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|Executive Summary||December 10, 2010|
The economic news has continued to be positive in the past couple weeks -- with one glaring exception.
That exception: The Labor Department's November unemployment report. As you've surely heard, the new data shows that the unemployment rate rose to 9.8% in November, with the private sector adding just 39,000 jobs for the month -- less than a third of what economists had been expecting.
The results are a bit concerning, but moreso puzzling. Recent weekly unemployment claims data had been trending downward at a fairly strong rate, both for new claims and continuing claims. In addition, there are indications companies are, or soon will, start increasing their hiring activity. New Labor Department figures showed that the number of private and public sector jobs being advertised at the end of October jumped 12% from the previous month, reaching the highest level since August 2008. And Manpower Inc., a staffing company, said its hiring index has nearly doubled for the first quarter of 2011, reaching its highest level since late 2008.
One reason for the discrepancy in the monthly unemployment report and the other data could involve seasonal factors. Some analysts cautioned that seasonal hiring timetables make it particularly difficult for the Labor Department to get a good read on November monthly unemployment figures. Given the improving weekly claims data and the hiring data, I would hold off on thinking that the weak November report was a sign of things to come.
Aside from unemployment, the economic data continues to show improvement. The manufacturing sector is keeps on growing, with the Institute for Supply Management's manufacturing index showing that the sector expanded in November for the 16th straight month. The group's non-manufacturing index, meanwhile, indicated that the service sector expanded for the 11th straight month. And the service sector employment sub-index, which has lagged the manufacturing employment sub-index through much of the recovery, indicated that employment conditions improved for the third straight month. In fact, the sub-index reached its highest level since the 2007-2009 recession began.
The housing sector also provided some good news. The National Association of Realtors Pending Home Sales Index jumped more than 10% in October, new data showed, though the group's chief economist said that "activity needs to improve further to reach healthy, sustainable levels".
The U.S. consumer, meanwhile, is continuing to surprise many analysts. Making more (personal income jumped 0.5% in October, according to new government data) and owing less (household debt fell to 122% of annual disposable income in the second quarter -- the lowest level since late 2004, according to Haver Analytics), consumers opened their wallets for the holiday shopping season. Retail Metrics' retail sales index jumped 5.3% in November vs. the year-ago period, easily topping analysts' expectations, the Financial Times reported. Big names like Macy's (+6.1% in sales), JC Penney (+9.2%), and Abercrombie & Fitch (+22%) led the way.
Big economic news also came from the political arena this week, with Republicans and President Obama agreeing to extend the Bush-era tax cuts, implement a one-year cutback on payroll taxes, and extend unemployment benefits. How exactly the government will pay for all of that is a question that needs to be addressed. But for now, the moves should put more money in Americans' pockets, stimulating the economy.
Amid all of this, the S&P 500 has returned 2.9% since our last newsletter, while the Hot List has returned 1.4%. For the year, the portfolio stands at 11.3% vs. 10.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 168.3% vs. the S&P's 23.2% gain.
What a Difference a Year Makes
As we head into the home stretch of 2010, the mood on Wall Street and Main Street seems to be one of trepidation, mixed with a touch of very cautious optimism. The earthquake that was the financial crisis of 2008-09 is now in the rearview mirror, though some minor aftershocks continue to pop up here and there. But investors are still very, very careful about sticking their heads out their front doors, fearing another quake. There remains, as one strategist has put it, a sort of collective "post-traumatic-armageddon-hypochondria".
Given that backdrop, I thought it would be a good time to look back at where the stock market and economy stood at a year or so ago, and where we now stand. The amount of progress we've made might surprise you.
Manufacturing: Heading into 2010, the manufacturing sector had expanded for five straight months, and some were wondering how many more months the rebound could continue. They still haven't gotten their final answer, because the sector has continued to expand in each month of this year. In fact, the lowest monthly reading on ISM's manufacturing index this year has been 54.4; if the December reading matches or exceeds that, it will mark just the fourth time in the past 25 years that the manufacturing sector has expanded in every month of the year at at least that pace.
Industrial Production: Manufacturing is one part of the Federal Reserve's monthly industrial production report, which also includes mining and electric and gas utilities output. In the first three quarters of this year, industrial production rose 7.1%, 7.1%, and 5.2%, respectively, marking the best Q1-Q3 performance since 1997. The results have weakened in the past two months for which data is available, with IP falling 0.2% in September and remaining flat in October. But that was due mainly to the utility performance, as unseasonably warm weather lessened demand for heating.
In the past three months, industrial production has reached levels not seen since the fall of 2008. It remains about 6.6% below 2007 levels, however, and there's still a good deal of slack. Capacity utilization has hovered around 75% for the past four months, up from 72.3% at the beginning of the year, but below the 80.6% long-term average.
Unemployment: As I noted above, the unemployment data has been a bit inconsistent of late. The monthly figures are uninspiring, and have remained stubbornly high throughout the year. Going into 2010, the unemployment rate stood at 10.0%; the most recent reading in November was 9.8%.
Monthly claims data shows a more encouraging story, however. In the most recent week (ending Dec. 4), 421,000 people filed new claims for unemployment. A year ago, the figure was 483,000. That's a 13% decline over the past year.
Continuing claims paint an even better picture. In the most recent week for which such data is available (ending Nov. 27), 4.09 million people filed continuing claims; in the corresponding week a year earlier, the figure was 5.31 million. That's a 30% drop. Over that span, the insured unemployment rate has fallen from 4.0% to 3.2%.
Market Performance: As you're probably aware, the market is up nicely for the year. But what's really intriguing is the recent nature of those gains. In late November, the correlation between stocks and bonds showed that the two asset classes were moving independently of each other for the first time since July 2007, according to Bloomberg. What does that mean? Well, it's an indication that for the first time in a long time, investors are basing their investment decisions on value -- not on their broader view of the economy and financial system. For stock-picking systems like ours, which use a variety of value-based metrics to pick up bargain-priced stocks, that's very good news.
Home Prices: Home prices remain well below the highs they reached in 2006, but that's to be expected. The housing market bubble pushed prices far higher than they should have been, creating illusory wealth, so anchoring on those previous highs and using them as a barometer of housing market health is unwise.
That being said, the housing market is far from going gangbusters. But prices have continued to stabilize in 2010. Since December 2009, the S&P-Case/Shiller 10-City Home Price Index has risen slightly, by about 0.7% (through September, the most recent month for which data is available). The 20-city index has declined by about 0.2%. Both of those figures are seasonally adjusted; the raw data paints a bit better picture, with the 10-city index up 2.0% and the 20-city index up 1.1%.
Home sales, meanwhile, are down from where they were at the end of 2009. The National Association of Realtors' Pending Home Sales Index most recent reading (October) was down about 8.7% since the end of 2009, while its Existing Home Sales Index was down about 18.6%. As I've mentioned in several previous newsletters, however, home prices and sales were certainly impacted by the government's homebuyer tax credit program, which has skewed year-over-year comparisons and made it very difficult to ascertain the true health of the housing market.
Loan/Credit Picture: Loan quality and performance at U.S. banks began improving in 2010. The FDIC's latest banking report showed that banks set aside $34.9 billion for loan losses in the third quarter, down 45% from the third quarter of 2009, and marking the lowest amount since the fourth quarter of 2007. Net charge-offs also declined for the second straight quarter after 13 straight quarterly increases, falling 16% below their year-ago levels. And commercial and industrial loan amounts finally increased in the third quarter, indicating that banks may be starting to open the credit lines that businesses have found closed for a long time. The level of commercial and industrial loans was still about 8% below year-ago levels, though, so it's not as though the flood gates have opened.
Retail sales: According to the Census Bureau, food and retail sales in the final month of 2009 totaled $354.09 billion. In October, the most recent month for which data is available, they'd hit $373.1 billion, a 5.4% increase. To put that in context, the mean December-to-December change since 1992 has been 4.4%. Looked at another way, retail and food sales have reached levels they haven't seen since August 2008, prior to the collapse of Lehman Brothers.
An Improving Picture
The indicators and figures I've just reviewed are, of course, not a complete list of factors used to judge the economy's health. And to be sure, there are still areas of concern. But overall, the data shows that the economy is in a much better place than it was a year ago; that the stock market has proved remarkably resilient as the recovery has progressed; and that investors have begun to show signs of a return to value-focused thinking, rather than the macro-obsessed market-timing that has dominated markets for the past couple years. As 2010 winds down, those are all very encouraging signs for the coming year.
Guru Spotlight: Warren Buffett
With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.
In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price Is Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
A Strong Rebounder
My Buffett-based 10-stock portfolio wasn't one of my original portfolios, instead coming online in late 2003. Since then, it's returned about 29%, almost twice what the S&P 500 has gained.
While the portfolio hasn't been one of my best performers, it has excelled coming out of downturns. In 2004, as we were emerging from the lengthy recession associated with the tech stock bust, the Buffett portfolio surged 37.3%, more than quadrupling the S&P's 9% gain. In addition, after struggling in 2007 and 2008 amid the latest recession and bear market, the portfolio bounced back strong in 2009 -- very strong. It gained 50.3%, more than doubling the gains of the broader market.
This strong performance out of downturns is no surprise, given Buffett's penchant for pouncing on good, beaten down stocks, which usually abound during tough times as investors let fear get the best of them. (One of Buffett's mantras is that investors "should try to be fearful when others are greedy and greedy only when others are fearful.")
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here's a look at my Buffett portfolio's current holdings:
Aeropostale, Inc. (ARO)
Ross Stores, Inc. (ROST)
The TJX Companies, Inc. (TJX)
China Mobile Ltd. (CHL)
World Acceptance Corp. (WRLD)
Garmin Ltd. (GRMN)
Coach, Inc. (COH)
FactSet Research Systems Inc. (FDS)
Wipro Limited (WIT)
Infosys Technologies Limited (INFY)
News about Validea Hot List Stocks
Raytheon Company (RTN): Raytheon is one of at least four defense contractors to submit an initial bid for cybersecurity firm Applied Signal, Reuters reported. The bid appears to be part of a larger trend of large defense contractors looking for technology takeover targets to quickly grow their cybersecurity offerings.
L&L Energy (LLEN): L&L has entered into an agreement to provide a secured bridge loan to Bowie Resources, LLC, which owns and operates the Bowie Mine, a coal mine in Paonia, Colorado. The deal calls for L&L to provide initial funding to Bowie of up to $3 million in loans that will be used to fund Bowie's ongoing coal mining operations. The loans will receive interest of 9% per year and L&L will receive an option to acquire up to 9% equity interest in Bowie at nominal costs, subject to certain conditions, the company said. The firm's chairman said L&L's "partnership in a U.S. mine of Bowie's caliber will be an important first step in becoming a global coal mining player."
The Nov. 29 announcement provided a big boost to LLEN shares, as they jumped more than 15% from Nov. 29 through Dec. 9.
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 email@example.com.
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