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Executive Summary January 2, 2015

The Economy

As the New Year begins, the U.S. is putting up some of the most impressive economic numbers it has since the expansion began back in 2009.

Gross Domestic Product growth for the third quarter was revised upward to 5.0%, for example -- the fastest pace since 2003. Bears have argued that the 5.0% figure is propped up by some factors that aren't bullish -- some of the gain was due to improvement in net exports, which was more to do with lower imports than increased demand for exports, for example. (Of course, many of these same bears ignore mitigating factors when they are a drag on GDP.) The bottom line is that 5.0% growth is very hard to ignore, and it's a sign that the US economy has been gaining steam (even as quantitative easing, which some said was propping up a weak economy, was winding down)

The latest consumer data was also impressive. The Commerce Department said that personal income jumped 0.4% in November, with real disposable personal income up 0.5%. Real personal consumption expenditures surged 0.7%. The personal savings rate fell slightly but was still a solid 4.4%.

Elsewhere, new claims for unemployment rose bit over the past two weeks, but in the most recent week were still close to 14% lower than they were in the year-ago period. Continuing claims, the data for which lag new claims by a week, edged slightly lower since our last newsletter and are 17.6% below year-ago levels.

New home sales fell by 1.6% in October, meanwhile, according to a new government report. That put them about 3% below year-ago levels.

Gas and oil prices, meanwhile, keep tumbling. A gallon of regular unleaded on average cost $2.26 as of Dec. 31, down 52 cents from a month earlier, according to AAA. As I've noted before, the gas price declines should give consumers a bit of a boost. But it is a double-edged sword. The energy sector is a big facilitator of job growth, and at some point, if the lower prices lead to less production, all of this could have an impact on the jobs market.

Since our last newsletter, the S&P 500 returned 2.3%, while the Hot List returned 1.1%. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 223.4% vs. the S&P's 105.8% gain.

Portfolio Update

The final two weeks of 2014 were relatively quiet ones for the Hot List. Since our last newsletter, six of the portfolio's ten holdings are in the black, with four in the red. Leading the way was United Insurance Holdings Corp., which was up 3.8% (all figures through Wednesday's close). UIHC announced that it has entered into merger plan with Family Security Holdings, the parent of Family Security Insurance Company (a Hawaii-based property and casualty insurer), and Family Security Underwriters (a managing general agency performing administrative and marketing services for FSIC).

Universal Insurance Holdings also notched a nice game, rising 2.4%. There didn't seem to be a stock-specific catalyst for its rise, so it may have been a case of industry issues or just noise moving the stock.

On the downside, Silicon Motion Technology Corp. was down 4%. There didn't seem to be any major catalyst for the decline, so it may have been another case of short-term noise in a small cap stock, particularly given that it was the end of the year. AmTrust Financial Services, meanwhile, was down 2.4%. That decline did appear to have a catalyst: statements from Alistair Capital alleging that AmTrust has "significant accounting problems that put shareholders, creditors, and policyholders at grave risk." The firm is requesting an investigation into AmTrust. No wrongdoing has been proved at this point, however.

Two weeks from now, we'll conduct our first regularly scheduled rebalancing of 2015. At that point we'll see if AmTrust and the portfolio's other holdings will have what it takes to remain in the Hot List .

 
Editor-in-Chief: John Reese










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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.

A Market-Beater

Over the long term my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. Overall since I started tracking it in July 2003, the portfolio has averaged annualized returns of 10.9%, easily beating the 6.6% annualized return for the S&P 500 (all performance figures are through Dec. 30). With one trading day left in 2014, it was up 9.2% while the index was up 12.6%. But that follows a year in which the Lynch portfolio gained 68.6%, more than doubling the S&P. The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 14.7% annualized since its mid-2003 inception.

Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:

Silicon Motion Technology Corporation (SIMO)
IDT Corporation (IDT)
FutureFuel (FF)
HCI Group (HCI)
WSFS Financial Corporation (WSFS)
New Oriental Education & Technology Group (EDU)
TriCo Bancshares (TCBK)
SLM Corporation (SLM)
Regional Management Corp. (RM)
Amtrust Financial Services (AFSI)




News about Validea Hot List Stocks

Williams-Sonoma Inc. (WSM): Sonoma announced that its Board of Directors has declared a quarterly cash dividend of $0.33 per common share. The dividend is payable on February 24, 2015 to stockholders of record as of the close of business on January 26, 2015. The firm's dividend yield as of Dec. 30 was 1.7%.

United Insurance Holdings Corp. (UIHC): UIHC announced that it has entered into merger plan with Family Security Holdings, an insurance holding company with two wholly-owned subsidiaries, Family Security Insurance Company, a Hawaii-based property and casualty insurer, and Family Security Underwriters, a managing general agency performing administrative and marketing services for FSIC. Under the agreement, which is subject to FSH shareholder approval, a UIHC subsidiary will acquire all of the issued and outstanding shares, units and other ownership rights of FSH.



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

AFSI   |   ZUMZ   |   AGCO   |   SSL   |   UVE   |   SIMO   |   BLK   |   UIHC   |   JLL   |   WSM   |  



Amtrust Financial Services, Inc. (AmTrust) underwrites and provides property and casualty insurance. The Company operates in three business segments: Small Commercial Business, Specialty Risk and Extended Warranty and Specialty Program. Small Commercial Business segment provides workers' compensation to small businesses that operate in low and medium hazard classes, such as restaurants, retail stores, physicians and other professional offices, and commercial package and other property and casualty insurance products to small businesses. The Company's Specialty Risk and Extended Warranty segment provides coverage for consumer and commercial goods and custom designed coverages, such as accidental damage plans and payment protection plans. The Company's Specialty Program segment provides workers' compensation, package products, general liability, commercial auto liability, excess and surplus lines programs and other specialty commercial property and casualty insurance





Zumiez Inc. (Zumiez) is a specialty retailer of action sports related apparel, footwear, equipment and accessories operating under the Zumiez brand name. As of January 28, 2012, the Company operated 434 stores in the United States and 10 stores in Canada. In addition, the Company operates a Website that sells merchandise online. At January 28, 2012, its stores averaged approximately 2,900 square feet. Its apparel offerings include tops, bottoms, outerwear and accessories, such as caps, bags and backpacks, belts, jewelry and sunglasses. Zumiez's footwear offerings primarily consist of action sports related athletic shoes and sandals. Its equipment offerings, or hardgoods, include skateboards, snowboards and ancillary gear, such as boots and bindings. The Company also offers a selection of other items, such as miscellaneous novelties.





AGCO Corporation is engaged in manufacturing and distributing agricultural equipment and related replacement parts throughout the world. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, application equipment, hay tools, forage equipment, tillage, implements, engines, precision farming technologies, grain storage and protein production systems, and replacement parts. Its products are used in the agricultural equipment industry and are marketed under a number of brands, including Challenger, Fendt, GSI, Massey Ferguson and Valtra. The Company distributes most of its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In addition, the Company provides retail financing, through its retail finance joint ventures with Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A. (Rabobank).





Sasol Limited (Sasol) is an integrated energy and chemicals company. Sasol mines coal in South Africa and produce natural gas and condensate in Mozambique, oil in Gabon and shale gas in Canada. In South Africa it refines imported crude oil and retail liquid fuels. It has chemical manufacturing and marketing operations in South Africa, Europe, the Middle East, Asia and the Americas. It operates in four segments: South African energy cluster, International Energy Cluster, Chemical Cluster and Other businesses. Effective March 31, 2013, Sasol Olefins & Surfactants sold G.D. Portbury Ltd. On 16 August 2013, Sasol Investment Company (Pty) Limited, a wholly owned subsidiary of Sasol, entered into a definitive sale and share purchase agreement pursuant to which Main Street 1095 (Pty) Limited, completed the acquisition of 100% of the interest of SPI International (Pty) Limited (SPII). SPII is the indirect owner of a 50% interest in the Iranian joint venture, Arya Sasol Polymer Company.





Universal Insurance Holdings, Inc. (UIH) is a vertically integrated insurance company. The Company's insurance products are offered to the Company's customers through Universal Property & Casualty Insurance Company (UPCIC) and American Platinum Property and Casualty Insurance Company (APPCIC), (collectively the Insurance Entities). Substantially all aspects of insurance underwriting, distribution and claims processing are covered through the Company's subsidiaries. Blue Atlantic Reinsurance Corporation (BARC), a wholly owned subsidiary of UIH, is a reinsurance intermediary broker. The Insurance Entities generate revenues primarily from the collection of premiums. Universal Risk Advisors, Inc. (URA), the Company's managing general agent, generates revenue through policy fee income and other administrative fees from the marketing of the Insurance Entities' insurance products through its distribution network of independent agents.





Silicon Motion Technology Corporation (SMTC) is a holding company. The Company's operations are conducted through Silicon Motion, Inc. (SMI Taiwan), a wholly owned subsidiary located in Taiwan and FCI, Inc. (FCI), a wholly owned subsidiary of SMTC, located in Korea. The Company is a fabless semiconductor company that designs, develops and markets, high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. SMTC designs, develops and markets high performance, low-power semiconductor products for the multimedia consumer electronics market. Its products include mobile storage, mobile communications, multimedia systems-on-a-chip (SoCs) and other products. Its product offerings address three main markets: mobile storage, multimedia SoCs and mobile communications markets. On October 25, 2011, its subsidiary FCI acquired BTL System, Inc.





BlackRock, Inc. (BlackRock) is an investment management firm. The Company provides a range of investment and risks management services. The Company's clients include retail, high net worth (HNW) and institutional investors, consists of pension funds, official institutions, endowments, insurance companies, corporations, financial institutions, central banks and sovereign wealth funds. The Company's platform enables the Company to offer active (alpha) investments with index (beta) products and risk management to develop tailored solutions for clients. Its product range includes single- and multi-asset class portfolios investing in equities, fixed income, alternatives and/or money market instruments. In October 2013, BlackRock Inc acquired Macquarie Global Property Advisors Ltd. In January 2014, Forge Group Limited announced that BlackRock Inc. and subsidiaries had ceased to be the substantial holder of Forge Group Limited.





United Insurance Holdings Corp. (UIHC) is a holding company for United Property and Casualty Insurance Company and its affiliated companies. Its business is conducted principally through four wholly-owned subsidiaries, including United Property and Casualty Insurance Company (UPC), which writes insurance policies; United Insurance Management, L.C. (UIM), the managing general agent that manages substantially all aspects of UPC's business, Skyway Claims Services, LLC (SCS), a claims adjusting company that provides services to UPC; and UPC Re. UPC Re provides reinsurance protection to UPC. The Company offers standardized policies for a range of exposures, and its policies include coverage options for standard single-family homeowners, tenants (renters), and condominium unit owners. It also writes flood policies.





Jones Lang LaSalle Incorporated (Jones Lang LaSalle), is a financial and professional services firm specializing in real estate. Jones Lang LaSalle has over 200 corporate offices worldwide and operations in more than 1,000 locations in 70 countries. The Company offers integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients. It delivers an array of Real Estate Services (RES) across its three geographic business segments: the Americas, Europe, Middle East and Africa (EMEA), and Asia Pacific. LaSalle Investment Management, a wholly owned member of the Jones Lang LaSalle group that consists of its fourth business segment, is a diversified real estate investment management company. In July 2014, Jones Lang LaSalle Inc acquired CLEO Construction Management (CLEO), a construction project management services firm that specializes in medical facilities.





Williams-Sonoma, Inc. is a multi-channel specialty retailer of products for the home. The Company is an e- commerce retailer with brands in home furnishings. It operates retail stores in the United States, Canada and Puerto Rico, and franchises its brands to a third party in a number of countries in the Middle East, including Bahrain, the Kingdom of Saudi Arabia, Kuwait and the United Arab Emirates. Its products are also available to customers through its catalogs and online worldwide. The Company operates in two segments: direct-to-customer and retail. The direct-to-customer segment has seven merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, PBteen, West Elm, Rejuvenation and Mark and Graham) which sell its products through its seven e-commerce Websites and eight direct-mail catalogs. The retail segment has five merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation) which sells products through its retail 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.





Disclaimer


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Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.