Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary October 14, 2011

The Economy

The U.S. economic news remains much the same as it has for the past several weeks, with the picture being one of slow but continuing growth. Of course, few seem to care about that, with most investors continuing to act based on one thing and one thing only: the European debt crisis.

This past week, the news was hopeful from Europe, and the market responded with some big upward moves. Slovakia, which had been the lone Eurozone country blocking a broader rescue plan, appeared to be moving toward an agreement that would allow the plan to go through. And the European Commission president offered a plan that would lower debt for Greece, the country at the center of all the debt hubbub, and help strengthen European banks.

Of course, the Europe situation is fraught with speculation about how the U.S. will be impacted by the overseas troubles. As for the real facts and data, they continue to show that -- despite all the Europe fears -- the U.S. economy is continuing to muddle through. And, frankly, that's a lot better than many have been predicting. Manufacturing activity increased in September for the 26th straight month, according to the Institute for Supply Management, and, while the pace was relatively slow, it was slightly faster than it was in August. The new orders sub-index was in contraction territory for the third straight month, however, and the backlog of orders sub-index fell to its lowest point since April 2009. That means next month's manufacturing numbers should be watched closely.

The service sector also expanded (for the 22nd straight month), according to ISM. And its new orders and backlog of orders sub-indices both made fairly large jumps, very good signs given how much of a role the service sector plays in the U.S. economy.

As for the labor market, we continue to see some job growth, but not enough to dent the unemployment rate, which stayed at a troublingly high 9.1% for the third straight month. The private sector added 137,000 jobs in September, according to the latest Labor Department data, while the government cut 34,000 jobs. The so-called "U-6" unemployment rate -- which also includes those working part-time because they can't find full-time work, and discouraged workers who've stopped looking for jobs -- increased to its highest level since last December.

The latest weekly claims numbers paint a similar picture. New claims for unemployment have remained right around the 400,000 mark for the past three weeks. That's about 13% below where we were a year ago, but still not low enough to indicate that the labor market is healthy.

With investors focused mostly on Europe, the S&P 500 has returned 3.7% since our last newsletter, while the Hot List has returned 4.5%. So far in 2011, the portfolio has returned -18.8% vs. -4.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 119.2% vs. the S&P's 20.3% gain.

Thinking Long-Term In A Short-Term World

If you're like most investors, the past couple months haven't been easy, to say the least. For many, the 2008-09 financial crisis and accompanying market plunge remain fresh in the mind, so when volatility -- mostly to the downside -- began to spike in late July and early August, it evoked some very powerful, frightening flashbacks. Many sold first and asked questions later.

These kind of swings can fray the nerves -- and going through them today is probably more difficult than it was a decade or two or three ago. The speed at which information flows in today's society is exponentially greater than it was before the Internet was born. The Internet, the advent of 24-hour cable financial news channels, the soaring popularity of social media sites like Facebook and Twitter, the rise of smartphones and tablet computers -- all of these things have made it possible to watch every single market gyration, and the resulting impact on your portfolio, in real-time.

All of this also makes the market seem more volatile -- and dangerous -- than ever. But is it? In trying to answer that question, I looked back through more than two decades worth of the Chicago Board of Options Exchange volatility index (VIX) data.

I looked specifically at the 25-day moving average of the VIX (which is based off S&P 500 data) over that period. I found, as you'd expect, that the period involving the 2008-09 financial crisis was the most volatile. In fact, the first 135 days with the highest 25-day moving average for the VIX came during that period, with a high of 65.45.

The first non-'08/'09 period to appear was not the past couple months, however. It was late October and early November of 1998, when the lingering effects of the "Asian Contagion", a Russian financial crisis, and the demise of Long-Term Capital Management had the world buzzing with fear of a financial disaster. The highest 25-day moving average for the VIX during that period: 39.5.

The third period to appear atop the list: the fall of 2002, when the bear market caused by the Internet-bubble-burst was bottoming, Congress was authorizing President Bush to use the military as he deemed fit in Iraq, terrorists struck in Bali, and the Beltway sniper was on a rampage. During that period, the 25-day moving average for the VIX topped out right around 38.

Finally, a handful of days from the past two months begin to appear on the list only after 184 other days from those first three time periods. The highest recent reading came on Oct. 6, when the 25-day VIX moving average was about 37.1.

As you can see, the August-September volatility was high, but well within the range of past volatile periods (with the exception of the '08-'09 crisis). But it probably felt worse, given that the 2008-09 plunge was still fresh in investors' minds, and given that today, you have a front-row seat to every twist and turn -- all you need to do is pull your phone out of your pocket and press a couple buttons, and all the data and charts are there for you to see.

So, how should investors deal with volatility during this new age of instantaneous information? Well, I think it's very important to focus on the facts, and not the emotions that are swirling in your gut, as hard as that may seem. And right now, I believe that -- despite what many pundits are saying -- the economy is hanging in there, and the market is offering some very good value. The facts show that, despite all the fear, both the manufacturing and service sectors expanded (albeit slightly) in each month of the third quarter. They show that new unemployment claims actually fell by about 6% from the end of the second quarter to the end of the third quarter. And they show that consumers did not, as many expected, stop spending. To be sure, there are a number of major problems facing the economy, both at home and in Europe. But so far, we're weathering the storm.

And, as I touched on last newsletter, the facts about the market's valuation are quite positive. Based on trailing and projected one-year earnings, sales, gross domestic product levels, and dividend yields, the market looks fairly valued or undervalued. The 10-year price/earnings ratio remains elevated, but it's still far from "exuberant" levels seen near past market tops.

Also keep this in mind: Periods of volatility tend to be followed by strong returns. Back in that turbulent 1998 period I mentioned, the daily VIX fell below 35 on Oct. 15. Over the next year, the S&P 500 returned 19.1%. In that 2002 period we examined, the VIX fell below 35 on Oct. 17. Over the next year, the S&P gained 18.2%. As for the '08-'09 financial crisis period, the VIX fell below 35 on May 4, 2009. Over the next year, the S&P surged 29.4%.

And today? Well, the VIX hit a recent high of 45.45 on Oct. 3, but since then has tumbled. It crossed the 35 threshold on Oct. 10, and, as of mid-day on Oct. 13, it was down below 32.

That doesn't mean the volatility is over, or that the market will shoot upward in a smooth, easy path from here. But it does mean that over the long haul, investors who have the stomach to stick with proven strategies through volatile periods usually end up better off for it. That's the hardest part of investing -- staying disciplined while facing dramatic short-term market swings. But that's how just about all the gurus I follow built their exceptional track records, and it's a big part of why the Hot List has been so successful over the long term.

Editor-in-Chief: John Reese

Validea Capital Management - Private Portfolio Management Based on Strategies of Legends

Are you looking for an alternative to your underperforming mutual funds or financial advisor? Click here to download Validea Capital's investment kit and learn more about the firm's guru-based portfolios.

Get More Information on Validea Capital!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.

Guru Spotlight: Benjamin Graham

Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world's richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as "The Father of Value Investing", Graham inspired a number of famous "sons" -- Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.

So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), Graham built his reputation -- and fortune -- by using an extremely conservative, low-risk approach to investing. To him, preserving one's original capital was every bit as important as netting big gains, and two factors from his early years may show why. The first was Graham's own family's fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived. Graham's clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe, and Graham worked without compensation for five years until his clients' fortunes were fully restored.

Having lived through both his own family's financial troubles and the market crash, it's no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach. To Graham, an investment wasn't something that could be turned into quick, easy profits; anything that offers such "easy" rewards also comes with substantial risk, and Graham abhorred risk. True "investment", he wrote, deals with the future "more as a hazard to be guarded against than as a source of profit through prophecy."

In terms of specifics, Graham's "Defensive Investor" approach limited risk in a number of ways, and my Graham-based model lays out several of those methods. For example, one key criterion is that a firm's current ratio -- that is, the ratio of its current assets to its current liabilities -- is at least two, showing that the firm is in good financial shape. The approach also targets financially sound firms by requiring that long-term debt not exceed net current assets. Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio. Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he looked not only at trailing 12-month earnings but also at three-year average earnings, to ensure that one-year anomalies didn't skew the P/E ratio). For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.

My Graham-inspired strategy tends to find bargains across a variety of areas of the market. Here are the current holdings of the 10-stock Graham portfolio:

Forest Laboratories, Inc. (FRX)
LHC Group, Inc. (LHCG)
L.B. Foster Company (FSTR)
UniFirst Corporation (UNF)
National Oilwell-Varco (NOV)
Curtiss-Wright Corp. (CW)
Regal-Beloit Corporation (RBC)
NTT DoCoMo, Inc. (DCM)
Reliance Steel & Aluminum (RS)
United Stationers Inc. (USTR)

Two types of stocks that you won't find in the Graham portfolio are technology and financial firms. Graham excluded tech stocks from his holdings because they were too risky, and, while they're not as risky today, I do the same. Financial stocks, meanwhile, aren't explicitly excluded from my Graham model. But because of the low-debt requirements in this strategy, it's nearly impossible for a financial firm to garner approval.

Since I started tracking my Guru Strategies more than eight years ago, the performance of my Graham-based model has been rather remarkable. Even though the strategy Graham outlined is now more than 60 years old, it just keeps on working. Through Oct. 12, the 10-stock Graham-based portfolio was up 203.7% since its July 2003 inception, making it my second-best performer. That's a 14.4% annualized return in a period in which the S&P 500 has gained just 2.3% per year. The model's strict balance sheet criteria helped it avoid big losers in 2008, as the portfolio lost less than half of what the broader market lost, and it rebounded big in 2009 and 2010, gaining 31.4% in '09 and 22.6% in '10. This year it's had some big swings amid the volatile market, but through Oct. 12 it was minimizing losses, down 2.5% for the year vs. -4.0% for the S&P.

Those figures are a great demonstration of how successful stock investing doesn't need to be incredibly complex or cutting-edge. You don't need fancy theories or gimmicks; you just need to focus on good companies whose stocks are selling at good values. Do that, and you should produce some strong results of your own.

News about Validea Hot List Stocks

Forest Laboratories Inc. (FRX): Forest said last week that its experimental bipolar disorder drug, cariprazine, met its goal in a late-stage clinical study, the Associated Press reported. The study was designed to evaluate cariprazine as a treatment for acute mania associated with bipolar I disorder, according to AP. The company said patients who took the drug did significantly better than patients who took a placebo.

Petroleo Brasileiro SA (PBR): A late September fire has closed Petrobras' 100,000-barrel-per-day Pasadena, Texas, refinery, which is now expected to remain closed through the end of October, Reuters reported. A delayed coking unit has remained open at the refinery, however. No one was injured in the fire.

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

TX   |   BPI   |   FRX   |   CPLA   |   PBR   |   ASIA   |   CECO   |   JOSB   |   HITK   |   DV   |  

Ternium SA is a steel company in Latin America that manufactures and processes flat and long steel products for the construction, home appliances, capital goods, container, food, energy and automotive industries. The Company operates in three segments: Flat Steel Products, comprising the manufacturing and marketing of hot rolled coils and sheets, cold rolled coils and sheets, tin plate, welded pipes, hot dipped galvanized and electro-galvanized sheets and pre-painted sheets; Long Steel Products, comprising the manufacturing and marketing of billets (steel in its basic, semi-finished state), wire rod and bars; Others, comprising mainly pig iron, pellets and pre-engineered metal buildings. During the year ended December 31, 2010, Flat Steel Products accounted to 86% of the Company's overall revenues. Approximately 57% of Ternium's sales were generated in North America and 41% in South and Central America.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Capella Education Company is an online postsecondary education services company. Through its wholly owned subsidiary, Capella University, the Company offers a range of doctoral, master's and bachelor's programs. As December 31, 2010, it offered over 1,250 online courses and 43 academic programs with 136 specializations to over 39,000 learners. It also offers certificate programs, which consist of a series of courses focused on a particular area of study. In addition, Capella Education Company also offers academic services, such as new learner orientation, technical support, academic advising, research services (particularly for doctoral degree candidates), writing services and online tutoring. It also provides appropriate educational accommodations to learners with documented disabilities through its disability support services team. During the year ended December 31, 2010, it formed the joint-venture Sophia Learning, LLC, as majority owner.

Petroleo Brasileiro SA Petrobras (Petrobras) is a Brazilian integrated oil and gas company. It operates in five segments: exploration and production; refining, commercialization and transport of oil and natural gas; petrochemicals; distribution of derivatives, electrical energy, biofuels and other renewable energy sources. Directly or through its subsidiaries, Petrobras is engaged in the research, extraction, refining, processing, commercialization and transport of oil from wells, shales and other rocks, its derivatives, natural gas and other liquid hydrocarbons, as well as in activities related to energy, promoting research, development, production, transport, distribution and commercialization of all forms of energy. As of December 31, 2010, it had 132 production platforms, 16 refineries, 291 vessels, 29,398 kilometers of pipelines, six biofuel plants, 16 thermoelectric plants, one pilot wind farm, 8,477 service stations and two fertilizer plants, as well as presence in 30 countries.

AsiaInfo-Linkage, Inc. (AsiaInfo-Linkage), formerly AsiaInfo Holdings, Inc., is a provider of telecommunications software solutions and information technology products and services in China. The Company's software and services enables its customers to build, maintain, operate, manage and improve their communications infrastructure. It's products and services in telecom business include business operation support systems, including billing and partnership relationship management applications; business intelligence systems, including data warehousing platforms and data mining applications; operating support systems (OSS) package, including protocol adaptor, service fulfilment, process management and service activation; service and data applications, such as mail centers, mobile device management and mobile e-commerce platforms, and network infrastructure services, including network design and implementation, integrated network management and professional maintenance and support.

Career Education Corporation (CEC), through colleges, schools and universities that are part of the CEC family, offers education to a diverse student population of over 116,000 students in a variety of career-oriented disciplines. The Company has more than 90 campuses that serve these students are located throughout the United States and in France, Italy and the United Kingdom and Monaco. Its institutions includes American InterContinental University (AIU), Brooks Institute; Colorado Technical University (CTU), Harrington College of Design, INSEEC Group (INSEEC) Schools, International University of Monaco (IUM), International Academy of Design & Technology (IADT), Istituto Marangoni, Le Cordon Bleu North America (LCB), and Sanford-Brown Institutes and Colleges. CEC organized its businesses across four segments: University, Health Education, Culinary Arts and International. On April 15, 2010, the Company acquired IUM, an international business university.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer of men's tailored and casual clothing and accessories and is a retailer of tuxedo rental products. It sells substantially all of its products exclusively under the Jos. A. Bank label through its 506 retail stores (as of January 29, 2011, which includes 12 outlet and factory stores and 14 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. It sources substantially all of its merchandise from suppliers and manufacturers or through buying agents using Jos. A. Bank designs and specifications. The Company operates in two segments: Stores and Direct Marketing. The Stores segment consists of all Company-owned stores, excluding outlet and factory stores (full-line stores). The Direct Marketing segment consists of its Internet and catalog operations.

Hi-Tech Pharmacal Co., Inc. (Hi-Tech) is a specialty manufacturer and marketer of prescription, over-the-counter (OTC) and nutritional products. Hi-Tech develops, manufactures and markets products in three categories: generics, prescription brands and OTC brands. The Company produces a range of products for various disease states, including glaucoma, asthma, bronchial disorders, dermatological disorders, allergies, pain, stomach, oral care and other conditions. Its generic products are primarily prescription items and include oral solutions and suspensions, topical creams and ointments, as well as nasal sprays. It also specializes in the manufacture of products in its sterile facility capable of producing liquid ophthalmic, otic and inhalation products. The generic product category includes a small amount of contract manufacturing sales for both the prescription and OTC markets. On May 9, 2011, the Company divested the Midlothian Laboratories division.

DeVry Inc. (DeVry) is a provider of educational services and the parent organization of Advanced Academics, Becker Professional Education, Carrington College and Carrington College California, Chamberlain College of Nursing, DeVry Brasil, DeVry University, and Ross University. These institutions offer a range of programs in business, healthcare and technology and serve students in middle school through postsecondary education, as well as accounting and finance professionals. In August 2011, the Company acquired he business operations of privately held American University of the Caribbean.

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.


The names of individuals (i.e., the 'gurus') appearing in this report are for identification purposes of his methodology only, as derived by Validea.com from published sources, and are not intended to suggest or imply any affiliation with or endorsement or even agreement with this report personally by such gurus, or any knowledge or approval by such persons of the content of this report. All trademarks, service marks and tradenames appearing in this report are the property of their respective owners, and are likewise used for identification purposes only.

Validea is not registered as a securities broker-dealer or investment advisor either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. Validea is not responsible for trades executed by users of this site based on the information included herein. The information presented on this website does not represent a recommendation to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment. The information on this website is generic by nature and is not personalized to the specific situation of any individual. The user therefore bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional prior to making any investment decisions.

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.