|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||October 24, 2014|
While markets have remained roiled and troubles are continuing in Europe and China, the US economy has kept on chugging over the past couple weeks.
For starters, new claims for unemployment continue to decline. In fact, the four-week moving average of new claims is now at its lowest level since May 2000. In the most recent week, new claims were 18% below year-ago levels; continuing claims were 19% below where they stood a year ago.
Industrial production also jumped 1.0% in September, according to a new Federal Reserve report. Manufacturing output rose 0.5%, the Fed said, and mining output increased 1.8%. Utility output, which tends to be seasonally driven, jumped nearly 4%.
Housing starts also rose in September by 6.3%, according to the Census Bureau, and now stand 19% above year-ago levels. Permit issuance for new construction edged forward 1.5%, meanwhile, putting it about 8% above its year-ago pace.
Retail sales were a disappointment, declining 0.3% in September, however, according to another government report. Still, the year-over-year increase of 5.8% was one of the best annual increases we've seen in a long time.
Inflation, meanwhile, remains tame. The Consumer Price Index rose just 0.1% in September, according to the Labor Department. That put it a mere 1.7% ahead of its year-ago pace. And gas prices continue to deflate. As of October 23, the price for a gallon of regular unleaded was just $3.08, according to AAA. That's down 8 cents over the past week and 26 cents over the past month. The plummeting fuel prices are certainly giving consumers a little more money in their pockets.
Overseas, Chinese growth continues to slow, coming in at 7.3% in the third quarter. While that's hardly anemic, it's the lowest the Asian growth giant has seen since the financial crisis. China is on track to have its lowest annual growth rate in nearly two-and-a-half decades this year. And fear continues to hover over Europe, where even Germany -- the Eurozone's growth engine in recent years -- has seen some very weak data recently. The latest data released yesterday showed, however, that European private sector business activity picked up slightly in October, The Wall Street Journal reported, though firms cut prices at the fastest pace in more than four years.
Since our last newsletter, the S&P 500 returned 1.2%, while the Hot List returned 5.7%. So far in 2014, the portfolio has returned -16.5% vs. 5.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 204.0% vs. the S&P's 95.0% gain.
Good Strategy, Rough Stretch
There's no getting around it: 2014 has been a rough year for the Hot List. With a little over two months left in the year, the portfolio having its worst annual relative performance vs. the S&P 500 since its 2003 inception.
Given the tough stretch, I think it's a good time to reexamine just how the Hot List is constructed, why it's constructed that way, and why we remain confident in the approach going forward. In doing so, we'll also get a better understanding of what has caused this year's poor performance.
We'll start with the fact that the Hot List is a consensus-based strategy. That means it draws from all of my Guru Strategies to find the portfolio's 10 holdings. The system looks for the stocks with the most combined interest from those 12 strategies, but with a twist. The twist is that we weight the strategies with the best historical risk-adjusted performance (as measured through our individual guru portfolios) more heavily in the Hot List scoring system. The result is a portfolio of the stocks with the most combined interest from our best strategies.
By using multiple strategies, we attempt to both minimize risk and maximize returns. The risk minimization comes in the fact that a number of my individual strategies are uncorrelated. That means that when one particular strategy is having a bad year, another uncorrelated strategy is likely to be counterbalancing it with better performance. And the consensus approach should help maximize returns because in order to get high marks from multiple strategies, a stock has to be strong across a myriad of financial and fundamental variables. And those are the types of stocks that tend to do well over the long haul.
The next key element of the Hot List is its size. With 10 stocks, it's a pretty concentrated portfolio, which means it can be quite volatile over short-term periods. But we have found that, over the long term, that's big enough to diversify away a good deal of stock-specific risk. And by running a concentrated portfolio, we focus only on what we consider to be the best ideas in the market. Often, mutual funds will hold hundreds of stocks, which in the end means that they basically mirror the returns of the broader market. Our goal is not to be the market, it's to beat the market, and to do that you have to be different from the market.
Of course, when running such a concentrated portfolio, you can experience greater-than-market volatility, so discipline is key. We exercise discipline in two main ways: One is that we stick to the numbers, buying and selling stocks only based on their fundamentals and financials -- not hunches about industry trends or one week's worth of stock price performance or rumors about new, exciting products.
The other way we stay disciplined involves our rebalancing system. The stocks within the Hot List are updated once every 28 days on Friday. Each time we update the portfolio, we perform a simulated transaction in which we sell the stocks that were previously in the portfolio and then buy the ten stocks that currently score highest based on the portfolio's underlying criteria. By performing the updates to the portfolio using this method, we are able to not only get the new stocks in and the old stocks out, but also to ensure that the stocks are equally weighted on each update date.
This equal weighting is a risk control, as we don't put too many of our eggs in one single basket. And the fixed rebalancing periods ensure that we don't let fickle emotions drive our buy and sell decisions. History has shown that far too many investors act emotionally, causing them to buy high and sell low.
There's one last characteristic of the Hot List I'd like to touch on, and it's a big reason -- the biggest, perhaps -- for our underperformance this year. It's that, generally, our models tend to focus more on small and mid-sized stocks than large firms. In some cases, the reasons for this are explicit. The Motley Fool-inspired model, for example, has criteria that include trailing 12-month sales of no more than $500 million and average daily dollar trading volume of no more than $25 million, so it specifically targets smaller firms. Other models don't have such hard and fast rules, but tend to key on smaller names because that's where opportunities often lie.
Why do small stocks usually offer lots of opportunities? There are several reasons. As several of the gurus upon whose writings I base my strategies have noted, smaller stocks tend to be followed by fewer analysts, for one thing, and thus can fly under the radar in a way that the bigger firms can't. Big institutions that make up a sizeable portion of the market also can't buy small stocks because they need to deploy huge sums of cash to move the needle on their portfolios, and they can't get enough shares of a $500-million-market-cap firm to make that happen.
The lack of attention and limited supply of potential buyers make small-caps more subject to mispricing than larger stocks, meaning that good, fundamental-focused value investors can take advantage. The proof is in the data. From 1927 through 2009, U.S. large-cap growth stocks averaged a 9.08% annual compound return, according to the data of Dartmouth College professor and noted stock researcher Kenneth French. Small-cap growth stocks, meanwhile, averaged 9.23%, and large-cap value plays fared even better, averaging 11.21%. But well ahead of the pack are small-cap value picks, which averaged a 14.17% return per year. (For the breakpoint between small and large stocks, French and colleague Eugene Fama use the mean market equity of New York Stock Exchange stocks. Growth stocks are defined as those in the bottom 30% of the market based on book/market ratios; value stocks are those in the top 30%.)
In 2014, small caps have had some forces working against them, however. Earlier in the year, fears about a slowdown in the US economy had many avoiding smaller firms' shares, the assumption being that a downturn would first hit the little guys. More recently, there've been concerns about small-cap valuations. The Russell 2000 was trading for nearly 20 times projected earnings at the end of last year, significantly above its 16.9 average since 1994, according to Russell Indexes and The Wall Street Journal. With the index in the black and approaching new all-time highs in Q3, it seemed that investors began to fear that valuations might be getting too lofty.
Added to this mix have been interest-rate fears. With the Federal Reserve in the final stages of winding down its quantitative easing program, many have begun to speculate that the central bank will soon start to raise rates. Rate hikes can have a greater impact on smaller firms than larger firms, and a recent Credit Suisse report showed that small stocks have been hit harder by rate-increase-triggered market pullbacks, according to the Journal.
Interest rates also may have been at play in another way. Top-rated economist Francois Trahan told WealthTrack in a recent interview that he thinks cuts in European interest rates have been a major factor in large cap outperformance. The cuts benefited large caps because they tend to be more indebted and exposed to Europe and thus benefit more than smaller firms from rate declines. Investors were thus targeting the big guys and passing on the little guys, Trahan says.
All of this has led to a very rough year for small caps, even though the S&P 500 is well in the black for 2014. In fact, the Russell 2000 index of small and mid-cap stocks actually entered into correction territory recently; from its July 3 peak to October 13, it was down nearly 13% (though it has rebounded over the past week or so). Individual names within the small-cap space have been hit much harder. According to Royce Funds, through the end of the 3rd quarter, 49% of Russell 2000 constituents were down at least 20% from their respective 52-week highs; 11% were down more than 30% over the past 12 months.
Amid all this, small stocks have had a big impact on the Hot List. Five of the portfolio's 10 worst performers this year have been small caps, with another two being relatively small mid-caps. To be sure, some of these had stock-specific issues (see below on CTC Media). But the broader small-cap selloff certainly has been a big drag on the portfolio.
There are numerous reasons to think that the small-cap underperformance is temporary and may in fact be short-lived, however. First, of course, there is the long-term historical outperformance of small caps, which has been dramatic.
But there are other factors as well. Trahan says for example that some powerful longer-term forces bode very well for US small cap stocks. When it comes to dealing with the types of problems that reared their head in 2008, the US is well ahead of the rest of the world, he said. Our debt, for example -- both government and consumer -- is down significantly. We're producing more oil than ever, he adds, significantly reducing our trade deficit. And after a long period of corporate underinvestment, we should be entering into a period of major capital spending, Trahan says. China, Europe, and other parts of the world, meanwhile, are much earlier in the process in terms of addressing their issues.
The big takeaway from all this, Trahan says, is that the US dollar has been on the rise and should continue to strengthen for some time thanks to the US's strong relative position in the world. He says that means smaller firms -- which tends to do much more of their business in the US than do larger firms -- should fare quite well in coming years while larger, multinational companies will be dealing with weakness in the rest of the world.
Royce Funds also provides some intriguing data showing that good stock picking strategies should be primed to excel in the small-cap space. They note that currently, 25% of all companies in the Russell 2000 index of small stocks are not making any money. "This tells us two things," Francis Gannon of Royce wrote in recent commentary. "One, the index as a whole might not be as expensive as a books because it includes such a large number of companies currently earning nothing. Second, and much more important in our view, is the idea that small cap investors need to really understand what they own. Active management can make an enormous difference in the small-cap space, more so we think than in other asset classes."
Gannon also notes that, while lower quality small caps are selling at a major premium to large caps, high-quality small caps don't look nearly as expensive. Royce broke the small-cap space down into quartiles based on return on invested capital. The quartile of small stocks with the lowest ROIC were trading at a 52% premium to large caps at the end of the 3rd quarter; the next-to-last quartile was trading at a 13% premium to large caps. But the second-highest quartile and highest quartile based on return on invested capital were actually trading at a discount to large caps (6% for the second-highest quartile and 9% for the highest quartile). In other words, while small caps as a group may be pricey, the types of fundamentally sound small caps that the Hot List would be invested in are on average trading at very reasonable values.
In addition, Gannon notes that since its inception in 1979, the Russell 2000 has been in the red in only five calendar years when the S&P has been in the black. Each of those times, the Russell 2000 has outperformed the following year. Of course, if things remain the way they are this year it's no guarantee that small caps will outperform the S&P next year. But looking at the long-term, I think there are many reasons to think that the types of high quality small and mid-cap stocks that the Hot List often targets will outperform significantly, as I've discussed.
That doesn't mean there won't be some major ups and downs along the way. In fact consider one final statistic from Royce: Since its inception 35 years ago, the Russell 2000 has averaged annual returns of 11.8% per year. But in no single calendar year -- not one -- has the index returned between 6% and 16%. In other words, smaller stocks can offer great opportunities to beat the market -- if you have a system in place that allows you to stick with them through the ups and downs.
We believe that our disciplined, unemotional approach gives us the framework to do just that. (Perhaps more to the point, it allows us to stick with financially sound, undervalued stocks through ups and downs regardless of their size, as the Hot List certainly finds values among larger stocks, too.) Over the long-term, this system has allowed the Hot List to far outperform the broader market, and I expect it to continue to do so going forward.
As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Ctc Media, Inc. (CTCM), Liquidity Services, Inc. (LQDT), Silicon Motion Technology Corp. (Adr) (SIMO), Sturm, Ruger & Company (RGR) and Piper Jaffray Companies (PJC).
5 stocks remain in the portfolio. They are: Agco Corporation (AGCO), Valero Energy Corporation (VLO), Anika Therapeutics, Inc. (ANIK), Jones Lang Lasalle Inc (JLL) and Omnivision Technologies, Inc. (OVTI).
We are adding 5 stocks to the portfolio. These include: Credit Acceptance Corp. (CACC), Lannett Company, Inc. (LCI), Zumiez Inc. (ZUMZ), Amtrust Financial Services Inc (AFSI) and Monster Beverage Corp (MNST).
Newcomers to the Validea Hot List
Zumiez (ZUMZ): This Washington State-based retailer sells skateboards, snowboards, and a variety of other "action sports" clothing and accessories. It has a market cap of about $1 billion.
Zumiez gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.
AmTrust Financial Services (AFSI): Founded as a workers' compensation insurance firm, this New York City-based company has expanded into a multi-national property and casualty insurer. It specializes in coverage for small businesses.
AmTrust ($1.5 billion market cap) gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models and my Momentum Investor strategy. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
Lannett Company, Inc.: This 72-year-old Philadelphia-based firm makes generic prescription pharmaceutical products for customers throughout the United States. Lannett ($1.6 billion market cap) markets its products primarily to drug wholesalers, retail drug chains, distributors, and government agencies.
Lannett was a big losing position in the Hot List earlier this year when biotechs were getting beaten down. It has bounced back strongly though, and now it gets strong interest from my Motley Fool- and Peter Lynch-based models, and my Momentum Investor approach. For more on the stock, see the "Detailed Stock Analysis" section below.
Monster Beverage Corporation (MNST): This California-based firm makes energy drinks and alternative beverages under such names as Monster Energy, Java Monster, X-Presso Monster, M-3, Worx Energy and Hansen's natural sodas and juices. It gets a 100% score from my Warren Buffett-based model, thanks in part to its having upped EPS in all but one year of the past decade. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.
Credit Acceptance Corporation (CACC): Credit Acceptance provides auto loans to consumers through a network of dealer-partners. It has a market cap of about $3 billion, and has grown earnings per share at a 28% pace over the long term.
Credit Acceptance gets strong interest from my Peter Lynch- and Warren Buffett-inspired models. To read more about the stock, scroll down to the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Piper Jaffray (PJC): On October 23, Piper reported third-quarter earnings-per-share of $1.03, far ahead of the $0.57 Capital IQ Consensus Estimate, Briefing.com reported. Revenues were up 24.7% vs. the year-ago period, coming in at $155.9 million. That also far outpaced the $133.85 million consensus estimate. The firm reported record revenues in its advisory business. Shares were up more than 10% as of late morning trading the day of the announcement.
CTC Media (CTCM): CTC shares were up nearly 19% since our last rebalancing (as of late morning trading on October 23). But the stock's rough stretch from late September to mid-October was enough to trigger our stop-loss provision, meaning we're selling the holding on today's rebalancing.
Prior to its recent rebound, CTC shares had tumbled more than 43% from the time it entered the portfolio on September 26 through October 15, on news that proposed amendments to Russia's "On Mass Media" law passed second and third readings in the lower house of the Russian parliament. The legislation would limit the direct or indirect foreign ownership of Russian mass market businesses.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. If you have any questions, please feel free to contact us at firstname.lastname@example.org.
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