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Executive Summary June 24, 2011

The Economy

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.

Editor-in-Chief: John Reese

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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.

Macro Issues

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 hotlist@validea.com.

Current Portfolio

Detailed Stock Analysis

Disclaimer: The analysis is from Validea's selection and interpretation of content from the guru's book or published writings, and is not from nor endorsed by the guru. See Full Disclaimer

ASYS   |   BPI   |   DLTR   |   GME   |   T   |   SNY   |   SKX   |   ACOM   |   SOLR   |   RIMM   |  

Amtech Systems, Inc. (Amtech), incorporated in October 1981, through its wholly owned subsidiaries, supplies horizontal diffusion furnace systems used for solar (photovoltaic) cell and semiconductor manufacturing. The Company provides products and services to two industries: the solar industry and the semiconductor industry. The Company's solar and semiconductor equipment is sold under brand names of Tempress Systems and Bruce Technologies, which have customers in both the solar industry and the semiconductor industry. Within the solar industry, its provide diffusion and automation equipment to solar cell manufacturers and it also offers plasma enhanced chemical vapor deposition (PECVD) and phosphocilicate glass (PSG) equipment. Within the semiconductor industry, it provides equipment to manufacturers of analog, power, automotive and microcontroller chips with geometries greater than 0.3 micron.

Bridgepoint Education, Inc. (Bridgepoint) is a accredited provider of postsecondary education services. The Company offers associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. It delivers its programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2009, it offered approximately 1,150 courses, 60 degree programs and 125 specializations and concentrations. As of December 31, 2009, it had 53,688 students enrolled in its institutions, 99% of whom were attending classes online.

Dollar Tree, Inc. is an operator of discount variety stores offering merchandise at the fixed price of $1. At January 29, 2011, the Company operated 4,101 discount variety retail stores. Its stores operate under the names of Dollar Tree, Deal$, Dollar Tree Deal$, Dollar Giant and Dollar Bills. Approximately 3,935 of these stores sell substantially all items for $1 or less in the United States and $1.25 or less in Canada. Substantially all of the remaining stores, operating as Deal$, sell items for $1 or less but also sell items for more than $1. The Company's optimal store is between 8,000 and 10,000 selling square feet. This store size provides the appropriate amount of space for its merchandise offerings while allowing it to provide service. At January 29, 2011, it operated 4,015 stores in 48 states and the District of Columbia, as well as 86 stores in Canada. In November 2010, it acquired 86 Dollar Giant stores based in Vancouver, British Columbia.

GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

AT&T Inc. is a holding company. The Company is a provider of telecommunications services in the United States and worldwide. These include wireless communications, local exchange services, long-distance services, data/broadband and Internet services, video services, managed networking, wholesale services and directory advertising and publishing. It operates in four segments: wireless, which provides both wireless voice and data communications services across the United States and, through roaming agreements, in foreign countries; wireline, which provides landline voice and data communication services, AT&T U-Verse TV, broadband and voice services (U-Verse) and managed networking to business customers; advertising solutions, which publishes Yellow and White Pages directories and sells directory advertising and Internet-based advertising and local search, and other, which provides results from customer information services and all corporate and other operations.

Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. It is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, it specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company. In February 2011, the Company acquired BMP Sunstone Corp. In April 2011, the Company acquired Genzyme Corporation.

Skechers U.S.A., Inc. (Skechers) design and market Skechers-branded contemporary footwear for men, women and children under several lines. addition to Skechers-branded lines, the Company also offers several designer, fashion and street-focused footwear lines for men, women and children. These lines are branded and marketed separately from Skechers and appeal to specific audiences. Its brands are sold through department stores, specialty stores, athletic retailers, and boutiques as well as catalog and Internet retailers. Along with wholesale distribution, its footwear is available at its e-commerce Website and its own retail stores. Skechers operates 90 concept stores, 92 factory outlet stores and 37 warehouse outlet stores in the United States, and 22 concept stores and five factory outlets internationally. The Company operates in four reportable segments: domestic wholesale sales, international wholesale sales, retail sales, and e-commerce sales.

Ancestry.com Inc. is an online resource for family history. It has developed systems for digitizing handwritten historical documents, and has established relationships with national, state and local government archives, historical societies, religious institutions and private collectors of historical content around the world. These digital records and documents, combined with the online search technologies and tools, enable the subscribers to research their family history, build their family trees and make meaningful discoveries about the lives of their ancestors. As of February 10, 2010, the registered users have created over 14 million family trees containing nearly 1.5 billion profiles. They have uploaded and attached to their trees a combination of nearly 32 million photographs, scanned documents and written stories. In addition, the Company continues to deploy tools and technologies to facilitate social networking and crowd sourcing, a means of leveraging collaborative efforts.

GT Solar International, Inc. through its subsidiaries is a global provider of polysilicon production technology, crystalline ingot growth systems and related photovoltaic manufacturing services for the solar industry. Its customers include various solar companies, as well as companies in the chemical industry. The Company's principal products include chemical vapor deposition (CVD) reactors and related equipment used to produce polysilicon, the key raw material used in silicon-based solar wafers and cells, and directional solidification systems (DSS) furnaces and related equipment used to cast multicrystalline ingots by melting and cooling polysilicon in a controlled process. These ingots are used to make photovoltaic (PV) wafers, which are, in turn, used to make solar cells. It operates under two segments: Polysilicon Business and Photovoltaic Business.

Research In Motion Limited (RIM) is a designer, manufacturer and marketer of wireless solutions for the worldwide mobile communications market. Through the development of integrated hardware, software and services that support multiple wireless network standards, RIM provides platforms and solutions for seamless access to time-sensitive information, including e-mail, phone, short message service (SMS), Internet and intranet-based applications. RIM's portfolio of products, services and embedded technologies are used by organizations worldwide and include the BlackBerry wireless solution, the RIM Wireless Handheld product line, software development tools and other software and hardware. Its subsidiaries include Research In Motion Corporation, Research In Motion UK Limited and RIM Finance, LLC. On June 2, 2010, Harman International sold its software operating systems unit, QNX Software Systems, to the Company. In June 2011, the Company acquired Scoreloop.

Watch List

The Watch List contains the highest scoring stocks according to our guru consensus system that are not currently in the Hot List portfolio. We provide this list both for informational purposes and for investors who are not comfortable with a portfolio of ten stocks.


The names of individuals (i.e., the 'gurus') appearing in this report are for identification purposes of his methodology only, as derived by Validea.com from published sources, and are not intended to suggest or imply any affiliation with or endorsement or even agreement with this report personally by such gurus, or any knowledge or approval by such persons of the content of this report. All trademarks, service marks and tradenames appearing in this report are the property of their respective owners, and are likewise used for identification purposes only.

Validea is not registered as a securities broker-dealer or investment advisor either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. Validea is not responsible for trades executed by users of this site based on the information included herein. The information presented on this website does not represent a recommendation to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment. The information on this website is generic by nature and is not personalized to the specific situation of any individual. The user therefore bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional prior to making any investment decisions.

Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.