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|Executive Summary||December 9, 2011|
Over the past few months, a myriad of pundits and prognosticators have continued to predict that the surprisingly resilient US economy is on the verge of -- or has already entered into -- another recession. But as the days and weeks continue to go by, more and more economic data is confirming that the economy is continuing to plug along.
After being stuck between 8.8% and 9.2% for all of 2011, the unemployment rate dipped nearly half a percentage point to 8.6% in November, new Labor Department data showed. That the lowest it's been since March 2009 -- more than two-and-a-half years. The so-called U-6 unemployment rate, which includes those working part-time who can't get full-time work and discouraged workers would stopped looking for a job, also fell sharply, hitting its lowest level since March 2009.
And the labor market data continues to improve in December. New claims for unemployment fell 5.7% in the week ending Dec. 3. With the exception of one week back in February, they reached their lowest mark since mid-2008. Continuing claims, meanwhile, fell to their lowest level since the week that Lehman Brothers collapsed back in September 2008. Overall, the employment situation remains far from healthy, but the data shows that the picture is brightening somewhat -- ironically, during a period that many had predicted was going to be very weak for the economy.
New data also showed that both the manufacturing sector and the service sector continued to expand in November. The manufacturing sector expansion accelerated, with the Institute for Supply Management's manufacturing index rising from 50.8 to 52.7, its highest level since June. It marked the 28th straight month that the sector has expanded, according to ISM, a remarkable streak. The service sector expansion was the 24th straight, meanwhile.
While the U.S. data has been solid, investors remain fixated on Europe, where the sovereign debt crisis continues to move markets in the short term. The news and tenor shifts daily, with the latest news as of this writing being that the European Central Bank had cut interest rates by a quarter of a percent, to 1%. It also decided to offer new credit lines to eurozone banks, cut its reserve requirements for banks, and broadened the pool of assets it will accept as collateral for loans, according to The Wall Street Journal. A plan for the ECB to lend money to the International Monetary Fund, which would then lend the money back to eurozone countries -- a way to circumvent regulations that prevent the ECB from issuing the loans directly to countries.
But ECB officials seem to be downplaying previous reports that the central bank would ramp up its purchases of government bonds, reports that had initially heartened investors. European leaders are now meeting at a summit intended to try to stop a collapse of the eurozone and its currency, and investors will no doubt be watching every move they make.
All in all, the market has responded well to all of the news over the past fortnight. Since our last newsletter, the S&P 500 has returned 6.5%, while the Hot List has returned 6.2%. So far in 2011, the portfolio has returned -17.4% vs. -1.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 122.8% vs. the S&P's 23.4% gain.
Time To Choose
As we head into the home stretch of 2011, the Hot List portfolio is trying to rebound from what so far has been one of its worst years, relative to the broader market. As of Dec. 8, the portfolio was down 15%, while the benchmark S&P 500 was just about flat for the year. Since its 2003 inception, the Hot List has lagged the index in only two other years. One was last year, when it was close to a dead heat with the S&P. The other was 2007, when the portfolio lost 11.6%, and the index gained 3.5%.
To be sure, the performance so far this year is disappointing. And disappointment has been the story far and wide across the market for active investment strategies. Earlier this month, CNBC.com reported that just 23% of large-cap fund managers were beating the S&P 500 on the year, citing Bank of America Merrill Lynch data. And just 27% were beating the large-cap Russell 1000 index. While active fund managers in general have a poor track record of beating the market over the long haul, those numbers are particularly bad.
And, some of the most successful long-term fund managers are among those struggling. Bruce Berkowitz, David Herro, Mason Hawkins and Stanley Cates -- these and other managers with decade-long track records of far outpacing the market have had bad years.
I bring this up not to make excuses or to downplay the Hot List's underperformance this year. I bring it up because it begs two larger, interconnected questions: Why are so many successful strategies failing in 2011, and does that signal a shift in what works and what doesn't work in stock investing?
With regard to the first question, the main reason for the underperformance of the Hot List and those top-performing managers seems to revolve around fundamentals and value. I've studied investment strategies for more than a dozen years, and in that time I've found that just about all successful strategies -- whether they lean toward the growth or value school -- include some sort of value component, and rely heavily on fundamentals.
But in the short term, fundamentals can fall prey to greed -- as happened during the Internet bubble -- and fear -- as they have recently. And trying to guess just when emotion will overtake (or give way to) fundamentals is a matter of guessing how millions of investors will act on a specific day -- that is, it's nearly impossible.
So recently, fear has been in the driver seat, with the European debt crisis superceding everything in investors' minds. Any sign of trouble in that part of the world thus hits the U.S. markets like a ton of bricks -- in large part because the 2008 financial crisis and market plunge remain so fresh in investors' minds. Individual stock fundamentals mean little to most investors, who dump stocks indiscriminately on negative European news, each time thinking another 2008 is upon us.
But this isn't 2008. In the U.S., corporations and consumers are in better position than they were three years ago, with both having paid down debt. And corporations have stockpiled near-record amounts of cash, fearful of getting caught again in an overextended position if another downturn hits. In their recent quarterly letter, Hawkins and Cates (whose funds have very strong long-term track records) touched on this. They said the strong positioning of many firms has made it so that, if we do hit another recession, it "would be like stepping off of a curb rather than falling from a skyscraper for these businesses and their values." That's a far cry from 2008, when companies were well overextended, and valuations were inflated.
Here's something else to consider: Many of the best performing funds in 2011 have had very little success prior to this year. According to Morningstar, the top performing large-cap value fund this year ranked in the 88th percentile in its class in 2010, and the 72nd percentile in 2009. The second-best performer ranked in the 84th percentile in 2010 and the 97th percentile in 2009. The third-best: 63rd percentile in 2010, 75th percentile in 2009. The fifth-best: 99th percentile in 2010, 100th in 2009. I skipped the fourth-best because it did quite well in 2010, coming in in the 2nd percentile in its class. But in 2009, it was in the 96th percentile. In other words, what worked in 2011 in most cases didn't work in previous years. Some of the year's top funds actually have bad track records going back a decade or more, which lends credence to the notion that what we're seeing this year is something of an anomaly.
The thuth is that even good strategies go through bad periods. It's inevitable. If a strategy worked every month or every year, everyone would pile into it, driving the prices of the stocks the strategy identifies up to levels that would lead to diminished returns. That's what Joel Greenblatt astutely notes in his Little Book that Beats the Market. Greenblatt -- upon whose writings I base one of my best-performing strategies -- says that, while his approach has posted exceptional returns over the long haul, it has had one-, two-, and even three-year periods where it has lagged the market. "Although over the short term, Mr. Market may set stock prices based on emotion, over the long term, it is the value of the company that becomes most important to Mr. Market," he says, using the term Benjamin Graham coined for the stock market. "This means that if you buy shares at what you believe to be a bargain price and you are right, Mr. Market will eventually agree and offer to buy those shares at a fair price. In other words, bargain purchases will be rewarded. Though the process doesn't always work quickly, two to three years is usually enough time for Mr. Market to get things right."
For the past year, we've been in one of those periods in which Mr. Market hasn't been agreeing with us. Such periods are trying on one's psyche, but how you deal with these periods is what separates successful investors from the also-rans. Remember what James O'Shaughnessy said in his updated version of What Works on Wall Street, which is one of the most extensive studies of investment strategies ever done: "Consistency is the hallmark of great investors and is what separates them from everyone else. If you use even a mediocre strategy consistently, you'll beat almost all investors who jump in and out of the market, change tactics in midstream, and forever second-guess their decisions."
In the end, I think at times like this investors need to make a basic choice: If you think that after decades upon decades, stock investing has fundamentally (pardon the pun) changed so that the fundamentals that have mattered for decades -- metrics like return on equity, price/book and price/sales ratios, dividend yield, and return on capital -- no longer matter, then it may be time to scrap your strategy. To me, that's an incredibly risky assumption. Fundamental-based value investing works because it is grounded in real concepts. Fundamentals identify businesses that have track records of successfully using investors' money to generate strong returns, and they then identify which of those companies have shares that are trading on the cheap. Those concepts are at the core of business and investing, and I don't think they have changed, or will change anytime soon.
The other choice is to stick to a strategy that has proven itself over the long run, a strategy that you believe makes sense at its core, regardless of what may be happening in the short term. That's the choice I'll make. Even with its recent struggles, the Hot List is still averaging annualized returns of more than 10% over its eight-plus years, while the S&P 500 has returned just 2.8% annualized. That's a track record few fund managers can claim, and the portfolio has built that track record using an approach -- focusing on strong companies with cheap shares -- that I believe still makes sense at its core. So we'll stick with it, and I believe that over the long haul Mr. Market will reward our discipline.
Guru Spotlight: David Dreman
While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.
But while most of these gurus are contrarians, one in particular is known for being, well, the most contrarian: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.
Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).
How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, 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, like Altria and Tyco. 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.
Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)
But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.
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. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."
This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.
But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and 23.1% in 2010 (vs. 12.8% for the S&P). It has struggled in 2011, but remains far ahead of the broader market over the long haul. Since its July 2003 inception, the 10-stock Dreman-based portfolio has returned 67.7%, or 6.3% annualized, vs. 26.0%, or just 2.8%, for the S&P (through Dec. 7).
As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Right now, its holdings include some very unloved firms, with a major tilt toward international stocks. Here's the full list of its current holdings:
AstraZeneca PLC (AZN)
BP PLC (BP)
Petroleo Brasileiro SA (PBR)
Southern Copper Corporation (SCCO)
Assured Guaranty Ltd. (AGO)
Total S.A. (TOT)
Telecom Argentina S.A. (TEO)
Eni S.p.A. (E)
Triangle Capital Corporation (TCAP)
Banco Macro SA (BMA)
News about Validea Hot List Stocks
Aeropostale Inc. (ARO): Aeropostale reported third-quarter earnings of $24.1 million, or $0.30 per share, down from $58.5 million, or $0.63 per share, in the year-ago period, The Wall Street Journal reported. Net sales fell just 1% in the period, but input costs rose about 14%, contributing to the earnings decline. The company forecast a fourth-quarter profit of $0.35 to $0.38 a share, below analysts' average estimates of $0.43, according to Thomson Reuters.
AstraZeneca PLC (AZN): The European Commission has approved the treatment Onglyza, which is co-marketed by Bristol-Myers Squibb and AstraZeneca, to be used in combination with insulin on diabetes patients, the Associated Press reported. Onglyza already is approved for use in several other combinations to treat diabetes patients, but the pairing with insulin is not approved in the United States, AP stated.
The Next Issue
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