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Executive Summary January 17, 2014

The Economy

The stellar economic news that marked the end of 2013 has given way to more mixed reports early in 2014, leaving investors to wonder if last year's momentum will continue in the new year.

On the positive side, the service sector expanded in December for the 48th straight month, according to the Institute for Supply Management. The rate of the expansion slowed slightly, but was still at a very healthy pace. What was a bit troubling was a sharp decline in new orders, which fell into contraction territory (though just barely) for the first time since mid-2009 as businesses indicated that they drew down their inventories significantly without replacing them. We'll have to see if this was a short-term issue or part of a trend. ISM's service sector employment sub-index indicated that employment conditions improved significantly during the month.

Retail sales, meanwhile, rose 0.2% in December, the Commerce Department reported. That put them about 4.3% ahead of where they were a year earlier, a solid year-over-year gain.

As for the recent unemployment data, it's been a very mixed bag. While private payroll processor ADP estimated that the private sector added 238,000 jobs in December -- the highest total for any month in 2013 -- the Labor Department put the figure at just 87,000, one of the worst months we've seen in some time. The Labor Department report also showed, however, that the unemployment rate fell from 7.0% to 6.7%, its lowest level since October 2008. The reason was in large part that the number of people in the labor force fell sharply, by 525,000.

Many bears will point to that as a result solely or primarily of workers being so discouraged about the job market that they stop looking for work. But as I've noted in the past, the decline in the headline unemployment rate has been accompanied by a decline in the "U-6" unemployment rate, a broader measure that includes discouraged workers. That figure held steady in December at 13.1%, a full 1.3 percentage points lower than it was one year earlier. The U-4 rate, which is the headline rate plus discouraged workers, actually declined from 7.4% to 7.2%.

So what gives? I'd recommend checking out a recent Washington Post piece from Brad Plumer, which looks at different factors causing the decline in the labor force. One is indeed discouraged workers, but another factor is demographics that have nothing to do with the strength of the economy -- the Baby Boomer generation is hitting retirement age, and the acceleration of retirements may account for as much as half of the decline in workforce participation since the Great Recession, according to some studies, Plumer says. It's a complex issue -- some retirees may have continued to work if more jobs were available, for example, making it hard to classify their withdrawal as demographic-driven or labor market-driven. The increase in people going on the disability rolls, which I've touched on before, is another factor, Plumer says. The bottom line, I think, is that this is a complex issue; don't believe those who say the declining unemployment rate is a mirage.

Since our last newsletter, the S&P 500 returned 0.8%, while the Hot List returned -3.2%. So far in 2014, the portfolio has returned -4.3% vs. -0.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 248.2% vs. the S&P's 84.5% gain.

Reasons for Optimism

While flows into domestic equity funds picked up in October and November, they have since fallen off rather sharply. And, while there are fewer disaster-type fears hanging over investors' heads, the general mood is far from ebullient, with many expecting a weak year for stocks after 2013's stellar -- perhaps too stellar? -- performance.

I wouldn't be so sure. Of course, in the short term anything can happen, and no one knows just how much the market will return in 2014. After all, think how many people actually predicted that the S&P 500 would return close to 30% in 2013. But I do see reasons for optimism heading forward -- signals that tell me this is not time to cut back on equities if you are a long-term investor. Here a few of those reasons.

The Economy: Yes, the economy still has a lot of lingering problems and growth is far from gangbusters. Unemployment -- in terms of both the headline and broader measures -- remains high, most notably. But there were a lot of really good signs in 2013, particularly in the second half of the year. Housing starts were more than 33% above where they stood a year ago in November (the latest data available). New home sales, meanwhile, were up about 18% through November, according to the Census Bureau. Manufacturing activity surged in the second half of the year, increasing in December for the 7th straight month, and at close to the fastest pace in two years, according to ISM. The group's manufacturing sub-indices for both new orders and employment are at high levels. ISM also said the service sector expanded in December for the 48th straight month. And the latest revisions show that GDP increased at a greater than 4% rate in the third quarter, one of the better figures we've seen over the past few years. All of this occurred amid the government budget sequestration that was expected to put a major crimp on growth in 2013.

Valuations: On the whole, the market is no longer cheap (though plenty of cheap individual stocks do remain). But it's also not grossly overvalued. The S&P 500's price/earnings ratio based on trailing 12-month operating earnings is about 17; its forward P/E (using projected operating earnings) is about 15. The index trades for about 2.6 times book value, according to Morningstar, and about 1.7 times sales. Those figures have been rising, but they indicate that we are probably merely on the high side of the fair value range -- at worst very slightly overvalued. And that's nothing to be worried about. By definition, you're sometimes going to be on the high side of an average. It seems to me that lingering fears from the 2008 crash, and perhaps even the 2000 crash, are making investors see anything but dirt cheap valuations as a reason to worry. History has shown that simply is not the case. Stocks can and usually do move far beyond their average historical valuations during bull markets -- and they often do so for quite some time.

The False Fear: Kenneth Fisher, whose writings form the basis of one of my best performing Guru Strategies, has talked about the "fear of false factors", saying that he takes it as a bullish sign when investors are worried about issues that in reality don't matter that much. (He has used the fiscal cliff as an example.) Right now, I see a false factor being feared -- the notion that the magnitude of last year's gains was so great that this year makes us due for underperformance. The mindset among many investors seems to be that last year's rally was so fast and strong and unexpected that in 2014, investors will quit while they're ahead, take profits, and drive the market downward. But history shows that big years for the market do not, in fact, tend to be followed by some sort of corrective downturn. Since 1960 there have been 18 years in which the S&P has gained more than 20% (prior to 2013). The average return for stocks the next year: 11.4%, a little bit above long-term historical norms. The worst return following one of those big years came in 2000, when the S&P lost 9.1% -- not exactly a disaster. That was one of only five years when a 20%-plus year was followed with a negative return. In half of those 18 occasions, the 20%-plus year was followed by a year in which the S&P went on to gain at least another 15%.

Perhaps you're thinking that the current situation is a bit different, in that growth wasn't particularly strong in 2013. Perhaps in those other 20%-plus years, strong growth merited the big gains, while in 2013 the market was "getting ahead of itself", meaning that there's more likelihood of a pullback in 2014. Well, the data tells a different story. In those 18 20%-plus years since 1960, GDP growth on average was a mere 2.5%. In five of those big years it was actually negative. In 1975, for example, the S&P gained 37.2% while the economy shrank by 0.2%. In 1976, the index gained another 23.8%. Interestingly, in 1976 GDP jumped by 5.4%, which you might think would provide good momentum going into 1977. It didn't. In '77 the S&P fell 7.2% -- even though GDP continued to expand by 4.6%.

Of course that 1975 to 1977 period was different in many ways from today. Factors like inflation, politics, timing (1975 was the first full year of a bull market whereas in 2014 we'll hopefully reach this bull's five-year mark) were all surely involved in the gains and losses of those years. But isn't that the point? Rarely do stocks move because of one single factor. Instead the market is a complex machine that factors in a myriad of issues and data points. The notion that 2014 would be a down year simply because 2013 was such a good year just has no basis in reality -- and the pessimism that this false fear creates very well may lead to a buying opportunity.

As I noted earlier, no one knows what's going to happen in the market in the short term. So many surprises can pop up that aren't even on the radar right now. Given that, and given the exceptional history and upside that equities offer, the question to me is not, "how will stocks do in 2014," but instead, "do I see such risks -- be they economic, valuation-related, or otherwise -- that I would want to pass up a chance to benefit from what has been the best investment vehicle of all time? Right now, I don't see that kind of risk. In fact, to the contrary, I see more potential reward than risk for long-term investors.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 1 stocks leave our portfolio. These include: Chevron Corporation (CVX).

The Keepers

9 stocks remain in the portfolio. They are: Agco Corporation (AGCO), The Tjx Companies, Inc. (TJX), Usana Health Sciences, Inc. (USNA), Cnooc Limited (Adr) (CEO), Lukoil (Adr) (LUKOY), Lear Corporation (LEA), Alliance Fiber Optic Products Inc (AFOP), Hollyfrontier Corp (HFC) and Hci Group Inc (HCI).

The Newbies

We are adding 1 stocks to the portfolio. These include: Bofi Holding, Inc. (BOFI).

Portfolio Changes

Newcomers to the Validea Hot List

BofI Holding, Inc. (BOFI): BofI -- short for "Bank of Internet" -- is the holding company for BofI Federal Bank, a diversified nationwide bank that provides financing for single and multifamily residential properties, small-to-medium size businesses in target sectors, and selected specialty finance receivables. Though it has just one location -- in San Diego -- its Internet business allows it to have approximately $3.3 billion in assets and approximately 40,000 retail deposit and loan customers across all 50 states.

BofI ($1.1 billion market cap) gets high scores from my Peter Lynch- and Motley Fool-based models as well as my Momentum Investor approach. To read more about the stock, scroll down to the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

USANA Health Sciences (USNA): USANA shares tumbled about 10% on Jan. 16 after fellow multi-level marketer Nu Skin Enterprises acknowledged revenue from China will likely be hurt by a government investigation there. According to Investor's Business Daily, China's People's Daily newspaper criticized Nu Skin for aggressive tactics and false marketing, characterizing the firm as a pyramid scheme and claiming it sells 20 more products in China than the government has given it approval for. The State Administration for Industry and Commerce is opening an investigation into the company, which said the claims were inaccurate or exaggerated. Though Nu Skin appears to be the target of the investigation, investors seemed worried USANA might face a similar fate, leading to the selloff.

Alliance Fiber Optic Products, Inc. (AFOP): Shares of Alliance surged more than 12% on Jan. 16. There did not immediately appear to have been a company specific catalyst for the move, nor did there appear to be an industry or competitor related catalyst. We will continue to keep an eye on the stock, and may have a better idea of what was behind the jump next newsletter.

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 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

USNA   |   HCI   |   LUKOY   |   LEA   |   HFC   |   AFOP   |   BOFI   |   CEO   |   TJX   |   AGCO   |  

USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.

HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.

NK Lukoil OAO (Neftyanaya Kompaniya LUKOIL OAO or NK LUKOIL OJSC) is a Russia-based integrated oil and gas company. The Company is engaged in the business of oil exploration, production, refining, marketing and distribution. It is an owner of refineries, gas processing, petrochemical plants and gas stations network located in Russia, Eastern and Western Europe, as well as Africa. The Company's petroleum products are sold in the Russian Federation, the Commonwealth of Independent States (CIS) countries, Eastern and Western Europe, Asia and the United States. NK Lukoil OAO operates through numerous subsidiaries and affiliated companies. In April 2013, the Company acquired a 100% of Samara-Nafta ZAO and completed acquisition of CJSC Kama-Oil. In June 2013, it sold a 99.57% stake in Lukoil Odes'kyi NPZ PAT. The Company's major shareholder is NKO ZAO NRD with a stake of 91.60%. In December 2013, it consolidated a 100% stake in ISAB Srl.

Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.

HollyFrontier Corporation (HollyFrontier), formerly Holly Corporation, is a petroleum refiner, which produces light products, such as gasoline, diesel fuel, jet fuel, specialty lubricant products, and specialty and modified asphalt. HollyFrontier operates in two segments: Refining and Holly Energy Partners, L.P. (HEP). The Refining segment includes the operations of its El Dorado, Tulsa, Navajo, Cheyenne and Woods Cross Refineries and NK Asphalt. The HEP segment involves all of the operations of HEP. As of December 31, 2011, it operated five refineries having a combined crude oil processing capacity of 443,000 barrels per day that serve markets throughout the Mid-Continent, Southwest and Rocky Mountain regions of the United States. The Company merged with Frontier Oil Corporation (Frontier), on July 1, 2011. On November 9, 2011, HEP acquired from the Company certain tankage, loading rack and crude receiving assets located at its El Dorado and Cheyenne Refineries.

Alliance Fiber Optic Products Inc. (AFOP) designs, manufactures and markets a range of fiber optic components, and integrated modules incorporating these components, for communications equipment manufacturers and service providers. The Company offers a range of products, including interconnect devices that are used to connect optical fibers and components, couplers and splitters that are used to divide and combine optical power, and dense wavelength division multiplexing (DWDM) devices that separate and combine multiple specific wavelengths. The Company's optical passive products include wavelength division multiplexing (WDM), coarse wavelength division multiplexers (CWDM) and DWDM components and modules that utilize thin film filter technologies to separate optical signals, variable attenuators, optical switches and other optical devices utilizing micro optic lensing technology including integrated electro-optical modules incorporating these products.

BofI Holding, Inc. is a holding company for BofI Federal Bank, a diversified financial services company. The Bank operate its bank from a single location in San Diego, California, serving approximately 40,000 retail deposit and loan customers across all 50 states. As of June 30, 2012, it had total assets of $2,386.8 million, loans of $1,799.7 million, mortgage-backed and other investment securities of $483.0 million, total deposits of $1,615.1 million and borrowings of $547.2 million. It distributes its deposit products through a range of retail distributions channels, and its deposits consist of demand, savings and time deposits accounts. It distributes its loan products through its retail, correspondent and wholesale channels, and the loans it retains are primarily first mortgages secured by single family real property and by multifamily real property.

CNOOC Limited is an investment holding company. The Company, along with its subsidiaries, is a producer of offshore crude oil and natural gas and an independent oil and gas exploration and production company. Its subsidiaries are engaged in exploration, development, production and sales of oil and natural gas. It has three segments: independent operations, operations under joint arrangement and trading business. The Company has four producing areas in offshore China, which include the Bohai Bay, Western South China Sea, Eastern South China Sea and East China Sea. It also has oil and gas assets in Indonesia, Iraq, Australia, Africa, North America and South America. As of December 31, 2012, its subsidiaries included CNOOC China Limited, CNOOC International Limited, China Offshore Oil (Singapore) International Pte Ltd and others.

The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office. In December 2012, the Company acquired Sierra Trading Post, an off-price Internet retailer.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

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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