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Executive Summary October 25, 2013

The Economy

The end of the two-and-a-half-week partial government shutdown and the temporary debt ceiling increase has provided some clarity as to the U.S. policy landscape, for a few months at least. But it hasn't given a whole lot of insight into how the economy has been faring recently.

Though closed areas of the government opened shop again after Congress and the President mercifully struck a budget deal, several economic reports continue to be delayed because of the shutdown. That means the housing starts, retail sales, and industrial production data we'd normally examine will remain a mystery for a while longer.

We did, however, get the September jobs report. The results were mediocre, with the private sector adding 126,000 jobs during the month. The government added 22,000 more, making for a total of 148,000 -- in line with the steady-but-unspectacular job market improvement we've seen over the past few years. The unemployment rate (calculated using a different survey) did fall to 7.2% -- the lowest level since November 2008 -- though the number of people not in the labor force rose by 136,000. Once again, while many theorize that those no longer in the labor force have simply given up looking for work, that may not explain it -- the "U-6" unemployment rate, which takes into account discouraged workers who've given up looking for a job, also fell in September, from 13.7% to 13.6%. Average weekly hours and earnings increased by 0.1% and 0.2%, respectively.

In the housing market, the data continues to look good. Residential construction was one area contributing significantly to the job growth numbers in September (though, interestingly, not as much as nonresidential construction, which made a big jump). Existing home sales actually fell 1.9% in September, though they remain 15.1% above where they were a year ago, according to the National Association of Realtors. Median sales prices, meanwhile, were nearly 12% above their year-ago level, posting another impressive year-over-year increase.

Since our last newsletter, the S&P 500 returned 3.5%, while the Hot List returned 4.8%. So far in 2013, the portfolio has returned 34.8% vs. 22.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 265.5% vs. the S&P's 75.1% gain.

Shutdown Lessons

Well, that was fun now, wasn't it? Watching our elected leaders squabble like children and, for nearly three weeks, fail to do the barest of bare minimums required by their jobs -- that is, keep the government operating.

Of course, it was an embarrassment, and a particularly troublesome period for many investors. After hitting 1,725 on Sept. 18, the S&P 500 tumbled some 70 points over the next three weeks amid the budget debacle. While the S&P's decline wasn't huge -- about 4% -- you can be sure that many lost more than that, as they jumped in and out of stocks as the headlines alternated between hopeful and dire.

But as much of a worry and frustration as it may have been, consider this: The S&P had eclipsed its pre-deal highs by Oct. 17 -- the day the shutdown ended. The brunt of the trouble for the market lasted less than a month.

That's not unusual. Throughout history, investors have feared the worst when crises have hit, and usually their fears turn out to be worse than the reality. One of the gurus I follow, David Dreman, provided some very interesting research on this topic in his book Contrarian Investment Strategies: The Next Generation. In his book, Dreman looked at "11 major postwar crises", which included the Berlin blockade, Korean War, Kennedy assassination, Gulf of Tonkin crisis, 1979-1980 oil crisis, and 1990 Persian Gulf War. He showed how, one year after all but one (the Berlin Blockade, when the market dropped), the market was up between 22.9 percent and 43.6 percent, except for a 7.2 percent rise after the Gulf of Tonkin crisis. The average gain was 25.8 percent. Two years after the crisis, the average gain was 37.5 percent. It's worth noting that following the September 11, 2001 terrorist attacks, which occurred after Dreman wrote Contrarian Investment Strategies, it took just one month for the S&P 500 to climb back to pre-September 11 levels; a year after the attacks, however, the index had fallen below pre-September 11 levels, the dot-com meltdown no doubt being a factor.

Then there was the financial crisis. On September 12, 2008, the last trading day before Lehman Brothers collapsed and the crisis exploded, the S&P closed at 1,251.70. It took about six months after that seminal moment for stocks to bottom and a little over two years for them to get back to pre-Lehman levels -- not bad when you consider that many thought America might never recover. Today (Oct. 24), the S&P is trading at about 1,750, meaning stocks are about 40% higher than they were the day before Lehman collapsed. That makes for an annualized gain of close to 7% over the past five or so years -- not all that far from historical norms, despite including the core of the worst bear market in 80 years.

The Trouble With Timing

Of course, if you can successfully sidestep a crisis, you can save your portfolio some significant losses. Had you jumped out of stocks just before Lehman Brothers collapsed in 2008 and jumped back in sometime in March 2009, your returns would of course be far greater than if you stayed the course through the financial crisis. But the problem is that getting the timing right is incredibly hard. Even if you get out at a good time, that's just half of the equation. Then you have to get back in at a good time so that you don't miss the big gains that usually occur when a crisis passes. It's not just a matter of seeing a crisis in the making; it's a matter of seeing it coming, knowing when it will blow up, and knowing when it will recede. That can mean an expert understanding of economics, the financial system, the government, and investor psychology, among other things.

One more thing about getting back in at a good time: History shows that when stocks have been falling, investors get much worse at making good timing decisions. Research firm Dalbar, Inc. tracks fund flows to calculate what it calls the "Guess Right Ratio". Essentially this tells you what percentage of the time investors execute a "buy" decision that leads to a positive return. Dalbar's data shows that over the past two decades, investors have collectively had the worst Guess Right Ratios (GRR) during or around bear markets. The worst year was 2002 -- the year that the tech bubble bear ended -- when the GRR was 33%. Next worst were four other years, at 42%. They were: 2000 -- when the tech bubble bear began; 2008 and 2009, when the financial crisis exploded and the turnaround began; and, interestingly, last year. Overall, this seems to indicate that investors tend to make better decisions when the market is in the middle of an upward run, but they are at their worst when the market is falling, or a turnaround is in those big-gain early stages -- precisely when a market timer needs to be accurate to succeed.

Intuitively, that sort of data makes a lot of sense. When you're in the middle of a bull market and stocks have been rising, you are probably much more relaxed than you are when stocks have been tumbling. Being more relaxed, you think more clearly, and you make decisions that are taking into account the long term. When stocks are falling, however, your emotions start running high. You see the value of your portfolio tumbling, and, instead of recognizing that a declining market can make for excellent buying opportunities, all you can see are more declines -- your hard earned money disappearing, your child's college education money dwindling, your retirement savings evaporating. In such situations, most people do what they think they have to do to alleviate those fears: they sell stocks, even though it's usually not the right move in the long term.

The outlier in the Guest Right Ratio data seems to be last year, 2012. While stocks were having a very strong year (the S&P 500 was up 13.4%, not including dividends) in the fourth year of a bull market that has continued on into this year, investors were collectively making some very bad decisions. When you think about it, however, it actually makes a lot of sense that 2012 would have been a bad year for investor guesses. That's because, while it was a strong year in the middle of a bull market, this particular bull has been fraught with perhaps more worry and pessimism and negative headlines than any I can recall, and that was on full display in 2012. Fears of financial disaster in Europe, fears of the US budget sequestration, fears of the Syria conflict exploding into a global conflict, fears of a Chinese housing crisis and economic slowdown -- all these and others worries dominated the headlines in 2012. Stocks rose, but fears remained high.

And maybe that's the real lesson in the Guess Right numbers. Maybe it's not that investors make worse decisions in declining markets or markets that are just starting to turn upward; it's that they make worse decisions when fears are high, and it just so happens, of course, that fears tend to be higher during or right after bearish periods (though, as 2012 showed, that's not always the case).

As we head toward 2014, I doubt the fears will abate. That's partially due to the fact that there still are a number of issues on America's and the rest of the globe's plates. But it's partially due to many investors never really having gotten over the scars of 2008 and early 2009. Those wounds were so deep and painful that many investors (and the media) are quick to the assumed that any obstacle is the start of a new crisis and devastating bear market. In today's world of 24-hour financial news coverage and ubiquitous social media, that sort of pessimism is tough to shake. That makes it more important than ever to focus on facts, to stick to the numbers, and to stay disciplined. Don't sell a stock because of a headline; sell because its valuation has gotten too high, or its growth has slowed, or its debt has risen sharply. Similarly, don't buy a stock because of a headline; buy it because its balance sheet is strong, its shares are attractively valued, and its internal returns are high. If you do that, and stick to it, you should produce good returns over the long haul, regardless of the periodic obstacles that will inevitably surface.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 2 stocks leave our portfolio. These include: Hibbett Sports, Inc. (HIBB) and The Tjx Companies, Inc. (TJX).

The Keepers

8 stocks remain in the portfolio. They are: Usana Health Sciences, Inc. (USNA), Stamps.com Inc. (STMP), Lukoil (Adr) (LUKOY), Amtrust Financial Services, Inc. (AFSI), Bridgepoint Education Inc (BPI), Lear Corporation (LEA), Hollyfrontier Corp (HFC) and Hci Group Inc (HCI).

The Newbies

We are adding 2 stocks to the portfolio. These include: Coach, Inc. (COH) and Xinyuan Real Estate Co., Ltd. (Adr) (XIN).

Portfolio Changes

Newcomers to the Validea Hot List

Coach Inc. (COH): This New York City-based luxury goods maker and handbag specialist actually wasn't hit too hard during the Great Recession, and it has thrived since then. The $14-billion-market-cap firm has long been a favorite of my Warren Buffett-based model, and currently also gets strong interest from my Peter Lynch- and Joel Greenblatt-based models. To read more about it, check out the "Detailed Stock Analysis" section below.

Xinyuan Real Estate Co. Ltd. (XIN): This Chinese developer focuses on large scale residential real estate projects geared toward middle-income consumers. It keys on "Tier II" cities -- larger, more developed urban areas with above average GDP and population growth rates. The 16-year-old company has a market cap of about $700 million.

Xinyuan gets strong interest from my Joseph Piotroski-based model and my James O'Shaughnessy-based growth approach. For more about its impressive blend of value and growth, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

USANA Health Sciences (USNA): USANA on Oct. 22 reported that net earnings fell 4.2% to $16.8 million (vs. the year-ago period). This firm said the decline was due "primarily to higher Associate Incentives expense, attributable to the enhancements that the Company made to its Associate Compensation Plan". Higher effective tax rates also hurt. Earnings per share were down 1.7% to $1.16, helped in part by share repurchases. Third-quarter net sales increased by 5.2% to $173.7 million, driven by increases in both the Asia Pacific and North America/Europe regions. The company said its quarterly results were negatively impacted by recently implemented changes that are expected to help the firm over the longer term. Wall Street wasn't pleased, however -- shares were down close to 20% in the day-and-a-half following the after-market announcement (as of about noon on Oct. 24). Still, the stock is up over 125% since joining the Hot List last December.

Stamps.com (STMP): Stamps.com reported third quarter earnings per share of $0.62, topping analysts' consensus estimate of $0.51. Revenues were $31.2 million, just short of the $31.55 million analysts forecast, StreetInsider reported. The firm upped its full-year guidance to $2.20-$2.40, versus prior estimates of $2-$2.20 and the consensus of $2.18. It now expects full-year revenue of $125-135 million, versus the consensus of $130.14 million. Shares had fallen 6% on Oct. 23 in advance of the after-market announcement, but they surged upward the next morning, jumping 13% as of early afternoon trading.

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

USNA   |   BPI   |   HCI   |   STMP   |   XIN   |   LUKOY   |   LEA   |   AFSI   |   HFC   |   COH   |  

USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's academic institutions include Ashford University and University of the Rockies. Its institutions deliver programs primarily online, as well as at their traditional campuses. As of December 31, 2011, the Company had 86,642 total students enrolled in its institutions. Bridgepoint's institutions conduct ongoing faculty and student assessment processes and provide a range of student services. The Company is also focused on developing new technologies, such as through Waypoint Outcomes, Constellation, and the development of its institutions' mobile learning platforms. The Company has developed Constellation to replace third party textbooks with digital course materials. Constellation materials are displayed in a browser-based platform. In January 2012, Bridgepoint introduced Thuze.

HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.

Stamps.com Inc. is a provider of Internet-based postage solutions. The Company's customers use its service to mail and ship a variety of mail pieces, including postcards, envelopes, flats and packages, using a range of United States Postal Service (the USPS) mail classes, including First Class Mail, Priority Mail, Express Mail, Media Mail, Parcel Post, and others. Its customers include individuals, small businesses, home offices, medium-size businesses and enterprises.

Xinyuan Real Estate Co., Ltd. (Xinyuan) is a developer of large-scale residential real estate projects aimed at providing middle-income consumers with a comfortable and convenient community lifestyle. Xinyuan has expanded its network to cover a total population of over 64.7 million people in eight selected cities, consisting Beijing, Hefei, Jinan, Kunshan, Suzhou, Zhengzhou, Xuzhou and Chengdu. The Company's United States development arm, XIN Development Group International, Inc. (XIN), is a real estate residential developer that entered the United States market with three projects in 2012. XIN's products portfolio consists of multiple rise buildings, sub-high-rise buildings and high-rise buildings, together with auxiliary services and amenities, such as retail outlets, leisure and health facilities, kindergartens and schools. In September 2013, Xinyuan Real Estate Co., Ltd. acquired four land parcels through auction.

NK Lukoil OAO (Neftyanaya Kompaniya LUKOIL OAO or NK LUKOIL OJSC) is a Russia-based integrated oil and gas company. The Company is engaged in the business of oil exploration, production, refining, marketing and distribution. It is an owner of refineries, gas processing, petrochemical plants and gas stations network located in Russia, Eastern and Western Europe, as well as Africa. The Company's petroleum products are sold in the Russian Federation, the Commonwealth of Independent States (CIS) countries, Eastern and Western Europe, Asia and the United States. NK Lukoil OAO operates through numerous subsidiaries and affiliated companies. In April 2013, the Company acquired a 100% of Samara-Nafta ZAO and completed acquisition of CJSC Kama-Oil. In June 2013, it sold a 99.57% stake in Lukoil Odes'kyi NPZ PAT. The Company's major shareholder is NKO ZAO NRD with a stake of 91.60%.

Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.

Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four segments: small commercial business, specialty program and personal lines reinsurance. In January 2013, the Company acquired First Nonprofit Companies, Inc. In February 2013, its subsidiary acquired Car Care Plan (Holdings) Limited from Ally Insurance Holdings, Inc. In April 2013, it acquired Sequoia Insurance Company and its subsidiaries, Sequoia Indemnity Company and Personal Express Insurance Company. In May 2013, the Company acquired Mutual Insurers Holding Company (MIHC) and MIHC's subsidiary, First Nonprofit Insurance Company.

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.

Coach, Inc. (Coach) is a marketer of accessories and gifts for women and men. The Company offers a range of modern, fashionable handbags and accessories. Its product offerings include women's and men's bags, accessories, footwear, wearables, jewelry, travel bags, sunwear, watches and fragrance. The Company operates in two segments: North America, which includes sales to North American consumers through Company-operated stores, including the Internet, and sales to wholesale customers and distributors and International, which includes sales to consumers through Company-operated stores in Japan and mainland China, including the Internet, Hong Kong, Macau, Singapore, Taiwan, Malaysia and Korea and sales to wholesale customers and distributors in 25 countries.

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.


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