The Economy

The market has taken a breather after a big jump forward since the results of the US Presidential election, but the overall move has been impressive to say the least. Since November 4th, the S&P 500 is up over 5% and the Russell 2000 is up over 14%. To put that in perspective, the Russell 2000 returned approximately 13% over a three year period from September of 2013 through early November of 2016. The upward move in the Russell in less than a month is larger than the index's return over the trailing three years prior to the election. In an upcoming Hot List we'll discuss the importance of being invested during these big up moves in the market and how it impacts long term returns so stay tuned for that.

On the economic front, things have been somewhat quiet, but December is going to pick up with the US employment number, the Federal Reserve interest rate decision and also continued developments regarding President Elect Trump's cabinet choices and his economic development plans, including corporate tax rates, infrastructure spending and regulatory changes.

Third quarter Gross Domestic Product came in at a revised 3.2%, which was a higher revision than most expected. The latest GDP figures are well above the second quarter GDP of 1.4%. Within the GDP numbers, the all-important consumer spending was strong, while housing and investment were down. To get a sense of the choppiness of the GDP figures, see the chart below. Since the end of 2014, GDP had been below trend, but the recent uptick is a positive development for the economy.



The Consumer Confidence reading in November registered at 107.1, a much higher number than most expected and well above the October reading of 100.8. The jump in confidence to the highest level since July of 2007 has the potential to help fuel a strong holiday season and fourth quarter earnings.

According to the Commerce Department, US companies generated 5.2% after tax earnings growth in the third quarter. The increase in profits is the first yearly improvement since late 2014 and the strongest year-over-year growth since the fourth quarter of 2012. According to Adobe Interactive, consumers spent $3.54 billion online on Cyber Monday and $3.3 billion online on Black Friday. Consumers continue to gravitate toward the Internet for purchases.

On Wednesday oil prices rallied as OPEC signaled a reduction in output, which is the group's first production cut in over 8 years. Crude oil prices were up almost 10% on the news and oil stocks followed suit, with many up double digits.

Performance Update

Since our last newsletter, the S&P 500 returned 0.2%, while the Hot List returned 0.7%. So far in 2016, the portfolio has returned 10.1% vs. 7.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 210.2% vs. the S&P's 119.0% gain.

Guru Spotlight: David Dreman

While most investors were heading for the hills in late 2008 and early 2009, Warren Buffett was diving into the market, putting billions of dollars of cash to work and penning an op-ed for The New York Times entitled, "Buy American. I Am". James O'Shaughnessy was writing about a "generational opportunity" in the market. Kenneth Fisher was saying that investors needed to "get a grip" on their fears.

Buffett, O'Shaughnessy, and Fisher were not advising people to buy stocks during what turned out to be one of the greatest buying opportunities in decades because they had some sort of "6th sense" about when the market would turn. They were doing so because they understood investor psychology. They knew that, as Buffett puts it, the best time to be greedy is when others are fearful. And that means that, during crises, you should be looking for bargains, not the exit door.

One guru who has done extensive research into this notion is David Dreman. Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.

When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.

Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies: The Next Generation. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower." He goes on to say, "Buy during a panic, don't sell."

In his book, Dreman provides a table that shows what he calls "11 major postwar crises." These include the Berlin blockade, Korean War, Kennedy assassination, Gulf of Tonkin crisis, 1979-1980 oil crisis, and 1990 Persian Gulf War. He shows how, one year after all but one (the Berlin Blockade, when the market dropped), the market was up between 22.9 percent and 43.6 percent, except for a 7.2 percent rise after the Gulf of Tonkin crisis. The average gain was 25.8 percent. Two years after the crisis, the average gain was 37.5 percent. It's worth noting that following the September 11 terrorist attacks, which occurred after Dreman wrote Contrarian Investment Strategies, it took just one month for the S&P 500 to climb back to pre-September 11 levels. And of course, we know how strongly the market rebounded after the 2008-09 financial crisis, despite the "this time it's different" cries from the pundits.

Taken from Contrarian Investment Strategies: The Next Generation (Simon & Schuster, 1998)



In fact, looking back on the financial crisis, Dreman's writings in Contrarian Investment Strategies seem particularly prescient. Consider what he had to say about the collective mindset of investors and the media when a crisis hits: "The event triggering the crisis is always considered to be something entirely new; nothing in our experience shows us how to cope with the current catastrophe. 'Sell, sell, sell,' the savants chorus. 'No matter how low prices have fallen, they are destined to go lower yet.' In each case, the crisis is the major news of the day. Legions of experts are interviewed, most making dour forecasts of structural damage to the nation. A common theme is 'things will never be the same again.' Because the nation, if not the world, is focused on the crisis, the media is in its glory. A crisis sells newspapers, builds ratings, and peddles advertising." Dreman said that "It is through this rout of panicky investors -- who as they rush past you shout how awful conditions are up ahead -- that you must resolutely advance."

Sound familiar? Even though Dreman wrote Contrarian Investment Strategies a decade before the financial crisis, 2008-09 played out just as you might have expected if you had read the book. It's the same old song, just a different verse: Bad news often gives the market the jitters, only to have it recover when the bad news turns out not to be as devastating as first feared. The savvy investor can take advantage of that knowledge.

I would be remiss if I did not note that Dreman himself was hit hard during the financial crisis. He doubled down on many of the big financials after they plunged, only to see them collapse further. His mistake, I believe, was that he trusted that the numbers on these firms' balance sheets were legitimate, when in many cases the companies had huge office-balance-sheet liabilities. If you are going to make big bets on particular companies, you have to be sure that the numbers on which you are basing your decisions are comprehensive and accurate.

That being said, the broader point of Dreman's research and writings is, I believe, a timeless one. When crises hit and the masses are fleeing the market, you should be on the lookout for the bargains they leave behind -- just make sure you're thorough and careful as you do so.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take an in-depth look at my investment strategies. If you have any questions, please feel free to contact us at hotlist@validea.com.

Portfolio Holdings
Ticker Date Added Return
BMA 7/1/2016 -4.7%
SAFM 11/18/2016 0.1%
GGAL 8/26/2016 -8.8%
RGR 11/18/2016 0.2%
WDR 11/18/2016 2.0%
EGOV 11/18/2016 -0.6%
CPLA 11/18/2016 2.6%
MMS 11/18/2016 -1.8%
DW 10/21/2016 15.1%
TSCO 9/23/2016 11.2%


Guru 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

BMA   |   SAFM   |   GGAL   |   RGR   |   WDR   |   EGOV   |   CPLA   |   MMS   |   DW   |   TSCO   |  

BANCO MACRO SA (ADR)

Strategy: Contrarian Investor
Based on: David Dreman

Banco Macro S.A. offers traditional bank products and services to companies, including those operating in regional economies, as well as to individuals. In addition, the Bank performs certain transactions through its subsidiaries, including mainly Banco del Tucuman, Macro Bank Limited, Macro Securities S.A., Macro Fiducia S.A. and Macro Fondos S.G.F.C.I. S.A. It has approximately two categories of customers, such as retail customers, including individuals and entrepreneurs and corporate customers, which include small, medium and large companies and major corporations. In addition, it provides services to over four provincial governments. It provides its corporate customers with traditional banking products and services, such as deposits, lending (including overdraft facilities), check cashing advances and factoring, guaranteed loans and credit lines for financing foreign trade and cash management services.

MARKET CAP: PASS

Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. BMA has a market cap of $4,162 million, therefore passing the test.


EARNINGS TREND: PASS

A company should show a rising trend in the reported earnings for the most recent quarters. BMA's EPS for the past 2 quarters, (from earliest to most recent quarter) 0.18, 1.77 have been increasing, and therefore the company passes this test.


EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: PASS

This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. BMA passes this test as its EPS growth rate over the past 6 months (785.00%) has beaten that of the S&P (25.65%). BMA's estimated EPS growth for the current year is (1,296.36%), which indicates the company is expected to experience positive earnings growth. As a result, BMA passes this test.


This methodology would utilize four separate criteria to determine if BMA is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


P/E RATIO: PASS

The P/E of a company should be in the bottom 20% of the overall market. BMA's P/E of 9.57, based on trailing 12 month earnings, meets the bottom 20% criterion (below 13.00), and therefore passes this test.


PRICE/CASH FLOW (P/CF) RATIO: FAIL

The P/CF of a company should be in the bottom 20% of the overall market. BMA's P/CF of 9.13 does not meet the bottom 20% criterion (below 7.36), and therefore fails this test.


PRICE/BOOK (P/B) VALUE: FAIL

The P/B value of a company should be in the bottom 20% of the overall market. BMA's P/B is currently 3.20, which does not meet the bottom 20% criterion (below 1.01), and it therefore fails this test.


PRICE/DIVIDEND (P/D) RATIO: FAIL

The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). BMA's P/D of 95.24 does not meet the bottom 20% criterion (below 19.69), and it therefore fails this test.


This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


PAYOUT RATIO: FAIL

A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for BMA is 9.44%, while its historical payout ratio has been 9.22%. Therefore, it fails the payout criterion.


RETURN ON EQUITY: PASS

The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 16.11%, and would consider anything over 27% to be staggering. The ROE for BMA of 39.70% is high enough to pass this criterion.


PRE-TAX PROFIT MARGINS: PASS

This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. BMA's pre-tax profit margin is 43.92%, thus passing this criterion.


YIELD: FAIL

The company in question should have a yield that is high and that can be maintained or increased. BMA's current yield is 1.05%, while the market yield is 2.68%. BMA fails this test.

SANDERSON FARMS, INC.

Strategy: Growth Investor
Based on: Martin Zweig

Sanderson Farms, Inc. is a poultry processing company. The Company is engaged in the production, processing, marketing and distribution of fresh and frozen chicken, and the preparation, processing, marketing and distribution of processed and prepared chicken items. The Company sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, primarily under the Sanderson Farms brand name to retailers, distributors and casual dining operators principally in the southeastern, southwestern, northeastern and western United States, and to customers reselling frozen chicken into export markets. The Company conducts its chicken operations through Sanderson Farms, Inc. (Production Division) and Sanderson Farms, Inc. (Processing Division), and its prepared chicken business through Sanderson Farms, Inc. (Foods Division). Its prepared chicken product line includes approximately 70 institutional and consumer packaged partially cooked or marinated chicken items.


P/E RATIO: PASS

The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. SAFM's P/E is 13.01, based on trailing 12 month earnings, while the current market PE is 17.00. Therefore, it passes the first test.


REVENUE GROWTH IN RELATION TO EPS GROWTH: FAIL

Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. SAFM's revenue growth is 6.63%, while it's earnings growth rate is 34.05%, based on the average of the 3 and 5 year historical eps growth rates. Therefore, SAFM fails this criterion.


SALES GROWTH RATE: PASS

Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (-1.6%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (-3.4%) of the current year. Sales growth for the prior must be greater than the latter. For SAFM this criterion has been met.


The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


CURRENT QUARTER EARNINGS: PASS

The first of these criteria is that the current EPS be positive. SAFM's EPS ($2.42) pass this test.


QUARTERLY EARNINGS ONE YEAR AGO: PASS

The EPS for the quarter one year ago must be positive. SAFM's EPS for this quarter last year ($2.27) pass this test.


POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. SAFM's growth rate of 6.61% passes this test.


EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: FAIL

Compare the earnings growth rate of the past four quarters with long-term EPS growth rate. Earnings growth in the past 4 quarters should be at least half of the long-term EPS growth rate. A stock should not be considered if it posted several quarters of skimpy earnings. SAFM had 3 quarters of skimpy growth in the last 2 years.


This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

If the growth rate of the prior three quarter's earnings, -62.31%, (versus the same three quarters a year earlier) is less than the growth rate of the current quarter earnings, 6.61%, (versus the same quarter one year ago) then the stock passes.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: FAIL

The EPS growth rate for the current quarter, 6.61% must be greater than or equal to the historical growth which is 34.05%. Since this is not the case SAFM would therefore fail this test.


EARNINGS PERSISTENCE: FAIL

Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. SAFM, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were -5.74, 2.35, 5.68, 10.80, and 9.52, fails this test.


LONG-TERM EPS GROWTH: PASS

One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. SAFM's long-term growth rate of 34.05%, based on the average of the 3 and 5 year historical eps growth rates, passes this test.


TOTAL DEBT/EQUITY RATIO: PASS

A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. SAFM's Debt/Equity (0.00%) is not considered high relative to its industry (125.94%) and passes this test.


INSIDER TRANSACTIONS: PASS

A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For SAFM, this criterion has not been met (insider sell transactions are 1,032, while insiders buying number 281). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.

GRUPO FINANCIERO GALICIA S.A. (ADR)

Strategy: Growth/Value Investor
Based on: James P. O'Shaughnessy

Grupo Financiero Galicia S.A. (Grupo Financiero Galicia) is a financial services holding company. The Company's segments include Banking, Regional Credit Cards, CFA, Insurance and Other Grupo Galicia Businesses. Banco de Galicia y Buenos Aires S.A. (Banco Galicia) is a subsidiary of the Company. Its banking business segment represents Banco Galicia consolidated line by line with Banco Galicia Uruguay S.A. (Galicia Uruguay). It operates the regional credit cards segment through Tarjetas Regionales S.A. and its subsidiaries. Its CFA business segment extends unsecured personal loans to low and middle-income segments of the Argentine population. The Company operates the insurance segment through Sudamericana Holding S.A. and its subsidiaries. Its Other Grupo Galicia Businesses segment includes the results of Galicia Warrants S.A., Galicia Administradora de Fondos S.A. Sociedad Gerente de Fondos Comunes de Inversion and Net Investment S.A.


MARKET CAP: PASS

The first requirement of the Cornerstone Growth Strategy is that the company has a market capitalization of at least $150 million. This will screen out the companies that are too illiquid for most investors, but still include a small growth company. GGAL, with a market cap of $2,815 million, passes this criterion.


EARNINGS PER SHARE PERSISTENCE: PASS

The Cornerstone Growth methodology looks for companies that show persistent earnings growth without regard to magnitude. To fulfill this requirement, a company's earnings must increase each year for a five year period. GGAL, whose annual EPS before extraordinary items for the last 5 years (from earliest to the most recent fiscal year) were 0.04, 0.07, 0.09, 0.17 and 0.22, passes this test.


PRICE/SALES RATIO: PASS

The Price/Sales ratio should be below 1.5. This value criterion, coupled with the growth criterion, identify growth stocks that are still cheap to buy. GGAL's Price/Sales ratio of 1.20, based on trailing 12 month sales, passes this criterion.


RELATIVE STRENGTH: PASS

The final criterion for the Cornerstone Growth Strategy requires that the Relative Strength of the company be among the top 50 of the stocks screened using the previous criterion. This gives you the opportunity to buy the growth stocks you are searching for just as the market is embracing them. GGAL, whose relative strength is 60, is in the top 50 and would pass this last criterion.

STURM RUGER & COMPANY INC

Strategy: Growth Investor
Based on: Martin Zweig

Sturm, Ruger & Company, Inc. and subsidiary, is engaged in the design, manufacture and sale of firearms to domestic customers. The Company operates through two segments: firearms and castings. The firearms segment manufactures and sells rifles, pistols and revolvers to a range of federally licensed, independent wholesale distributors located in the United States. The castings segment manufactures and sells steel investment castings, and metal injection molding parts. Its castings segment provides castings and MIM parts for the Company's firearms segment. In addition, the castings segment produces some products for various customers in a range of industries. It offers products in three industry product categories: rifles, pistols and revolvers. Its firearms are sold through independent wholesale distributors to the commercial sporting market. It manufactures and sells investment castings made from steel alloys and metal injection molding parts for internal use in the firearms segment.


P/E RATIO: PASS

The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. RGR's P/E is 12.25, based on trailing 12 month earnings, while the current market PE is 17.00. Therefore, it passes the first test.


REVENUE GROWTH IN RELATION TO EPS GROWTH: PASS

Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. RGR's revenue growth is 11.42%, while it's earnings growth rate is 8.31%, based on the average of the 3, 4 and 5 year historical eps growth rates. Therefore, RGR passes this criterion.


SALES GROWTH RATE: PASS

Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (33.6%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (19.2%) of the current year. Sales growth for the prior must be greater than the latter. For RGR this criterion has been met.


The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


CURRENT QUARTER EARNINGS: PASS

The first of these criteria is that the current EPS be positive. RGR's EPS ($1.03) pass this test.


QUARTERLY EARNINGS ONE YEAR AGO: PASS

The EPS for the quarter one year ago must be positive. RGR's EPS for this quarter last year ($0.62) pass this test.


POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. RGR's growth rate of 66.13% passes this test.


EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: PASS

Compare the earnings growth rate of the previous three quarters with long-term EPS growth rate. Earnings growth in the previous 3 quarters should be at least half of the long-term EPS growth rate. Half of the long-term EPS growth rate for RGR is 4.16%. This should be less than the growth rates for the 3 previous quarters, which are 214.29%, 49.38%, and 34.07%. RGR passes this test, which means that it has good, reasonably steady earnings.


This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

If the growth rate of the prior three quarter's earnings, 248.42%, (versus the same three quarters a year earlier) is greater than the growth rate of the current quarter earnings, 66.13%, (versus the same quarter one year ago) then the stock fails, with one exception: if the growth rate in earnings between the current quarter and the same quarter one year ago is greater than 30%, then the stock would pass. The growth rate over this period for RGR is 66.1%, and it would therefore pass this test.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: PASS

The EPS growth rate for the current quarter, 66.13% must be greater than or equal to the historical growth which is 8.31%. RGR would therefore pass this test.


EARNINGS PERSISTENCE: FAIL

Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. RGR, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were 2.09, 3.60, 5.58, 1.95, and 3.21, fails this test.


LONG-TERM EPS GROWTH: FAIL

The final important criterion in this approach is that Earnings Growth be at least 15% per year. RGR's long-term growth rate of 8.31%, based on the average of the 3, 4 and 5 year historical eps growth rates, fails the minimum required.


TOTAL DEBT/EQUITY RATIO: PASS

A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. RGR's Debt/Equity (0.00%) is not considered high relative to its industry (114.47%) and passes this test.


INSIDER TRANSACTIONS: PASS

A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For RGR, this criterion has not been met (insider sell transactions are 102, while insiders buying number 56). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.

WADDELL & REED FINANCIAL, INC.

Strategy: Contrarian Investor
Based on: David Dreman

Waddell & Reed Financial, Inc. is a mutual fund and asset management company. The Company provides investment management, investment advisory, investment product underwriting and distribution and shareholder services administration to Waddell & Reed Advisors group of mutual funds, Ivy Funds, Ivy Funds Variable Insurance Portfolios, InvestEd Portfolios and 529 college savings plan (collectively, the Funds), and the Ivy Global Investors Fund SICAV and its Ivy Global Investors sub-funds (the IGI Funds), and institutional and separately managed accounts. Its retail products are distributed through third parties, such as other broker/dealers, registered investment advisors and various retirement platforms or through its sales force of independent financial advisors. The Company also markets its investment advisory services to institutional investors, either directly or through consultants. It operates its investment advisory business through Waddell & Reed Investment Management Company.

MARKET CAP: FAIL

Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. WDR has a market cap of $1,616 million, therefore failing the test.


EARNINGS TREND: PASS

A company should show a rising trend in the reported earnings for the most recent quarters. WDR's EPS for the past 2 quarters, (from earliest to most recent quarter) 0.41, 0.65 have been increasing, and therefore the company passes this test.


EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: FAIL

This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. WDR's EPS growth rate over the past 6 months (44.44%) has beaten that of the S&P (25.65%), but WDR's estimated EPS growth for the current year is (-39.12%) while that of the S&P is (-17.24%), therefore failing this test.


This methodology would utilize four separate criteria to determine if WDR is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


P/E RATIO: PASS

The P/E of a company should be in the bottom 20% of the overall market. WDR's P/E of 8.62, based on trailing 12 month earnings, meets the bottom 20% criterion (below 13.00), and therefore passes this test.


PRICE/CASH FLOW (P/CF) RATIO: FAIL

The P/CF of a company should be in the bottom 20% of the overall market. WDR's P/CF of 7.86 does not meet the bottom 20% criterion (below 7.36), and therefore fails this test.


PRICE/BOOK (P/B) VALUE: FAIL

The P/B value of a company should be in the bottom 20% of the overall market. WDR's P/B is currently 1.91, which does not meet the bottom 20% criterion (below 1.01), and it therefore fails this test.


PRICE/DIVIDEND (P/D) RATIO: PASS

The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). WDR's P/D of 10.60 meets the bottom 20% criterion (below 19.69), and it therefore passes this test.


This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


PAYOUT RATIO: FAIL

A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for WDR is 81.54%, while its historical payout ratio has been 47.37%. Therefore, it fails the payout criterion.


RETURN ON EQUITY: PASS

The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 16.11%, and would consider anything over 27% to be staggering. The ROE for WDR of 22.28% is high enough to pass this criterion.


PRE-TAX PROFIT MARGINS: PASS

This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. WDR's pre-tax profit margin is 21.82%, thus passing this criterion.


YIELD: PASS

The company in question should have a yield that is high and that can be maintained or increased. WDR's current yield is 9.43%, while the market yield is 2.68%. WDR passes this test.

NIC INC.

Strategy: Growth Investor
Based on: Martin Zweig

NIC Inc. is a provider of digital government services that help governments use technology. The Company operates through Outsourced Portals segment. The Other Software & Services category includes its subsidiaries that provide software development and services, other than outsourced portal services, to state and local governments, as well as federal agencies. The Company offers its services through two channels: primary outsourced portal businesses, and software & services businesses. In its primary outsourced portal businesses, it enters into long-term contracts with state and local governments to design, build, and operate Internet-based, enterprise-wide portals on their behalf. These portals consist of Websites and applications that the Company has built to allow businesses and citizens to access government information online and secure transactions, such as applying for a permit, retrieving government records, or filing a government-mandated form or report.


P/E RATIO: PASS

The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. EGOV's P/E is 31.71, based on trailing 12 month earnings, while the current market PE is 17.00. Therefore, it passes the first test.


REVENUE GROWTH IN RELATION TO EPS GROWTH: FAIL

Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. EGOV's revenue growth is 12.29%, while it's earnings growth rate is 16.54%, based on the average of the 3, 4 and 5 year historical eps growth rates. Therefore, EGOV fails this criterion.


SALES GROWTH RATE: PASS

Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (7.1%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (6.6%) of the current year. Sales growth for the prior must be greater than the latter. For EGOV this criterion has been met.


The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


CURRENT QUARTER EARNINGS: PASS

The first of these criteria is that the current EPS be positive. EGOV's EPS ($0.24) pass this test.


QUARTERLY EARNINGS ONE YEAR AGO: PASS

The EPS for the quarter one year ago must be positive. EGOV's EPS for this quarter last year ($0.19) pass this test.


POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. EGOV's growth rate of 26.32% passes this test.


EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: FAIL

Compare the earnings growth rate of the previous three quarters with long-term EPS growth rate. Earnings growth in the previous 3 quarters should be at least half of the long-term EPS growth rate. Half of the long-term EPS growth rate for EGOV is 8.27%. This should be less than the growth rates for the 3 previous quarters which are -76.27%, 35.71% and 17.65%. EGOV does not pass this test, which means that it does not have good, reasonably steady earnings.


This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

If the growth rate of the prior three quarter's earnings, -41.11%, (versus the same three quarters a year earlier) is less than the growth rate of the current quarter earnings, 26.32%, (versus the same quarter one year ago) then the stock passes.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: PASS

The EPS growth rate for the current quarter, 26.32% must be greater than or equal to the historical growth which is 16.54%. EGOV would therefore pass this test.


EARNINGS PERSISTENCE: PASS

Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. EGOV, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were 0.35, 0.40, 0.49, 0.59 and 0.63, passes this test.


LONG-TERM EPS GROWTH: PASS

One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. EGOV's long-term growth rate of 16.54%, based on the average of the 3, 4 and 5 year historical eps growth rates, passes this test.


TOTAL DEBT/EQUITY RATIO: PASS

A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. EGOV's Debt/Equity (0.00%) is not considered high relative to its industry (232.11%) and passes this test.


INSIDER TRANSACTIONS: PASS

A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For EGOV, this criterion has not been met (insider sell transactions are 353, while insiders buying number 4). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.

CAPELLA EDUCATION COMPANY

Strategy: Small-Cap Growth Investor
Based on: Motley Fool

Capella Education Company is an online postsecondary education services company. The Company's academic programs are delivered through its subsidiary, Capella University (the University), which is an online academic institution offering online postsecondary education services primarily to working adults. The Company also offers educational programming through its other subsidiaries, including Arden University, Ltd., which is a provider of United Kingdom university distance learning qualifications that markets, develops and delivers these programs across the world; Sophia Learning LLC (Sophia), which supports self-paced learning; Capella Learning Solutions (CLS), provides online training solutions and services to corporate partners, which are delivered through the Company's online learning platform, and Hackbright Academy, which is a non-degree software engineering school for women. The Company's subsidiary, DevMountain, LLC, is involved in software coding industry.


PROFIT MARGIN: PASS

This methodology seeks companies with a minimum trailing 12 month after tax profit margin of 7%. The companies that pass this criterion have strong positions within their respective industries and offer greater shareholder returns. A true test of the quality of a company is that they can sustain this margin. CPLA's profit margin of 9.96% passes this test.


RELATIVE STRENGTH: PASS

The investor must look at the relative strength of the company in question. Companies whose relative strength is 90 or above (that is, the company outperforms 90% or more of the market for the past year), are considered attractive. Companies whose price has been rising much quicker than the market tend to keep rising. CPLA, with a relative strength of 93, satisfies this test.


COMPARE SALES AND EPS GROWTH TO THE SAME PERIOD LAST YEAR: FAIL

Companies must demonstrate both revenue and net income growth of at least 25% as compared to the prior year. These growth rates give you the dynamic companies that you are looking for. These rates for CPLA (12.50% for EPS, and 5.77% for Sales) are not good enough to pass.


INSIDER HOLDINGS: FAIL

CPLA's insiders should own at least 10% (they own 4.27%) of the company's outstanding shares. This does not satisfy the minimum requirement, and companies that do not pass this criteria are less attractive.


CASH FLOW FROM OPERATIONS: PASS

A positive cash flow is typically used for internal expansion, acquisitions, dividend payments, etc. A company that generates rather than consumes cash is in much better shape to fund such activities on their own, rather than needing to borrow funds to do so. CPLA's free cash flow of $1.76 per share passes this test.


PROFIT MARGIN CONSISTENCY: PASS

CPLA's profit margin has been consistent or even increasing over the past three years (Current year: 9.34%, Last year: 8.99%, Two years ago: 8.47%), passing the requirement. It is a sign of good management and a healthy and competitive enterprise.


R&D AS A PERCENTAGE OF SALES: NEUTRAL

This criterion is not critically important for companies that are not high-tech or medical stocks because they are not as R&D dependant as companies within those sectors. Not much emphasis should be placed on this test in CPLA's case.


CASH AND CASH EQUIVALENTS: PASS

CPLA's level of cash $113.6 million passes this criteria. If a company is a cash generator, like CPLA, it has the ability to pay off debt (if it has any) or acquire other companies. Most importantly, good operations generate cash.


ACCOUNT RECEIVABLE TO SALES: PASS

This methodology wants to make sure that a company's accounts receivable do not get significantly out of line with sales. It's a warning sign if a company's accounts receivable relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more. Accounts Receivable to Sales for CPLA was 4.24% last year, while for this year it is 3.97%. Since the AR to sales is decreasing by -0.27% the stock passes this criterion.


LONG TERM DEBT/EQUITY RATIO: PASS

CPLA's trailing twelve-month Debt/Equity ratio (0.00%) is at a great level according to this methodology because the superior companies that you are looking for don't need to borrow money in order to grow.


"THE FOOL RATIO" (P/E TO GROWTH): FAIL

The "Fool Ratio" is an extremely important aspect of this analysis. The methodology says consider shorting shares when the company's Fool Ratio is greater than 1.30. CPLA's PEG Ratio of 25.88 is excessively high.

The following criteria for CPLA are less important which means you would place less emphasis on them when making your investment decision using this strategy:

AVERAGE SHARES OUTSTANDING: PASS

CPLA has not been significantly increasing the number of shares outstanding within recent years which is a good sign. CPLA currently has 12.0 million shares outstanding. This means the company is not taking any measures, with regards to the number of shares, that will dilute or devalue the stock.


SALES: PASS

Companies with sales less than $500 million should be chosen. It is among these small-cap stocks that investors can find "an uncut gem", ones that institutions won't be able to buy yet. CPLA's sales of $427.6 million based on trailing 12 month sales, are fine, making this company one such "prospective gem". CPLA passes the sales test.


DAILY DOLLAR VOLUME: PASS

CPLA passes the Daily Dollar Volume (DDV of $8.4 million) test. It is required that this number be less than $25 million because these are the stocks that remain relatively undiscovered by institutions. "You'll be scoring touchdowns against the big guys on your turf."


PRICE: PASS

This is a very insignificant criterion for this methodology. But basically, low prices are chosen because "small numbers multiply more rapidly than large ones" and the potential for big returns expands. CPLA with a price of $88.05 passes the price test, even though it doesn't fall in the preferred range. The price should be above $7 in order to eliminate penny stocks and below $20 since most stocks in this price range are undiscovered by the institutions.


INCOME TAX PERCENTAGE: PASS

CPLA's income tax paid expressed as a percentage of pretax income this year was (39.85%) and last year (40.13%) are greater than 20% which is an acceptable level. If the tax rate is below 20% this could mean that the earnings that were reported were unrealistically inflated due to the lower level of income tax paid. This is a concern.

MAXIMUS, INC.

Strategy: Growth/Value Investor
Based on: James P. O'Shaughnessy

MAXIMUS, Inc. provides business process services (BPS) to Government health and human services agencies. The Company is primarily focused on operating Government-sponsored programs, such as Medicaid, children's health insurance program (CHIP), health insurance exchanges and other health care reform initiatives, Medicare, welfare-to-work, child support services and other Government programs. It provides health and human services to Governments in the United States, Australia, Canada, the United Kingdom and Saudi Arabia. The Company's United States federal services business provides various contract vehicles. The Company's Health Services segment provides a range of business process services, as well as related consulting services, for state, provincial and federal Government programs. The Company's Human Services segment provides federal, national, state and county human services agencies with a range of business process services, as well as related consulting services.


MARKET CAP: PASS

The first requirement of the Cornerstone Growth Strategy is that the company has a market capitalization of at least $150 million. This will screen out the companies that are too illiquid for most investors, but still include a small growth company. MMS, with a market cap of $3,514 million, passes this criterion.


EARNINGS PER SHARE PERSISTENCE: PASS

The Cornerstone Growth methodology looks for companies that show persistent earnings growth without regard to magnitude. To fulfill this requirement, a company's earnings must increase each year for a five year period. MMS, whose annual EPS before extraordinary items for the last 5 years (from earliest to the most recent fiscal year) were 1.09, 1.67, 2.10, 2.35 and 2.69, passes this test.


PRICE/SALES RATIO: PASS

The Price/Sales ratio should be below 1.5. This value criterion, coupled with the growth criterion, identify growth stocks that are still cheap to buy. MMS's Price/Sales ratio of 1.46, based on trailing 12 month sales, passes this criterion.


RELATIVE STRENGTH: FAIL

The final criterion for the Cornerstone Growth Strategy requires that the Relative Strength of the company be among the top 50 of the stocks screened using the previous criterion. This gives you the opportunity to buy the growth stocks you are searching for just as the market is embracing them. MMS has a relative strength of 39. This does not pass the final criterion. As a result, this methodology would not consider the stock even though it passed the previous three criteria.

DREW INDUSTRIES, INC.

Strategy: Value Investor
Based on: Benjamin Graham

Drew Industries Incorporated, through its subsidiaries, supplies an array of components in the United States and abroad for the manufacturers of recreational vehicles (RVs) and manufactured homes. The Company also supplies components for adjacent industries, including buses; trailers used to haul boats, livestock, equipment and other cargo; pontoon boats; modular housing, and mobile office units. It operates in two segments, which include the recreational vehicle products segment (the RV Segment), and the manufactured housing products segment (the MH Segment). RVs are motorized (motorhomes) or towable, such as travel trailers, fifth-wheel travel trailers, folding camping trailers and truck campers. It manufactures and distributes a range of products used primarily in the production of RVs and manufactured homes, such as electronic components, windows, slide-out mechanisms and solutions, furniture and mattresses, chassis components, and thermoformed bath, kitchen and other products.


SECTOR: PASS

DW is neither a technology nor financial Company, and therefore this methodology is applicable.


SALES: PASS

The investor must select companies of "adequate size". This includes companies with annual sales greater than $340 million. DW's sales of $1,610.2 million, based on trailing 12 month sales, pass this test.


CURRENT RATIO: PASS

The current ratio must be greater than or equal to 2. Companies that meet this criterion are typically financially secure and defensive. DW's current ratio of 2.44 passes the test.


LONG-TERM DEBT IN RELATION TO NET CURRENT ASSETS: PASS

For industrial companies, long-term debt must not exceed net current assets (current assets minus current liabilities). Companies that meet this criterion display one of the attributes of a financially secure organization. The long-term debt for DW is $49.9 million, while the net current assets are $221.2 million. DW passes this test.


LONG-TERM EPS GROWTH: PASS

Companies must increase their EPS by at least 30% over a ten-year period and EPS must not have been negative for any year within the last 5 years. Companies with this type of growth tend to be financially secure and have proven themselves over time. DW's EPS growth over that period of 60.9% passes the EPS growth test.


P/E RATIO: FAIL

The Price/Earnings (P/E) ratio, based on the greater of the current PE or the PE using average earnings over the last 3 fiscal years, must be "moderate", which this methodology states is not greater than 15. Stocks with moderate P/Es are more defensive by nature. DW's P/E of 21.93 (using the current PE) fails this test.


PRICE/BOOK RATIO: FAIL

The Price/Book ratio must also be reasonable. That is, the Price/Book multiplied by P/E cannot be greater than 22. DW's Price/Book ratio is 4.88, while the P/E is 21.93. DW fails the Price/Book test.

TRACTOR SUPPLY COMPANY

Strategy: Value Investor
Based on: Benjamin Graham

Tractor Supply Company is an operator of rural lifestyle retail stores in the United States. The Company operates in the retail sale of products that support the rural lifestyle segment. The Company focuses on supplying the lifestyle needs of recreational farmers and ranchers, as well as tradesmen and small businesses. It operates over 1,490 retail stores in over 50 states under the names Tractor Supply Company, Del's Feed & Farm Supply and HomeTown Pet. It also operates a Website under the name TractorSupply.com. The Company's stores offer merchandise, which includes equine, livestock, pet and small animal products; hardware, truck, towing and tool products; seasonal products, including heating, lawn and garden items, power equipment, gifts and toys; work/recreational clothing and footwear, and maintenance products for agricultural and rural use. The Company's products are offered under various brands, which include 4health, Blue Mountain and Countyline.


SECTOR: PASS

TSCO is neither a technology nor financial Company, and therefore this methodology is applicable.


SALES: PASS

The investor must select companies of "adequate size". This includes companies with annual sales greater than $340 million. TSCO's sales of $6,509.7 million, based on trailing 12 month sales, pass this test.


CURRENT RATIO: PASS

The current ratio must be greater than or equal to 2. Companies that meet this criterion are typically financially secure and defensive. TSCO's current ratio of 2.29 passes the test.


LONG-TERM DEBT IN RELATION TO NET CURRENT ASSETS: PASS

For industrial companies, long-term debt must not exceed net current assets (current assets minus current liabilities). Companies that meet this criterion display one of the attributes of a financially secure organization. The long-term debt for TSCO is $310.0 million, while the net current assets are $917.5 million. TSCO passes this test.


LONG-TERM EPS GROWTH: PASS

Companies must increase their EPS by at least 30% over a ten-year period and EPS must not have been negative for any year within the last 5 years. Companies with this type of growth tend to be financially secure and have proven themselves over time. TSCO's EPS growth over that period of 364.0% passes the EPS growth test.


P/E RATIO: FAIL

The Price/Earnings (P/E) ratio, based on the greater of the current PE or the PE using average earnings over the last 3 fiscal years, must be "moderate", which this methodology states is not greater than 15. Stocks with moderate P/Es are more defensive by nature. TSCO's P/E of 24.10 (using the current PE) fails this test.


PRICE/BOOK RATIO: FAIL

The Price/Book ratio must also be reasonable. That is, the Price/Book multiplied by P/E cannot be greater than 22. TSCO's Price/Book ratio is 6.88, while the P/E is 24.10. TSCO fails the Price/Book test.


Watch List

The top scoring stocks not currently in the Hot List portfolio.

Ticker Company Name Current
Score
THO THOR INDUSTRIES, INC. 60%
BOFI BOFI HOLDING, INC. 54%
STS SUPREME INDUSTRIES, INC. 51%
IBTX INDEPENDENT BANK GROUP INC 50%
TARO TARO PHARMACEUTICAL INDUSTRIES LTD. 46%
TREX TREX COMPANY INC 44%
ERIC TELEFONAKTIEBOLAGET LM ERICSSON 34%
CSTE CAESARSTONE LTD 34%
PII POLARIS INDUSTRIES INC. 32%
FIZZ NATIONAL BEVERAGE CORP. 32%



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