|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||May 25, 2012|
While global stock markets continue to tumble amid the renewed European debt crisis fears, the U.S. economy keeps chugging along, improving at a steady (albeit slow) pace.
Industrial production, for example, jumped 1.1% in April vs. March, according to a new report from the Federal Reserve. (All month-over-month figures here are seasonally adjusted, while year-over-year changes are unadjusted.) The March figure was revised lower to -0.6% (from flat), but the March figure was revised higher to 0.4% gain (also from flat). A big driver behind the April increase was the utility sector, with output rising 4.5% because unseasonably warm weather during the first quarter had kept heating demand down in previous months. Still, manufacturing sector output nonetheless increased a very respectable 0.6% during April. Capacity utilization climbed to its highest level since 2008, and now stands only about one percentage point below its long-term historical average.
Retail sales, meanwhile, edged upward 0.1% in April, according to the Commerce Department. It was the 11th straight month that they increased. Using non-seasonally adjusted data, however, sales were 4.4% above their year-ago level, which was well below the year-over-year increases seen over the past year and the lowest since August 2010.
Jobs data also continues to get a little better, with new claims for unemployment holding steady over the past two weeks, and continuing claims (the data for which lags new claims by a week) falling slightly in the most recent week. New claims are 13% below where they were a year ago, while continuing claims are 12.5% lower.
Existing home sales also increased 3.4% in April, according to the National Association of Realtors. They are 6.7% higher than they were a year ago. In addition, with foreclosure properties making up a lower percentage of sales, the median sales price was about 10% higher than it was a year ago. The realtor group's head economist said that the housing recovery "is underway," and that it is "no longer just the investors who are taking advantage of high affordability conditions. A return of normal home buying for occupancy is helping home sales across all price points, and now the recovery appears to be extending to home prices."
Overseas, however, the debt fears continue to dominate, with worries that Greece will have a disorderly exit from the eurozone driving stocks lower both in the U.S. and abroad. Another macroeconomic factor that may be at play is the looming danger of the U.S.'s "fiscal cliff" -- that is, the major economic impact that await us if Congress doesn't reach a compromise that would stop drastic budget cuts from automatically occurring at the start of 2013. Charles Schwab's Liz Ann Sonders, whose economic forecasting has been remarkably accurate in recent years, recently said she thinks those looming cuts are already providing a bigger drag on the markets than many believe. That, and the eurozone issues, are significant short-term risks to stocks. But given the declines of the past several weeks, some pretty bad scenarios have already gotten baked into prices. Better-than-expected news on either the eurozone situation or the "fiscal cliff" situation could thus provide a major catalyst for the market to reverse course and make some major moves upward.
Since our last newsletter, the S&P 500 returned -2.7%, while the Hot List returned -2.8%. So far in 2012, the portfolio has returned 7.4% vs. 5.0% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 142.7% vs. the S&P's 32.0% gain.
In addition to the European debt crisis, the biggest stock market story of the past two weeks was the Nasdaq debut of Facebook, which had its initial public offering on May 18. It was one of the most widely anticipated IPOs ever -- and the results were disappointing, with shares dropping about 15% in the first four trading days.
The reasons for investing in Facebook are obvious: The website has become a global phenomenon, with nearly 850 million monthly users, 2.7 billion comments and likes per day, and 250 million photos uploaded per day. It has access to the eyes and ears of nearly one billion people -- not to mention a huge supply of consumer data that other businesses covet.
For all of its hype and very real potential, however, Facebook doesn't get any interest from my strategies. In fact, the highest score it gets from any one of my models is 52%, from the Molly Fool-inspired strategy. Perhaps the biggest reason it falls short: valuation. Facebook shares trade for more than 100 times trailing 12-month earnings, more than 18 times sales, and nearly 15 times book value, figures which aren't even close to getting approval from any of the strategies used by the gurus I follow. Even if you use a valuation metric that takes into account Facebook's impressive 56% long-term earnings-per-share growth rate, it still looks pricey, with a PE-to-Growth ratio nearly double the maximum that my Peter Lynch inspired strategy uses, and nearly four times the target my Fool-based strategy employs.
The Facebook issue touches on the key broader issue for investors, which is the importance of valuation. Every one of the gurus upon whom I base my strategies -- even the growth investors -- use at least one value metric in their approaches. They were not speculators, but instead fundamental-focused, price-conscious stock-pickers.
How these gurus went about judging value varied quite a bit, however. Given the hubbub surrounding Facebook and the ever-present questions about the cheapness or expansiveness of stocks today, I thought it would be a good time to take a look at just how each of these highly successful investors assessed value when putting together their portfolios:
Peter Lynch: Lynch, like many investors, looked at the price/earnings ratio. But he added an insightful twist. He realized that for some stocks, it could be worth paying higher P/Es if the companies were producing enough growth. He thus pioneered the PE-to-Growth ratio (PEG), which divides a stock's P/E by its long-term growth rate. For larger, dividend-paying stocks, he added dividend yield to the growth rate. PEG's below 1.0 are attractive to my Lynch-inspired model, with those under 0.5 being the best case.
Warren Buffett: The strategy I base on the approach of the "Oracle of Omaha" looks at earnings yield, which is essentially the inverse of the P/E ratio. It wants a stock's earnings yield to be at least as high as the yield on the 10-year Treasury bond. (Of course, given how low Treasury yields are right now, it's best if the earnings yield is significantly higher in the current environment.)
Benjamin Graham: Graham wanted P/E ratios to be no greater than 15 (and, as a sign of his conservative style, he looked at P/Es using both trailing 12-month earnings and three-year average earnings, to ensure that one-year anomalies didn't skew the ratio). For the price/book ratio, he used a more unusual standard: The P/E ratio multiplied by the P/B ratio should be no greater than 22.
Joel Greenblatt: At first glance, Greenblatt appears to use a simple earnings yield measure as his valuation metric. But upon closer inspection, it's more complicated than that. Rather than just dividing earnings-per-share by share price, Greenblatt says to divide earnings before interest and taxes (EBIT) by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. He says he likes EBIT because he wants to see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture; he likes enterprise value because it give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts.
John Neff: It's pretty easy to guess what metric Neff used, given that he called himself a "low-P/E investor". But what's interesting is that he didn't just look for stocks with the lowest P/E ratios. That's because he found that stocks with P/Es that were too low were often just dogs, and were trading at ultralow valuations because everyone knew it. So, he looked for stocks with P/Es that were 40% to 60% of the market average. Stocks in this range will often be companies that are flying under the radar, but which don't have fatal problems.
Kenneth Fisher: At the time Fisher wrote his book Super Stocks in 1984, the predominant valuation ratio being used by investors was the price/earnings ratio. But Fisher found that the P/E had a major flaw: Earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing. Fisher found that sales were far more stable and a better indicator, and he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR). My Fisher-inspired model considers stocks with PSRs below 1.5 good values. And the real winners are those with PSR values under 0.75. In addition, because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing-type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSRs under 0.4.
James O'Shaughnessy: My O'Shaughnessy-based value model uses dividend yield as its valuation metric, while the growth approach uses the price/sales ratio. O'Shaughnessy found that the PSR was the best indicator of a stock's future performance -- a revelation that came as a surprise, given how much emphasis is put on the P/E ratio in the investment world. (He since has revised his research and found that a hybrid valuation tool, which incorporates several different metrics, has the best long-term track record; given the success of my O'Shaughnessy-based growth approach, however, I stuck with the PSR for that model.)
Tom and David Gardner: These brothers and creators of the Motley Fool investment community have inspired one of my best-performing models. It uses the "Fool Ratio", which is actually the same thing as the PE-to-Growth ratio that Lynch pioneered. My Fool-based strategy ideally likes a stock to be trading at a PEG below 0.5.
Joseph Piotroski: Piotroski keyed on stocks that were in the highest 20% of the market based on book/market value. Essentially this is the same thing as focusing on the cheapest 20% of stocks in the market based on price/book value.
Martin Zweig: While Zweig is a growth investor, there were limits to how much he would pay for a good growth stock. The strategy that I based on his writings makes sure that a stock has a P/E ratio no more than three times the market average, and never higher than 43, no matter what the market average is at the time. In addition, like Neff, he found that stocks with very low P/Es were often outright dogs. He thus avoided stocks with P/Es below 5.
David Dreman : This contrarian guru looked at more valuation metrics than any of the gurus I follow. He measured stocks using the price/earnings ratio, price/cash flow ratio, price/book ratio, and price/dividend ratio. The model that I base on his writings targets stocks that fall into the market's cheapest 20% in two or more of those categories.
As you can see, different investing greats have used a variety of different valuation metrics to produce their exceptional returns. The key thing to note, however, is that they all looked at valuation in some context -- no stock was so tantalizing that they would buy it at any price.
Does this mean that a stock trading at astronomical valuations can't be a big winner, or that a stock trading at a very low valuation can't be a loser? Of course not. But over the long-term, history has shown that focusing on attractively valued stocks puts the odds in your favor.
With the Hot List, I think one of the things that has made the portfolio so successful over the long term is that it takes all of these gurus' various metrics into account. As I noted above, in the latest version of his book, O'Shaughnessy found that combining a variety of valuation metrics has actually proved to be the most successful approach over the long term, and Dreman came to a similar conclusion in a recent updated version of his book. The Hot List has been using this sort of consensus valuation approach since its inception. In order to get the highest ratings, a stock must be offering value when looked at from a variety of different angles. This reduces the risk that that one particular metric is skewed because of a short-term anomaly (for example, a company could get a windfall in a lawsuit settlement that makes its P/E ratio look artificially low, given that the settlement was a one-time gain that won't be repeated). And over the long-term, that type of multi-factor approach should put the odds even more in your favor.
Guru Spotlight: Peter Lynch
Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".
If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.
Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.
Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.
But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.
The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.
To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.
The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG as a way to make sure he wasn't paying too much for growth really makes him a hybrid growth-value investor.
One Size Doesn't Fit All
One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).
The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.
"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.
One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.
Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.
Beyond The PEG
The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)
The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.
For most of the time since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has been one of my better performers. It has averaged annualized returns of 5.3%, easily beating the 3.1% annualized return for the S&P 500 (all performance figures are through May 21). The portfolio's performance numbers have been hurt by a poor 2011 (when it lost more than 20%) and a sub-par first part of 2012 (down 1.5%), but given its long-term track record, I expect the recent troubles are short-term and wouldn't be surprised to see the portfolio post some strong bounce-back gains before the year is over. Interestingly, the 20-stock Lynch-inspired portfolio we track held up much better in 2011, and has one of the best long-term track records of all my portfolios. It has averaged annual returns of 12.6% since its July 2003 inception, vs. that 3.1% figure for the S&P. That would seem to be a sign that the strategy is a solid one, and that the 10-stock portfolio's troubles should be short-term issues.
Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:
Ternium S.A. (TX)
OmniVision Technologies, Inc. (OVTI)
Kulicke and Soffa Industries Inc. (KLIC)
Nacco Industries (NC)
Crexus Investment Corp. (CXS)
AsiaInfo-Linkage, Inc. (ASIA)
Humana Inc. (HUM)
GT Advanced Technologies Inc. (GTAT)
FXCM Inc. (FXCM)
Apollo Group (APOL)
The Stomach's The Key
While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success, and it's one that is particularly relevant given the portfolio's rough recent run: Don't bail when things get bad.
Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."
Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.
That, of course, is particularly hard to do when the market gets volatile. But Lynch said it's critical to stay disciplined: "The real key to making money in stocks," he once said, "is not to get scared out of them."
News about Validea Hot List Stocks
Advance Auto Parts (AAP): Shares of Advance Auto tumbled as the firm announced solid first-quarter results but guidance that fell short of analysts' estimates. Net income for the first quarter rose about 33% while sales rose 3.1%, and the company reaffirmed its full-year profit outlook of $5.55 to $5.75 per share, Reuters reported. But analysts were expecting $5.97 per share, according to Thomson Reuters I/B/E/S, and company officials warned of challenging sales trends for the current quarter. Shares fell 17% on May 17, but rebounded somewhat this week.
The TJX Companies (TJX): TJX shares jumped last week on strong earnings results. The firm announced first-quarter earnings of $419.2 million, or 55 cents a share, far outpacing the $266.0 million, or 34 cents a share, it earned a year earlier. Analysts, on average, expected earnings of 54 cents a share, according to Thomson Reuters I/B/E/S. TJX also said it expects to earn between $2.27 and $2.37 a share for the full year, up slightly from its previous estimates.
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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