|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||July 22, 2011|
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.
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.
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.
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
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