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|Executive Summary||September 16, 2011|
Given that the headlines of the past month or two have been dominated by the financial crisis in Europe and fears of another recession in the U.S., you'd expect the latest round of economic data to show a major downturn in U.S. economic activity.
So far, however, that hasn't happened. Rather than a major downturn, the latest numbers are showing that activity for the past month or two has been relatively flat. That's certainly not what we want to see, but it's far better than many have been predicting.
In fact, some of the data has actually been positive. The service sector expanded at a healthy pace in August, for example, according to the Institute for Supply Management. It was the 21st straight month the sector has expanded, and it did so at a faster rate than it did in July. The group's employment and new orders sub-indices also both showed growth for the month.
Industrial production also increased in August, according to the Federal Reserve, the fourth straight month it increased. And that was in spite of one of the three main industrial groups -- utilities -- posting a 3% decline because temperatures moderated during the month.
The latest Commerce Department data showed that business sales and inventories both increased in July, indicating that businesses were more confident about the economy than you might think. They aren't confident enough to start hiring, however. The August jobs report from the Labor Department showed that job creation was flat for the month, a very disappointing figure. The headlines seemed to be a bit misleading on this, however. Many blared some variation of "Zero job growth for first time since 1945", as though the results were the worst since 1945. Of course, there have been plenty of months over the past 66 years when job growth was negative. August was simply the first time it had been exactly zero -- no growth, no shrinkage -- since '45.
Like job growth, retail and food service sales were also flat in August, after two straight months of gains. Not a good sign, but, again, we're talking about flat growth -- not the huge decline that many were expecting.
New claims for unemployment, meanwhile, have risen slightly (about 4%) since our last newsletter, a discouraging sign. They are still significantly higher than they'd need to be to make a dent in the unemployment rate. There's some hope on the horizon though -- job openings hit their highest level in three years in July, according to the Labor Department. Typically it takes a couple months to fill openings, so we could be looking at some decent hiring numbers in September or October -- if employers are hiring people who are unemployed, not those who are simply switching from another job.
That's part of what President Obama's $447 billion jobs bill aims to do -- provide incentives for employers to hire those who have been out of work for more than six months. There are some big questions about whether that will work, however. As Charles Schwab's Liz Ann Sonders noted recently, employers tend to add jobs not because of short-term incentives; they do so because they see increasing demand on the horizon and have confidence in the longer-term picture. And until some of the major regulatory questions -- what will happen with taxes, and whether Obama's healthcare bill will be repealed -- are resolved, Sonders says businesses lack the clarity and confidence to make major investments in new employees.
All in all, since our last newsletter, the S&P 500 returned 0.4%, while the Hot List returned 1.6%. So far in 2011, the portfolio has returned -9.1% vs. -3.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 145.4% vs. the S&P's 20.9% gain.
Tune Out The Noise
Lately -- for the past few years, in fact -- it seems like macroeconomic factors have had a far greater impact on the market than have individual stock fundamentals. Some have termed it the "risk-on, risk-off" trade: Negative news about the global economy sends equity investors rushing herd-style for the door, fearing another 2008-like crisis and market crash; when economic news is good (or "less bad"), they breathe a sigh of relief and pile back into equities. Often, this occurs indiscriminately. It doesn't matter much what the individual stock or company does -- if the broader economic news is bad, sell it; if the news is okay, buy it.
Correlation levels bear out this trend. The Chicago Board of Options Exchange runs a "correlation index" that measures how closely the movements of the S&P 500 components track each other. The index had been in the 40 to 50 range in the months leading up to the Lehman Brothers collapse; after, it rose sharply, topping 100 in November 2008. It fell quite a bit, but hasn't gotten back to pre-Lehman levels, staying well above 50 for most of the nearly three years since. It's been rising since late July as the Europe fears have heated up, and for the past couple days has been in the low-80s.
This can be maddening for a value investor. After all, value investors depend on certain stocks becoming overvalued and others becoming undervalued. When everything moves more or less together, a wrench is thrown into that whole process. Stocks move less on their earnings power and share prices, and more on vague premonitions and hunches. One day, a resignation by a top European Central Bank official sends the market plunging downward, as investors fear it's a sign that Europe won't be able to pull together to fix its problems. Another day, the German Chancellor makes some positive comments about Greece, and the market jumps -- all is well again.
Some say this has brought in a new age of investing, one in which you have to play the risk-on, risk-off game, and somehow do it better than the masses. To those who try, I say good luck. Because, most likely, luck is the only thing that will work if that's the game you're playing. Think you can predict what top European officials will do or say from day to day? Or that you can jump in early -- ahead of the high-frequency traders -- when the market starts to assert an upward or downward trend on a given day? I certainly can't do either of those things. And frankly, I don't know anyone who can. I think even great investors like Warren Buffett, Benjamin Graham, Joel Greenblatt, and Peter Lynch would readily admit that they can't either.
What to do then? Well, in a recent Wall Street Journal article, Jason Zweig offered some insights. One big thing you can do is keep perspective, he says, and I couldn't agree more. The first step in doing that is realizing that, while it may seem like today's market is more at risk from macro factors than markets of the past were, it's really not. Back in a March newsletter I noted that the notion of "normal" times is a misguided one. While today macro events like the European banking crisis, U.S. debt, and terrorist threats play on investors minds', a myriad of other macro events -- many with far wider-reaching impacts -- played on investors' minds in the past. World War II threatened to end our country as we know it. The opening of China to the outside world created tremendous opportunity, and uncertainty, in the global economy. So too did the fall of the Soviet Union -- which, at the time, was the largest nation in the world.
In his article, Zweig interviews investment advisor William Bernstein, who, in addressing the issue of terrorism and the supposed "unprecedented" impact it has on the economy, put things in crystal-clear perspective: "Two generations ago, the U.S. endured a global conflict that cost 50 million lives," Bernstein said. "The next generation faced down the Soviet Union and its 20,000 nuclear warheads. If you had told Americans then that the U.S. should someday be even more afraid of a handful of jihadis from countries that couldn't even make their own bicycles, they'd have keeled over laughing."
I don't mean to make light of the problems facing us today. They are very serious indeed, and there is no guarantee they will be fixed efficiently or in totality. But I believe we've lost some perspective. And a big reason, as Zweig astutely notes, is the tremendous advances in information-sharing. "The average person lives today in a virtually mediated reality," Sheldon Solomon, a psychology professor at Skidmore College, told Zweig. "Thanks to the unfiltered spread of news over services like Facebook and Twitter, we all get a wide variety of instantaneous images that are likely to have more-inflammatory effects."
You also have instantaneous access to your portfolio. Every time the market drops, you see it right there on the screen, and it can hit you right in the gut. That's led many investors to shorten their time horizons, Zweig notes, when they should in fact be lengthening them.
I agree. If you think you can time all of the macro news and move in and out of the market in short intervals, you're most likely fooling yourself. Equity investors have over the past 20 years (through 2010) averaged annualized returns of 3.83%, according to the research firm Dalbar, Inc. In the same period, the S&P 500 has gained 9.14%. By jumping in and out of the market at the wrong times, investors have cost themselves more than 5 percentage points per year. From 2008-2010 -- as this brave new "macro" world took hold -- investors fared slightly better, but still lagged the S&P by about 1.4 percentage points per year. Their hunch-playing, on average, still detracted from their returns.
Instead of trying to time the market's day-to-day or week-to-week swings, I'd rather stay the course and stick to a good strategy for the long term. Let the traders take each others' money -- and then give it right back -- as they try to outguess the market in the short term. Focus on the fact that plenty of good values exist right now in the market -- eight of the ten stocks in the Hot List have price/earnings ratios (using trailing 12-month earnings) of 12 or lower, even though they have been growing earnings at rates of 13% to 50% over the long term. Of the nine non-financials, five have no long-term debt, one has a debt/equity ratio of less than 1%, and three have debt/equity ratios between 18% and 39%. And there are plenty of other stocks out there that are nearly as attractive.
History has shown that when fears are high, those who buy equities with a long-term perspective make out well. They buy low -- maybe not at the absolute low, but low enough -- and good things happen when you buy low. Remember, when Lehman Brothers collapsed exactly three years ago yesterday, on September 15, 2008, many said those who kept buying stocks -- particularly U.S. stocks -- were headed for ruin. Well, it's three years later, and the S&P 500 is actually in the black, and the Nasdaq Composite is up about 20%. And those are indices. Many good stock-picking strategies have fared far better. Since Sept.1, 2008 (we track monthly data but not day-to-day data, thus the slightly different start date), my Motley Fool-inspired portfolio, for example, is up 47.7%. My Joel Greenblatt-based portfolio has gained about 15%. The Hot List is right around even, not a bad place to be given that we're not even fully healed from the 2008 crisis and Great Recession.
Just as importantly, the portfolio is well positioned to take advantage of the current fears and resulting bargains in the market going forward. Others can crowd into overpriced bonds, speculate on gold, or sit in cash that is yielding virtually nothing -- we'll stick with stocks, block out the day-to-day noise, and focus on long-term value.
Guru Spotlight: Peter Lynch
Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".
If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.
Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.
Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.
But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.
The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.
To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.
The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG as a way to make sure he wasn't paying too much for growth really makes him a hybrid growth-value investor.
One Size Doesn't Fit All
One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).
The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.
"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.
One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.
Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.
Beyond The PEG
The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)
The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.
For most of the time since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has been one of my better performers. It's run into a very rough patch in 2011, however, and is down 19.1% year to date (all figures in this paragraph through Sept. 14). Still, even with that rough patch, the strategy is averaging annualized returns of 6.4% since its inception -- a very respectable return considering the S&P 500 has averaged annual returns of 2.1% over the same period. Interestingly, the 20-stock Lynch-inspired portfolio we track has held up much better this year, and has one of the best long-term track records of all my portfolios. It has averaged annual returns of 13.3% since its July 2003 inception, vs. that 2.1% figure for the S&P. That would seem to be a sign that the strategy is a solid one, and that the 10-stock portfolio's troubles should be short-term issues.
Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:
TeleNav, Inc. (TNAV)
Capella Education Company (CPLA)
Tech Data Corporation (TECD)
Ternium S.A. (TX)
STMicroelectronics N.V. (STM)
Xyratex Ltd. (XRTX)
Superior Industries International, Inc. (SUP)
OmniVision Technologies, Inc. (OVTI)
Rudolph Technologies, Inc. (RTEC)
Advanced Energy Industries, Inc. (AEIS)
The Stomach's The Key
While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success, and it's one that is particularly relevant given the portfolio's rough recent run: Don't bail when things get bad.
Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."
Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.
That, of course, is particularly hard to do when the market gets volatile. But the fear and anxiety investors feel during such times make it more important than ever to heed Lynch's advice: "The real key to making money in stocks," he once said, "is not to get scared out of them."
News about Validea Hot List Stocks
Micron Technology Inc. (MU): Micron shares had soared 27% (as of mid-afternoon Sept. 15) since the Hot List picked up the stock on Sept. 2. The move lacked a specific catalyst, but it seemed that value (the stock had lost more than half its value since late April amid concerns that chipmakers would be hit hard by an economic downturn) and optimism that the chip industry has taken the worst of its licks seemed to be at work.
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 firstname.lastname@example.org.
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