|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||June 24, 2011|
As any good climber knows, scaling a mountain doesn't involve a straight, easy, upward climb. Sometimes you have to go sideways, or even downward, taking a pause before you can continue back up toward the summit.
Right now, the economy seems to be doing just that -- pausing and trying to get its feet back under it before it hopefully heads back upward. The strongest evidence of the slowdown may be coming from the manufacturing sector. The New York Federal Reserve Bank reported last week that its general business conditions index fell into negative territory in June, indicating a contraction in New York area manufacturing activity for the first time since last November. The Philadelphia Fed's manufacturing index, which covers several mid-Atlantic states, also fell into contraction territory.
But it's important to remember that periodic manufacturing sector contractions aren't unusual during economic expansions. In fact, based on the past 30 years, it would be odd if they didn't occur. After the double-dip recession of the early 1980s, for example, the manufacturing sector began expanding in February 1983, according to the Institute for Supply Management's data. It expanded for two years straight (with the exception of one month when activity was flat), but then contracted for eight straight months. It caught a second wind, however, and manufacturing activity increased in 41 of the next 43 months.
The economic expansion that ran from April 1991 through February 2001, meanwhile, featured numerous months when the manufacturing sector contracted, including a 13-month stretch in which only one month featured an expansion in the sector. Another stretch featured seven straight months of contraction. In the 2001-2007 economic expansion, manufacturing activity picked up in February 2002. After eight months of relatively minor expansion, the manufacturing sector then contracted in seven of the next nine months. (All data from ISM.)
How about today? Well, manufacturing activity started expanding in August 2009; since then, we've had 22 straight months of increasing activity in the sector. Keep that longer-term trend in mind if ISM's June figures turn out to indicate a slight contraction for the month.
All of that's not to say that the soft patch isn't a concern, especially since data from other areas of the economy has been on the weaker side. New unemployment claims remain well below their recessionary highs, but are still above where they were earlier this year, and above the level that would signal significant job growth. Retail and food service sales also declined in May for the first time in 11 months, falling 0.2%, the Commerce Department reported.
But, as the retail sales figures showed, a significant factor in the recent slowdown seems to be supply chain disruptions caused by the earthquake and tsunami in Japan, a major world manufacturing hub. Japan is of course a big player in the auto industry, for example, and not including automobile-related sales, retail and food service sales actually increased 0.3% in May. As I've mentioned before, Japan is a resilient nation, and I expect that it will recover from the recent tragedy and continue to be one of the world's leading economies. That being said, the devastation caused by the natural disaster will of course lead to short-term problems, which we're now feeling in the U.S.
On the bright side, U.S. companies are continuing to report solid earnings, even amid the economic slowdown. Big bellwethers Walgreen, FedEx, and Oracle all reported strong quarterly profit growth over the past week (all of their quarters ended May 31). Companies appear to have streamlined operations during the recession, and are continuing to take advantage of low interest rates to boost their bottom line.
Given all of the concerns -- which also include a renewed round of Greek debt fears -- the market has overall help up reasonably well over the past couple weeks. Since our last newsletter, the S&P 500 returned -0.4%, while the Hot List returned 0.7%. So far in 2011, the portfolio has returned 3.3% vs. 2.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 178.8% vs. the S&P's 28.3% gain.
Diversification: How Many Stocks Is Enough?
Over the past month, the Hot List has seen a couple of its holdings get hit quite hard. One was shoe and apparel manufacturer Skechers USA, which between our May 27 and June 10 newsletters tumbled about 23%. The main factor seemed to be one analyst firm decreasing its price target for the company's shares. Given how often analysts are wrong, the big decline was surprising in terms of its magnitude.
Research in Motion, meanwhile, has fallen about 33% in the period covered by our last two newsletters. It announced second-quarter earnings and sales guidance that were well below expectations, and said it would be embarking on a job-cutting restructuring plan.
You might expect that having two holdings experience such big dips would be a huge problem for a 10-stock portfolio. But, while the Hot List's performance relative to the S&P has fallen a bit over the past month, it really hasn't taken that big of a hit. A month ago, the portfolio was up 2.5 percentage points on the index year-to-date; as of today the portfolio has returned 3.3% for the year, while the S&P has returned 2.1%.
That data supports something that I've found to be true during the nearly eight years since we started tracking the Hot List: You don't need to hold hundreds of stocks to properly diversify your equity portfolio.
Most fund managers won't tell you that. In fact, average mutual funds hold close to 200 stocks, according to one study from investment research firm Morningstar. In the study, Morningstar looked at how focused funds (those with no more than 40 stocks) fared compared to those 200-stock behemoths. Discussing the study's findings in late 2009, The Wall Street Journal's Larry Light wrote that "as a group, these funds haven't consistently outperformed or underperformed funds with more diverse holdings. [And] based on recent performance and an earlier Morningstar study, concentrated funds aren't more volatile than more diversified funds, on average, and some are surprisingly steady despite their small number of holdings."
Some of the world's most successful investors have put the idea of concentrated portfolios into practice. One is Joel Greenblatt, whose writings form the basis of one of my most successful Guru Strategies. In a recent article written for RegisteredRep.com, Greenblatt said portfolio size is one big reason most fund managers lag the broader market indices. Many fund managers, he says, tend to put together funds with dozens of stocks that end up mirroring their benchmarks. That's because, while holding a more concentrated portfolio gives you a better chance to beat the benchmark over time, it can also lead to short-term underperformance, which many investors can't handle. "Even a very talented manager who makes excellent stock picks over the long term can trail the market averages for years at a time. In fact, this is almost a certainty with a concentrated portfolio," Greenblatt writes. "Yet the reality is that a manager who significantly underperforms the market averages for two or three years has a good chance of losing most of his or her investors. And no investors means no business"
In my book, The Guru Investor, I looked at some other data that has similar implications. A 2003 study performed by California State University-Chico Professor H. Christine Hsu and H. Jeffrey Wei found, for example, that "the benefit of risk diversification is somewhat limited when the number of stocks in the portfolio goes beyond 50."
With the Hot List, we of course use a 10-stock portfolio. (We also track a 20-stock version of the portfolio that has been very successful, returning more than 11% annually since inception vs. 3.2% for the S&P.) And, in the eight years we've been tracking it, we've found that the 10-stock portfolio is a bit more volatile than the broader market -- but it's far from a roller coaster. Through Wednesday, its beta was 1.19 vs. the S&P, hardly a sky-high figure. Its frequency and magnitude of bad months also hasn't been all that much greater than that of the broader market. From its inception date in July 2003 through the end of 2010, the Hot List posted a monthly loss of 5% or more 14 times; the S&P 500 has lost 5% or more 9 times. The worst of those monthly intervals for the Hot List was a 22.89% decline in October 2008; the worst for the S&P was a 16.83% decline in the same period. When you consider that the Hot List has returned about 175% over its eight years or so while the S&P has returned less than 30%, that extra risk and volatility seems well worth it, if you ask me.
To be sure, you need to have some limits on how concentrated a portfolio you should hold. (A five-stock portfolio that includes four financial stocks, for example, is probably not a good idea.) But over the long haul, I think the Hot List's concentrated nature has been a big reason for its excellent returns. Yes, occasionally it will run into sizeable losses on picks like Research in Motion or Skechers. But by using rigorous fundamental-based strategies that do a good job of digging deep into a company's balance sheet, such major tumbles are rare -- and even a 10-stock portfolio can provide enough diversification that any big losses on a single position don't hurt the portfolio too much. (Think of it this way: Skechers 23% loss that I referenced above is essentially a 2.3% loss for the portfolio when spread over ten positions -- not exactly a catastrophic loss.)
And, of course, the ability of these strategies to find strong, undervalued companies offers far more upside potential than the broader market offers, as the past eight years or so have borne out. Just over the past few months, several of the Hot List's other positions have helped absorb Skechers' and RIM's losses. GameStop is up more than 30% since our March 4 newsletter; Bridgepoint Education has gained more than 30% since joining the portfolio in mid-March; and GT Solar International is up more than 21% since it joined the portfolio just two weeks ago (all returns through yesterday).
To me, the long-term results clearly show that a focused system offers rewards that are well worth a limited amount of extra risk and short-term volatility. That's why we'll continue to allow the portfolio to focus on its best ideas, rather than holding hundreds of stocks, which would just serve to make the portfolio look like the indexes that it is trying to beat.
Guru Spotlight: Martin Zweig
Generally, my Guru Strategies have a distinct value bias. The majority of these models -- ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy -- are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.
But that doesn't mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we'll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock's earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently -- and that their growth was coming from the right sources.
Zweig's thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron's list of the most successful hedge funds.
Before we delve into Zweig's strategy, a few words about the man himself. While some of the gurus we've looked at in recent Guru Spotlights -- Buffett and John Neff in particular come to mind -- lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan's Pierre Hotel that was at one time valued at more than $70 million. He's also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he's owned such one-of--a-kind items as Buddy Holly's guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan's jersey from his rookie season with the Chicago Bulls.
A Serious Strategy
Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:
Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.
Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).
Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.
Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn't getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.
While Zweig's EPS focus certainly puts him on the "growth" side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock's price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn't like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)
In addition, Zweig wanted to know that a firm's earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales -- not cost-cutting or other non-sales measures. My Zweig model requires a firm's revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.
Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock's sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter's sales growth rate (vs. the year-ago quarter).
Finally, Zweig also wanted to makes sure a firm's growth wasn't driven by unsustainable amounts of leverage (a key observation given all that's happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.
There's one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve's discount rate; installment debt levels; and the prime rate. His mottos included "Don't fight the Fed" (meaning investors should be more bullish when interest rates were low or falling) and "Don't fight the tape" (which related to his practice of getting more bullish or bearish based on market trends).
Those rules are tough for an individual investor to put into practice; Zweig used what he called a "Super Model" that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I've found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired 10-stock portfolio has been a very strong performer since its July 2003 inception, returning 103.9%, or 9.4% per year, while the S&P 500 has gained just 28.7%, or 3.2% per year.
This year, the Zweig portfolio has been a particularly strong performer, gaining 8.2% while the S&P is up just 2.3% (through June 22). The model tends to choose stocks from a variety of areas. Currently, my 10-stock Zweig-based portfolio has three tech stocks (not surprising for a growth strategy), but it also holds a healthcare firm, a restaurant, a chemical firm, and a printing company. Here are all of the portfolio's current holdings:
Quality Systems Inc. (QSII)
Bridgepoint Education, Inc. (BPI)
Apple Inc. (AAPL)
Amtech Systems, Inc. (ASYS)
Buffalo Wild Wings (BWLD)
Vistaprint NV (VPRT)
Balchem Corporation (BCPC)
IPC The Hospitalist Company, Inc. (IPCM)
Coinstar, Inc. (CSTR)
IntercontinentalExchange, Inc. (ICE)
As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.
What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn't look at growth in a vacuum. As you've seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.
News about Validea Hot List Stocks
Skechers USA, Inc. (SKX): Skechers announced last week that it has signed a multi-year licensing agreement with LF USA, a subsidiary of Hong Kong-based Li & Fung Limited, to produce a collection of Skechers Fitness apparel and accessories for men and women. LF USA's Regatta division will design, produce, distribute and market the collection, which will include Shape-ups, Tone-ups and Skechers Resistance-branded activewear; outerwear and performance-related accessories. Plans call for a 2012 launch in department store, sporting goods and independent retailers in the U.S.
AT&T Inc. (T): The U.S. Department of Justice has asked AT&T to supply additional information pertaining to the telecom giant's proposed $39 billion buyout of T-Mobile USA, Inc., company officials said, according to Bloomberg. The company officials said the government was looking for data that included market shares and customer counts. AT&T officials said they have responded to the request. The proposed deal has led some to raise antitrust concerns, as it would involve merging the U.S.'s second- and fourth-largest wireless carriers. AT&T officials said the deal is still on track for approval.
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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