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Executive Summary July 22, 2011

The Economy

The economy seems to be pushing through the headwinds that troubled it this spring, with most recent data indicating improvement in a number of areas.

New claims for unemployment have edged slightly downward, for example, falling below the 420,000 mark for two straight weeks for the first time since April. While they're still higher than usual, we're moving in the right direction.

Retail sales also improved in June, according to new data from the Commerce Department, reversing a slight decline the previous month. They increased 0.1%. Total sales for the second quarter were up 7.7% vs. the second quarter of 2010. So despite the continued calls for their demise, American consumers keep showing that they are alive and kicking.

Industrial production also reversed its slight April and May declines, nudging upward 0.2% in June, according to The Federal Reserve. Production was 3.4% higher than it was in the same month last year.

Regional manufacturing reports for July were mixed, however. The New York Fed's manufacturing index indicated deteriorating conditions in New York State for the second straight month, though July's level wasn't as bad as June's. The Philadelphia Fed's manufacturing index showed improvement in the mid-Atlantic region, however, moving back into expansion territory after signaling a contraction in the sector in June. It's worth noting that several regional manufacturing reports were weak last month, and the final June manufacturing data for the entire U.S. ended up well in expansion territory.

The much-maligned housing market, meanwhile, got some good news. Privately-owned housing starts rose 14.6% in June (vs. May), while building permit issuance increased 2.5%, according to a government report. Existing-home sales declined slightly in June, according to the National Association of Realtors, falling less than 1%. The prices of single-family existing-home sales rose, however, to the highest level in over a year.

Of course, the big topic in the economic headlines continues to be debt, both in terms of the U.S. approaching its debt ceiling limit and Europe figuring out how to deal with Greece's continued woes. American legislators continue to play a partisan game of chicken, unwilling to reach a compromise that would keep the country from defaulting on its obligations in early August. As the deadline grows closer, I expect the partisan wrangling will give way to some sort of compromise; the political consequences to a debt default will be too great. Of course, it is Washington, so you never know.

European policymakers, meanwhile, have made much more progress, nearing a deal to rescue Greece and limit a potential "financial contagion" that could have pushed into other areas of Europe. The markets have responded quite well to that news.

All in all since our last newsletter, the S&P 500 returned -0.7%, while the Hot List returned -2.0%. So far in 2011, the portfolio has returned 7.8% vs. 6.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 190.9% vs. the S&P's 34.3% gain.

It's Different (But It's Not)

The economy's recent performance has been encouraging given the fears that the spring slowdown had raised. Still, while it's muddling through, the economy hasn't exactly been red-hot. After a reasonable start to the recovery, the problems dogging the economy have proved, well ... "sticky". First-quarter GDP grew by less than 2% and indications are that that will be the case again in the second quarter; unemployment remains around 9%; and the U.S. is, of course, dealing with a giant budget deficit.

All of that has a lot of people echoing the "this time it's different" refrain: "The recovery should be stronger", they say; "Unemployment should be lower by now"; "The housing market will never recover".

They're both right, and wrong.

They're right because this recovery is proving a bit different than those from recent memory. They're wrong because those recent recoveries may not be the recoveries we should be using as a yardstick.

That's what Barry Ritholtz, one of the strategists I keep a close eye on, wrote in a recent Washington Post column, and he makes a compelling case. Citing research performed by Professors Carmen Reinhart and Kenneth Rogoff, Ritholtz says that recoveries from recessions that involve credit crises have historically been a slightly different breed than other recoveries. "History suggests the correct frame of reference is not the usual contraction-expansion cycles, but rather credit-crisis collapse and recovery," he says. "These are not your run-of-the-mill recessions. They are far rarer, more protracted and much more painful."

Reinhart and Rogoff authored a paper back in early 2008 warning of the looming credit crisis. In it, they examined a handful of other credit crises that have occurred around the world, and found a number of similarities. Among them, Ritholtz notes:

-- Asset market collapses were prolonged and deep, with real housing prices falling 35% on average over six years and equity prices tumbling an average of 55%;

-- Aftermaths of banking crises are associated with profound declines in employment. After a financial crisis, Reinhart and Rogoff found that unemployment rates increased an average of 7 percentage points over four years.

-- Government debt surges, rising an average of 86%. And it's not because of bailouts -- it's because tax revenues plummet.

How does this recession/recovery stack up? Well, the S&P 500 declined 56.8% from its 2007 high to the 2009 low. Home prices? Through April, the S&P/Case-Shiller 10- and 20-city indices were 32.6% and 32.8% off their 2006 peaks -- putting both the equity and housing declines within a mere 3 percentage points of the averages Reinhart and Rogoff calculated. As for unemployment, it rose almost 6 percentage points from its pre-recession low to its 2009 high. The "U-6" measure of unemployment, which includes discouraged workers who've given up looking for jobs, rose about 9 points. And, of course, the U.S. deficit has surged, though not as much as the 86% figure. By the end of this year, it should be somewhere around 65% higher than it was four years ago.

Talking about numbers like these might seem depressing, but I think they are actually encouraging. They show that we're not, as many contend, in completely uncharted territory. Instead, the economy is following the same approximate path you'd expect to see, given the nature of the troubles it encountered in the last recession. The world is not ending, and there's no reason to think stocks or the economy are forever doomed. As long as hordes of investors continue to think that we are and avoid stocks, however, that makes for some exceptional buying opportunities -- even with the market nearly 100% off its 2009 low. The Hot List is continuing to find a number of those bargains.

Of course, that doesn't mean it's going to be smooth sailing from here on out -- it's never smooth and easy. But I do think that overall there are plenty of opportunities for long-term investors, and disciplined investors are wise to pounce on them.

Portfolio Update

As for the Hot List's current holdings, we've had some big movers since our last newsletter, on both the up and down sides. For-profit education firm Bridgepoint Education has been a big winner, gaining nearly 10% (through yesterday). Since joining the portfolio back in mid-March, the stock has gained about 65%, as investors apparently realized they overreacted to the concerns about the for-profit education industry.

On the down side, AmTech Systems is off about 10% since our last newsletter. The decline was a bit perplexing because the company actually updated its quarterly revenue forecast to $70 million, which would represent a 62% increase over the year-ago quarter and a significant increase over its May projection of $63 million to $66 million. There was speculation that the decline was due to a decrease in its order backlog, which fell to $140 million, down from $195 million at the end of the previous quarter. My models continue to be quite high on the stock, which gets strong interest from my Peter Lynch-, Martin Zweig-, and Joel Greenblatt-based approaches, and some interest from a couple other models.
 
Editor-in-Chief: John Reese










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Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach had just two variables: return on capital and earnings yield.

Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" -- it's only 176 pages long and small enough to fit in your jacket pocket -- broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt's youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason's business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices -- something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense -- and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past four years or so. So far, the model has been an exceptional performer. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 4.8%; the Greenblatt-based portfolio has gained about 80% -- that's 11.0% per year.

The Greenblatt portfolio also did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% in 2009, vs. 23.5% for the S&P. Greenblatt stresses that the strategy won't beat the market every month or even every year, however, which is important to remember. Over the long haul, though, it should produce excellent returns.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.

Here's a look at the current holdings of my Greenblatt-based portfolio:

Bridgepoint Education Inc. (BPI)
Lincoln Educational Services Corporation (LINC)
LHC Group (LHCG)
Oshkosh Corporation (OSK)
ITT Educational Services (ESI)
Meredith Corporation (MDP)
United Online, Inc. (UNTD)
Power-One, Inc. (PWER)
AmSurg Corp (AMSG)
Lender Processing Services (LPS)




"Magic"? Or Discipline?

While Greenblatt's methodology is completely quantitative, one of the most important aspects of his approach is psychological -- and it's something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn't in the specifics of the variables; it's having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn't always work -- a notion that is true for any good strategy.



News about Validea Hot List Stocks

AT&T Inc. (T): AT&T reported second-quarter net income of $3.6 billion, or $0.60 per diluted share, down from $4.0 billion, or $0.67 per diluted share, in the second quarter of 2010. EPS matched the year-ago EPS excluding the Telmex Internacional transaction from 2010's second quarter. Consolidated revenues were up 2.2% to $31.5 billion. Wireless revenues increased by 9.5%, and total wireless subscribers increased 1.1 million to 98.6 million

AstraZeneca PLC (AZN): The Food and Drug Administration approved AstraZeneca's anticlotting drug Brilinta for sale in the U.S., saying clinical trials showed the drug "was more effective than Plavix in preventing heart attacks and death, but that advantage was seen with aspirin maintenance doses of 75 to 100 milligrams once daily."



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

BPI   |   ASYS   |   LINC   |   DLTR   |   AZN   |   CSTR   |   SNY   |   SKX   |   T   |   RUE   |  



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.





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.





Lincoln Educational Services Corporation is a provider of career-oriented post-secondary education. As of December 31, 2009, the Company operated 43 campuses in 17 states. It offers recent high school graduates and working adults degree and diploma programs in five areas of study health sciences, automotive technology, skilled trades, hospitality services and business and information technology. For the year ended December 31, 2009, the Company's health science program, its automotive technology program, its skilled trades program, its hospitality services program and its business and information technology program accounted for approximately 37%, 31%, 13%, 10%, and 9%, respectively, of its average enrollment. The Company had 29,340 students enrolled as of December 31, 2009 and its average enrollment for the year ended December 31, 2009 was 27,808 students.





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.





AstraZeneca PLC (AstraZeneca) is a global biopharmaceutical company. AstraZeneca discovers, develops and commercializes prescription medicines for six areas of healthcare: Cardiovascular, Gastrointestinal, Infection, Neuroscience, Oncology, and Respiratory and Inflammation. It has a range of medicines that includes treatments for illnesses, such as its antibiotic, Merrem/Meronem and Losec/Prilosec for acid related diseases. AstraZeneca's products include Crestor, Seloken/Toprol-XL, Atacand, Nexium, Synagis, Seroquel IR, Seroquel XR, Arimidex, Zoladex and Symbicort. The Company owns and operates a range of research and development (R&D), production and marketing facilities worldwide. AstraZeneca operates in over 100 countries, including China, Mexico, Brazil and Russia. On March 3, 2010, AstraZeneca completed the acquisition of Novexel S.A. Novexel is a France-based research company focused on the infection therapy area.





Coinstar, Inc. (Coinstar) is a provider of automated retail solutions. Coinstar's core offerings in automated retail include its digital video disk (DVD) business, where consumers can rent or purchase movies from self-service kiosks (DVD Services segment), and its Coin business, where consumers can convert their coin to cash or stored value products at coin-counting self-service kiosks (Coin Services segment). As of December 31, 2010, the Company had approximately 30,200 DVD kiosks in 26,100 locations and 18,900 coin-counting kiosks in 18,700 locations (approximately 12,100 of which offer a variety of stored value products to customers) in supermarkets, drug stores, mass merchants, financial institutions, convenience stores, and restaurants. On May 25, 2010, the Company sold its subsidiaries consisting of its E-Pay Business to InComm Holdings, Inc. and InComm Europe Limited (collectively InComm).





Sanofi, formerly Sanofi-Aventis, is a global and diversified healthcare company. The Company discovers, develops and distributes therapeutic solutions focused on patients' needs. Sanofi focuses on the field of healthcare with seven growth platforms: diabetes solutions, human vaccines, innovative drugs, rare diseases, consumer healthcare, emerging markets and animal health. As of February 2011, Sanofi portfolio comprised 55 projects in clinical development, of which 13 were in Phase III or had been submitted to the health authorities for approval. Sanofi has a portfolio of prescription drugs, vaccines, generics and consumer healthcare products. Its prescription medicines include Lantus, which is an insulin band. The range of products in the field of diabetes also include Apidra and Amaryl. Its human vaccines for Polio/Pertussis include Pentacel and Pentaxim along with influenza vaccines (Vaxigrip et Fluzone). Its animal health products include Frontline and Heartgard.





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.





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.





rue21, inc. (rue21) is a specialty apparel retailer offering the newest fashion trends for girls and guys. As of January 30, 2010, the Company operated 535 stores in 43 states throughout the United States. The Company's merchandise is designed to appeal to 11 to 17 year olds who aspire to be 21 and adults who want to look and feel 21. In addition, it offers its own brands, such as rue21 etc!, Carbon, tarea and rueKicks, to create merchandise excitement and differentiation in its stores.





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.





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