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Executive Summary August 31, 2012

The Economy

Though still battling against the stiff headwinds of debt and high unemployment, the U.S. economy has been continuing to improve, according to various data released over the past two weeks.

Perhaps the biggest source of encouragement comes from the housing market, which appears to be undergoing its long-awaited rebound. Home prices in 20 major cities rose an average of 2.3% in June (vs. May), according to the S&P/Case-Shiller Home Price Indices. For the entire second quarter, prices were up nearly 7% nation-wide vs. the first quarter; they were up 1.2% vs. the year-ago period. When adjusted for seasonal variations, the numbers weren't as high, but they were still good, with the 20-city composite index up 0.9% in June (vs. May) and the second-quarter national index up 2.2% vs. the year-ago period. "We seem to be witnessing exactly what we needed for a sustained recovery; monthly increases coupled with improving annual rates of change," said David M. Blitzer, Chairman of the Index Committee at S&P Dow Jones Indices. "The market may have finally turned around."

The National Association of Realtors, meanwhile, said existing-home sales rose 2.3% in July (vs. June), even though inventory is constrained -- it's down more than 30% from July 2011. (Unless noted, all month-over-month, quarter-over-quarter, or week-over-week figures here and below are seasonally adjusted; year-over-year comparisons are unadjusted.) Existing-home sales are now 11.4% above where they were a year ago, a great sign, and the median sale price is now 9.4% above year-ago levels. It was the fifth straight month that the year-over-year price comparison has shown an increase.

On the employment front, new claims for unemployment remained pretty much flat since our last newsletter, as have continuing claims (the data for which lags new claims by a week). New claims are now about 8% below their year-ago level, while continuing claims are about 10.6% below where they stood a year ago.

Good news also came in the form of an upward GDP revision. GDP grew 1.7% in the second quarter, according to the Commerce Department, better than the previous estimate of 1.5%. Still, that's pretty anemic growth, and isn't anything to get excited about.

Corporate earnings, however, continue to be solid. With 488 of the S&P 500 companies having reported second-quarter earnings, over 75% of firms had met or beaten expectations for operating earnings, according to Standard & Poor's. The results mean that the index is trading for about 14.3 times trailing 12-month earnings (through the Aug. 28 close). The gap between operating and as-reported P/Es is the widest since the fourth quarter of 2008, however, though at about 16, the as-reported trailing 12-month P/E is far from excessive.

As for the consumer, the Commerce Department said that personal income rose 0.3% in July, while personal consumption expenditures rose 0.4%.The personal savings rate fell slightly, from 4.3% in June to 4.2% in July, but still remains at a pretty solid level.

Since our last newsletter, the S&P 500 returned -1.1%, while the Hot List returned -2.2%. So far in 2012, the portfolio has returned 13.3% vs. 11.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 156.0% vs. the S&P's 39.9% gain.

Valuation Update

A lot has happened in the market and economy over the past few months, so I think it's a good time to check back in on valuations. We'll start with the earnings metrics. As I noted above, the S&P 500 trades for 14.3 times trailing 12-month operating earnings and about 16 times trailing 12-month as-reported earnings (through Aug. 29, as are all the current figures we'll look at). The operating figure is fairly close to where it was when we last looked in-depth at valuation (back in late April), while the as-reported number is up slightly from 15.

If we use projected earnings for the next year, the operating figure is about 13.1, up slightly from 12.6 in late April, and the as-reported figure is 14.4, also up slightly from April's 13.5 level, according to S&P data. Still, which they've risen a bit, neither of those figures is particularly high.

The S&P's price/sales ratio, meanwhile, is right where it was back in April, at a reasonable 1.3, and its price/book ratio is 2.0, according to Morningstar.com. Its dividend yield is now a solid 2.52%, up slightly from 2.44% in April. That's far above the yield on 10-year Treasury bonds -- a rarity and a good sign.

One figure that continues to show the market to be overvalued is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It has risen to 97.7%, up from 95.6% in April, according to GuruFocus.com. That puts it in "modestly overvalued" territory (90% to 115%), based on the site's analysis of historical data.

The 10-year cyclically adjusted price/earnings ratio also remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 21.9, using the Aug. 28 closing price for the S&P 500 and Yale Economist Robert Shiller's earnings data. That's down slightly from April, but is still well above the 16.5 historical average (which dates back to 1871). The figure doesn't look as high, however, when compared to the average of 18.3 since 1946 (which is a significant date because after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor).

Another valuation metric that paints a picture of overvaluation is Tobin's Q. Developed by Nobel Laureate James Tobin, it is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter. As of the most recent report, which came at the end of the first quarter, the Q ratio was 0.96. The historical average is 0.71 using the arithmetic mean and 0.65 using the geometric mean, according to Doug Short of Advisor Perspectives. The current Q thus shows significant overvaluation, though the figure remains below levels seen at other market tops. (It got as high as 1.78 during the tech bubble, according to Short.)

In general then, the valuation picture isn't too different from what it was four months ago. Several metrics are showing market to be fairly valued or undervalued, with a couple notable exceptions (the ten-year P/E ratio, Tobin's Q, and the Stock Market/GDP ratio). On the whole, I think all of that means we are probably somewhere near the fair value range for the broader market.

Of course, more importantly, numerous individual stocks are trading at very attractive values. Take Hot List newcomer HollyFrontier Corp. The Dallas-based oil and gas firm trades for just 5.6 times trailing 12-month earnings and 6.2 times projected 12-month earnings. Its price/sales ratio is just 0.41, and its PE-to-growth ratio is a dirt cheap 0.14. All of this for shares of a company that has been growing earnings at a 41% rate over the long haul, has a 47% return on equity, and has more annual earnings than long-term debt.

HollyFrontier is far from alone. Overall, the five new stocks being added to the Hot List this week average trailing 12-month P/Es of about 10, price/sales ratios of about 1.2, PE-to-growth ratios of 0.36, and free cash flow yields of nearly 9%.

Value is important because many studies have shown that over the long haul, stocks with strong value characteristics have significantly outperformed more expensive stocks. But there's another reason that value is so important, and it's one that Bill Nygren touched on in a recent letter to his Oakmark fund shareholders. Nygren, one of the gurus I keep an eye on at my Guru Investor blog, has posted an excellent track record over the long-term. In his letter, he notes that his fund has been more volatile than usual this year. He offers a couple reasons for the change. One is that "investors today are less willing to accept cyclical risk than usual. Not surprisingly, it is the companies with cyclical exposure that seem to have the most day-to-day volatility, swinging up or down based on the words of various European politicians. The financials, technology and industrial stocks react more sharply than do the utilities, health care and consumer staples. Because valuation differentials have seldom been larger, we own a lot more of the former group than we do the latter."

In the years since the financial crisis, we've also seen more volatility for the Hot List. From its 2003 inception through 2008, the portfolio's average annual beta was 1.10. From 2009 through the present, its annual beta has averaged 1.26. But Nygren raises a key question: Does more volatility mean more risk? Often in stock market discussions, risk and volatility are used almost interchangeably. But Nygren thinks they aren't one and the same. "To us, risk means losing money. Not just a daily price quote that goes down, but an error in estimating business value such that we want to sell our position despite the price being lower," he says. "Based on our criteria, risk is highly dependent on the price paid for a stock. When a stock is priced at a premium to its business value, risk is high. When the price is at a large discount to value, risk is low."

Nygren's comments echo the "margin of safety" concept that the late, great Benjamin Graham famously touted, and I agree with him. If you are a long-term investor -- and in my mind, if you're not investing for the long term, you shouldn't be investing -- day-to-day volatility really shouldn't be synonymous with risk. David Dreman, one of the gurus upon whom I base my strategies, has tackled this topic at length, with similar conclusions. "It has been known for decades that there is no correlation between risk, as the academics define it, and return," he wrote in Contrarian Investment Strategies: The Next Generation. "Higher volatility does not give better results, nor lower volatility worse."

To Dreman, risk was something much different than day-to-day fluctuations. "The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about," he wrote. "Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it risk -- for investors who have time horizons 5, 10, 15, or even 30 years away -- is a completely inappropriate definition." He said a realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and includes 1) the probability your investment will preserve your capital over your investment time horizon, and 2) the probability your investments will outperform alternative investments during the period.

Nygren's and Dreman's comments about risk get to the heart of what good investing is all about. While most investors get caught up in day-to-day market fluctuations, leading them to make emotional decisions that often hurt their portfolios, these gurus focus on the long term, and aren't swayed by faulty conventional wisdom. In order to beat the crowd, you have to think differently from the crowd, and their comments are a great example of such out-of-the-box thinking.

As for the current market and risk, while things have been calmer of late, the odds are that sooner or later the European debt crisis, the U.S. fiscal cliff, or some other issue will flare up and lead to significant volatility again. When that happens, remember Dreman's and Nygren's words. Short-term swings in prices of your holdings have little to do with making money over the long term -- and isn't making money over the long haul the point?

In my opinion, if you buy shares of good companies trading at attractive valuations, you'll do just that -- make money over the long haul. If, that is, you have the discipline to stick to your strategy and not bail when the market gets volatile; those who do bail more likely than not will end up selling low and buying high. It's what we're hardwired to do as humans: When danger arises, we flee. It's an instinct that in many ways serves us quite well, but in the stock market -- where many "dangers" are unfounded or overhyped -- it leads us astray.

That's why we use the disciplined, systematic approach we use in managing the Hot List. By allowing the cold, hard numbers to drive our buy and sell moves, we remove the potential for our own pesky emotions and gut feelings to lead us astray. In doing so, I believe we dramatically cut down on real risk -- that is, the risk of not producing strong returns over the long term -- regardless of what sorts of ups and downs our holdings are having on a day-to-day basis.

 
Editor-in-Chief: John Reese










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The Fallen

As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Gamestop Corp. (GME), Main Street Capital Corporation (MAIN), Lkq Corporation (LKQ), Marathon Petroleum Corp (MPC) and Altisource Portfolio Solutions S.a. (ASPS).

The Keepers

5 stocks remain in the portfolio. They are: The Tjx Companies, Inc. (TJX), Apollo Group Inc (APOL), Northrop Grumman Corporation (NOC), Autoliv Inc. (ALV) and Solarwinds Inc (SWI).

The Newbies

We are adding 5 stocks to the portfolio. These include: Nu Skin Enterprises, Inc. (NUS), Triumph Group Inc (TGI), World Acceptance Corp. (WRLD), Astrazeneca Plc (Adr) (AZN) and Hollyfrontier Corp (HFC).

Portfolio Changes



Newcomers to the Validea Hot List

Nu Skin Enterprises, Inc. (NUS): Utah-based Nu Skin ($2.5 billion market cap) is a direct selling company that sells personal care, nutrition, and technology products, such as skin creams, supplements intended to fight aging, and a biophotonic scanner that measures carotenoid antioxidant activity. It sells its products through a network of more than 750,000 independent distributors and preferred customers around the world.

Nu Skin gets approval from my Peter Lynch-based strategy, and high marks from several of my other models. To read more about it, scroll down to the "Detailed Stock Analysis" section below.

HollyFrontier Corp. (HFC): Dallas-based HollyFrontier ($8.1 billion market cap) is one of the U.S.'s largest independent petroleum refiners. It has operations in the Midwest, Southwestern, and Rocky Mountain regions, operating five complex refineries. Its subsidiaries are involved in the manufacture and marketing of lubricants and specialty products, as well as the manufacturing and marketing of asphalt products.

HollyFrontier gets approval from three of my models, those I based on the writings of Peter Lynch, Joel Greenblatt, and David Dreman. For more on the stock, see the "Detailed Stock Analysis" section below.

World Acceptance Corp. (WRLD): Based in Greenville, S.C., World Acceptance ($960 million market cap) specializes in small, short-term loans, and has close to 1,000 offices in the southern and central U.S., and Mexico. Its loans are generally under $3,000 and have durations of less than 24 months, and much of its business comes from repeat customers.

World Acceptance gets strong interest from my Peter Lynch- and Warren Buffett-based models. For more on its fundamentals, see the "Detailed Stock Analysis" section below.

AstraZeneca PLC (AZN): The London-based drugmaker ($58 billion market cap) is active in more than 100 countries, and makes a variety of well-known medications, including Crestor and Symbicort.

AstraZeneca gets high marks from my Peter Lynch-, Warren Buffett-, and James O'Shaughnessy-based strategies. To learn more about the stock, scroll down to the "Detailed Stock Analysis" section below.

Triumph Group, Inc. (TGI): This Pennsylvania-based firm ($2.9 billion market cap) makes, repairs, and sells a variety of aircraft parts. It operates in about 60 locations, mostly in the U.S. but also in Europe and Asia, serving commercial and regional airlines, air cargo carriers, and Original Equipment Manufacturers of commercial, regional, business and military aircraft and aircraft parts.

Triumph Group gets strong interest from my Peter Lynch-based strategy, and good marks from several of my other models. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.



News about Validea Hot List Stocks

The TJX Companies Inc. (TJX): TJX shares hit a new 52-week high on Aug. 29. They closed at $46.64 a share, eclipsing the previous high of $46.17. Through Wednesday, the stock was up more than 23% since joining the Hot List portfolio on March 16.



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

TJX   |   NOC   |   SWI   |   APOL   |   HFC   |   ALV   |   NUS   |   WRLD   |   TGI   |   AZN   |  



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.





Northrop Grumman Corporation (Northrop Grumman) provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. As of December 31, 2011, the Company operated in four segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The Company conducts most of its business with the United States Government, principally the Department of Defense (DoD) and intelligence community. It also conducts business with local, state, and foreign Governments and domestic and international commercial customers. Effective as of March 31, 2011, the company completed the spin-off of Huntington Ingalls Industries, Inc. (HII). HII operates the Company's former shipbuilding business.





SolarWinds, Inc. (SolarWinds) designs, develops, markets, sells and supports enterprise information technology (IT), infrastructure management software to IT professionals in organizations of all sizes. The Company's product offerings range from individual software tools to more comprehensive software products that solve problems encountered by IT professionals. Its products are designed to help management of their infrastructure, including networks, applications, storage and physical and virtual servers, as well as products for log and event management. It offers a portfolio of products for IT infrastructure management. Its products operate in three categories: Free Tools, Transactional Products and Core Products. In January 2011, it acquired Hyper9, Inc. (Hyper9). In July 2011, it acquired TriGeo Network Security, Inc. (TriGeo). In October 2011, it acquired DNS Enterprise, Inc. (DNS). In December 2011, it acquired certain assets of DameWare Development LLC (DameWare).





Apollo Group, Inc. (Apollo Group) is a private education provider. The Company offers educational programs and services both online and on-campus at the undergraduate, master's and doctoral levels through its wholly owned subsidiaries, The University of Phoenix, Inc. (University of Phoenix); Institute for Professional Development (IPD); The College for Financial Planning Institutes Corporation (CFFP), and Meritus University, Inc. (Meritus). Apollo Group also formed a joint venture with The Carlyle Group (Carlyle), called Apollo Global, Inc. (Apollo Global), to pursue investments primarily in the international education services industry. As of August 31, 2011, Apollo Group owned 85.6% of Apollo Global, with Carlyle owning the remaining 14.4%. During the year ended December 31, 2011, the Other Schools segment includes IPD and CFFP, as well as Meritus University, Inc. (Meritus), which ceased operations.





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.





Autoliv, Inc. (Autoliv) is a holding company. Autoliv is the supplier of automotive safety systems, with a range of product offerings, including modules and components for passenger and driver-side airbags, side-impact airbag protection systems, seatbelts, steering wheels, safety electronics, whiplash protection systems and child seats, as well as night vision systems, radar and other active safety systems. Autoliv has two main operating segments: airbags/seatbelt (including restraint electronics) products and active safety electronics products. In addition, in April 2010, Autoliv Inc.'s Automotive Holding AS increased its stake in Norma AS from 51% to 93.74%. Additionally, Skandinaviska Enskilda Banken AB and ING Luxembourg SA sold their 6.67% and 10% stake, respectively, held in Norma AS. In November 2011, the Company acquired the airbag cushion cut&sew assets from Milliken. In June 2012, the Company sold its subsidiary Autoliv Mekan AB to Verktygs Allians i Hassleholm AB.





Nu Skin Enterprises, Inc. is a global direct selling company with operations in 52 markets worldwide. The Company develops and distributes anti-aging personal care products and nutritional supplements under its Nu Skin and Pharmanex brands, respectively. The Company operates through a direct selling model with independent distributors in all of its markets except Mainland China. As of December 31, 2011, the Company had more than 850,000 distributors. The Company has two primary product categories, each operating under its own brand. It markets its personal care products under the Nu Skin brand and its nutritional supplements under the Pharmanex brand. During the year ended December 31, 2011, approximately 88% of its revenues came from its markets outside of the United States. On December 13, 2011, the Company acquired LifeGen Technologies, LLC (LifeGen).





World Acceptance Corporation operates a small-loan consumer finance business in 12 states and Mexico. The Company is engaged in the small-loan consumer finance business, offering short-term small loans, medium-term larger loans, related credit insurance and ancillary products and services to individuals. As of March 31, 2012, the Company offered standardized installment loans through 1,137 offices in South Carolina, Georgia, Texas, Oklahoma, Louisiana, Tennessee, Illinois, Missouri, New Mexico, Kentucky, Alabama, Wisconsin, and Mexico. The Company serves individuals with limited access to consumer credit from banks, credit unions, other consumer finance businesses and credit card lenders. In the United States offices, the Company also offers income tax return preparation services to its customers and others.





Triumph Group, Inc. (Triumph) designs, engineers, manufactures, repairs, overhauls and distributes a portfolio of aerostructures, aircraft components, accessories, subassemblies and systems. The Company serves a range of the aviation industry, including original equipment manufacturers (OEMs), of commercial, regional, business and military aircraft and aircraft components, as well as commercial and regional airlines and air cargo carriers. The Company offers a range of products and services to the aerospace industry through three groups of operating segments: Triumph Aerostructures Group, whose companies' revenues are derived from the design, manufacture, assembly and integration of metallic and composite aerostructures and structural components for the global aerospace OEM, market; Triumph Aerospace Systems Group, and Triumph Aftermarket Services Group, whose companies serve aircraft fleets.





AstraZeneca PLC (AstraZeneca) is a global biopharmaceutical company. AstraZeneca discovers, develops and commercializes prescription medicines for six areas of healthcare: Cardiovascular, Gastrointestinal, Infection, Neuroscience, Oncology, and Respiratory and Inflammation. It has a range of medicines that includes treatments for illnesses, such as its antibiotic, Merrem/Meronem and Losec/Prilosec for acid related diseases. AstraZeneca's products include Crestor, Atacand,Seloken/Toprol-XL, Plendil, Onglyza, Zestril, Symbicort and Zoladex. The Company owns and operates a range of research and development (R&D), production and marketing facilities worldwide. AstraZeneca operates in over 100 countries, including China, Mexico, Brazil and Russia. In August 2012, Alliance Pharma plc's subsidiary, Alliance Pharmaceuticals Limited, acquired the antimalLato brands. In August 2012, the Company announced the acquisition of Amylin Pharmaceuticals, Inc. by Bristol-Myers Squibb Company.





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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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.