 40% from July 6-Nov. 23; and employment website company Monster Worldwide, which surged 36.5% during a one-month stint in the portfolio in February and March.
The 20-stock Top 5 Gurus portfolio, meanwhile, gained 20.3% in 2012. It has been a strong performer over the long term, though not nearly as strong as its smaller 10-stock counterpart, posting annualized gains of 9.5%.
So, what can we learn from 2012? I think the biggest lesson may be that investing based on macroeconomic headlines is a mistake. All year, we heard about how the economy -- and the stock market -- were in big trouble. First, Europe's woes were seen as a looming disaster that would topple the global economy and financial markets. Then, the U.S. fiscal cliff was the Bogeyman, with speculation that a fall from the cliff would cause a punishing new recession and market collapse. These were real issues, to be sure, but the problem was that many investors, still scarred by the 2008 market plunge, viewed them as certain financial Armageddon. In doing so, they overlooked other factors like valuations, which were attractive, and corporate balance sheets, which are far better than they were a few years back. Those were both very bullish factors for stocks (as were some macro factors, too, like the improving labor and housing markets, though they were overshadowed in the headlines by the fiscal cliff and Euro crisis). The S&P 500 responded with that strong 13.4% gain, and, on average, our 10- and 20-stock portfolios fared slightly better. Investors who let their fears get the best of them missed out on some nice profits.
Remember, Warren Buffett, who may be the greatest investing guru of all, has repeatedly said that the time to be greedy is when others are fearful, and the time to be fearful is when others are greedy. In 2012, fears were high, and those who dove into stocks (or stuck with them) were rewarded. That's a trend that has recurred throughout history, and I'm willing to bet that it will continue to play out in the years and decades to come.
Guru Spotlight: Peter Lynch
Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".
If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.
Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.
Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.
But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.
The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.
To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.
The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG as a way to make sure he wasn't paying too much for growth really makes him a hybrid growth-value investor.
One Size Doesn't Fit All
One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).
The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.
"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.
One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.
Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.
Beyond The PEG
The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)
The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.
Over the long term my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. Since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has averaged annualized returns of 6.2%, easily beating the 3.6% annualized return for the S&P 500 (all performance figures are through Dec. 30). The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 13.0% annualized over that period.
Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:
Capella Education Company (CPLA)
Bridgepoint Education Inc. (BPI)
HomeStreet Inc. (HMST)
Finish Line Inc. (FINL)
AutoNavi Holdings Limited (AMAP)
Crexus Investment Corp. (CXS)
Lexmark International Inc. (LXK)
Enstar Group Ltd. (ESGR)
AsiaInfo-Linkage, Inc. (ASIA)
Humana Inc. (HUM)
The Stomach's The Key
While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success, and it's one that is particularly relevant given the portfolio's rough recent run: Don't bail when things get bad.
Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."
Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.
That, of course, is particularly hard to do when the market gets volatile. But Lynch said it's critical to stay disciplined: "The real key to making money in stocks," he once said, "is not to get scared out of them."
News about Validea Hot List Stocks
Ross Stores Inc. (ROST): Ross' same-store sales jumped 6% in December, the Associated Press reported on Jan. 3. The firm's shares jumped nearly 8% the day of the announcement. Ross also raised its fiscal fourth-quarter earnings per share guidance from the $0.99-$1.04 range to the $1.05-$1.06 range.
The TJX Companies (TJX): Like Ross, TJX saw its same-store sales rise 6% in December, according to the Associated Press. Shares rose 3.3% the day of the announcement.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at email@example.com.
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