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Executive Summary September 28, 2012



The Economy

Is the housing recovery for real? That's one of the big questions on investors' minds right now. And, so far at least, the answer seems to be 'yes'.

Home prices across 10 major cities rose an average of 1.5% in July, according to the latest data from the S&P/Case-Shiller Home Price Indices, while the 20-city index rose 1.6% (both figures versus June). It was the third straight month prices increased in all 20 of the major cities. (Here and below, week-over-week and month-over-month comparisons are seasonally adjusted; year-over-year comparisons are not.)

Housing starts, meanwhile, increased 2.3% in August, according to a new Commerce Department report. And existing-home sales rose 7.8% in August, according to the National Association of Realtors, and are now 11.2% above where they were last year at this time. Median sales prices for the month were 9.5% higher than they were a year ago.

Still, Case-Shiller indices co-founder Robert Shiller says it's too early to tell whether the housing market has indeed finally bottomed, as a big part of recent price gains has been due to seasonal factors. And he's right. But the good news is that even when adjusted for seasonal variations, the S&P/Case-Shiller 10-and 20-city indices were each up 0.4% in July.

A housing recovery would be a boon to the economy, which though not growing at a gangbusters pace, continues to improve. Retail sales increased 0.9% in August, for example, according to the Commerce Department. A decent chunk of that came, however, from gasoline sales, as gas prices rose significantly during the month (they've now come back down a bit).

Industrial production, meanwhile, declined 1.2% in August, according to a new Federal Reserve report. Hurricane Isaac played a significant role in that, however, forcing precautionary shutdowns of oil and gas rigs and restraining output in the Gulf Coast region, so it may be a one-month aberration.

Finally, new claims for unemployment fell nearly 7% in the two weeks since our last newsletter. They are now 8.4% below where they were a year ago. Continuing claims, the data for which lag new claims by a week, were down slightly over the past two weeks. They are 11.7% below year-ago levels.

The fuel price increases also played a big role in the Consumer Price Index increasing 0.6% in August, the biggest jump in more than three years. That's certainly something to keep an eye on going forward.

Since our last newsletter, the S&P 500 returned -0.9%, while the Hot List returned -2.4%. So far in 2012, the portfolio has returned 15.2% vs. 15.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 160.5% vs. the S&P's 44.7% gain.

Why Fund Managers Fail -- And How To Succeed

We are now nearly three-quarters of the way through the year, and, despite all the concerns about the U.S. fiscal cliff, European debt, and China's slowdown, 2012 has thus far been a pretty strong year for the stock market. Unless things have turned around markedly in the third quarter, however, it has not been a good year for many mutual fund managers. According to a Bank of America Merrill Lynch report, about 70% of large-cap active fund managers underperformed the Russell 1000 benchmark during the first half of the year.

Unfortunately, that's not that unusual. While I often highlight some top-performing mutual fund managers in this newsletter, whether it be gurus upon whom I base my strategies or top current managers like Donald Yacktman and Bruce Berkowitz, the reality is that most fund managers fail to meet their benchmarks. Consider this: In 2011, 81.3% of active large-cap funds failed to beat the S&P 500, according to Standard & Poor's. Mid-cap managers fared better, but the results were still dismal -- 67.4% of them failed to beat the S&P MidCap 400 benchmark. And small-cap managers fared worst of all: 85.8% of them failed to beat the S&P SmallCap 600 benchmark.

Those results were particularly bad. But over the longer term, the track record is still very weak. In the 10-year period ending in 2011, an average of 59.4% of actively managed large-cap funds failed to beat the S&P 500, according to S&P; an average of 63.5% of mid-cap managers failed to beat the S&P MidCap 400; and an average of 63.1% of small-cap managers failed to beat the S&P SmallCap 600. How about international fund managers? Well, over the past five years, according to S&P, about 83% of emerging markets fund managers have failed to beat the S&P/IFCI Composite, and about 78% of international funds have failed to beat the S&P 700. International small-cap fund managers are one of the few bright spots: Only about 26% of them underperformed the S&P World Ex-U.S. Small-Cap benchmark.

In theory, fund managers should have the expertise, experience, and resources to beat the market pretty consistently, right? So, why do so many fail to generate the returns you could get from simply investing in a passive index fund? Part of the reason is that fund managers are human, and, as I've often discussed, we humans are poorly wired for investing -- it's no different if you're an individual investor managing a $10,000 portfolio, or if you're a fund manager overseeing billions of dollars in assets. We're prone to a number of behavioral biases that, if unchecked, can constantly eat away at returns. There's Myopic Loss Aversion, which is when investors, not wanting to feel the pain of locking in losses, hold onto losing stocks well after they're no longer attractive. And Anchoring, which is when one bases one's expectations on facts or figures that are no longer relevant. (When a stock falls from, say, $100 a share to $50 a share, for example, many investors will "anchor" on that initial $100 price and assume the stock must be a bargain, without considering its fundamentals.) Then there's Recency Bias, which is when investors extrapolate the recent past into the future. And don't forget Hindsight Bias, which is more than just realizing how you could have made money (or not lost money) after the fact -- it's when we incorrectly think that what we should have done was obvious or easily predictable, and allow that misconception to color our future decisions.

All of these and other biases that are hardwired into our brains impact not only individual investors, but fund managers as well. But in addition, there are a couple other factors that negatively impact fund managers specifically, perhaps the most significant being "career risk". Jeremy Grantham and his GMO colleagues have written pretty extensively on this topic, and here's how Grantham explains career risk: "The central truth of the investment business is that investment behavior is driven by career risk," he wrote in his first-quarter letter this year. "In the professional investment business we are all agents, managing other peoples' money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority 'go with the flow,' either completely or partially. This creates herding, or momentum ..."

It's understandable, really. In today's world, many investors -- who are continuously barraged by reports from a financial media that has the attention span of a gnat -- have little tolerance for underperformance. They might give a fund manager six months, maybe a year, but quite often it isn't long before they'll jump ship if a fund is significantly underperforming its peers or the broader market. Of course, if you're going to beat the market over the long term, you're going to go through periods of significant underperformance -- every one of the incredibly successful gurus I follow experienced that at some point. But many investors are too shortsighted to realize that, or they've been duped by crafty fund marketers into thinking that it's possible to always beat the market.

However you want to dole out the blame, the resulting situation is one that often isn't good for investors over the long haul. Knowing that they will lose their clients -- and perhaps eventually even their jobs -- if they significantly lag their peers for more than few months, fund managers don't deviate too far from their benchmarks. After all, it's a lot easier to defend your performance -- even if it's a bad performance -- if the broader market and many of your peers are in the same boat then it is if you're alone.

Research shows that leads to a myriad of funds that are overdiversified and look extremely similar to their benchmarks. James Montier, Grantham's colleague at GMO, pointed to one study in a 2010 letter to clients. He said that Jonathan Lewellen of Dartmouth College examined aggregate holdings of U.S. institutional investors over the period 1980 to 2007. "Quite simply," Lewellen found, "institutions overall seem to do little more than hold the market portfolio ... Their aggregate portfolio almost perfectly mimics the value-weighted index ... Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns."

What's interesting is that there's evidence showing that fund managers actually aren't bad stock-pickers. In one paper, Montier noted, researchers Randy Cohen, Chris Polk, and Bernhard Silli looked at the "best ideas" of U.S. fund managers over the period 1991 to 2005. ("Best ideas", Montier explained, were measured as those stocks with the biggest difference between the managers' holdings and the weights of the benchmark index.) Their findings: The top 25% of best ideas from active managers generated an average return of over 19% annually vs. a market return of 12% annually. "The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability," the authors said, "but rather to institutional factors that encourage them to over-diversify."

Other factors can also stack the deck against mutual funds, including size. Managers who have success attract a lot of attention and new clients, which at a certain point limits the types of stocks you can invest in -- if you're running a multi-billion-dollar fund, you're not going to be able to focus on smaller stocks, no matter how much you like them. Success can thus become self-defeating in some cases.

And, of course, fees are a huge issue. A percent or two off your returns might not sound like much, but over the long haul it can really add up.

To be sure, there are some great active fund managers, and I don't mean to malign an entire industry. Lynch, Neff, Berkowitz, and Yacktman are among those who have had great success for lengthy periods of time. While there's no specific formula for achieving that kind of success, I found that, generally, successful fund managers have the emotional fortitude to overcome the obstacles we've just examined. Often, they'll hold more concentrated portfolios, with holdings that diverge significantly from their benchmark. They also focus on cold, hard facts and figures, and focus on the long-term -- they aren't swayed by popular opinion or short-term hype. Berkowitz, for example, took all sorts of criticism last year when a big investment in financials like much-maligned AIG dragged his fund down, putting it at the very bottom of his category in terms of 2011 returns. But he wasn't swayed, and this year his fund has rebounded sharply, and is ranked in the top 1% of its class, according to Morningstar.

The majority of fund managers and most individual investors don't have that kind of temperament, however. That's why I created Validea. By using a system that is purely quantitative and focuses only on facts and figures, and by using a fixed rebalancing period that allows for buying and selling only at regular intervals, the Hot List and our other portfolios take emotion and behavioral biases out of the equation. That doesn't mean the system will be right on every pick, or that it will beat the market every month, or even every year. But over the long haul, the system has proven that this sort of fundamental-focused, unemotional approach can generate impressive returns. Whatever the specifics of your own investment approach, I would urge you to make sure that you, or those who you trust to manage your money, are willing to follow a similar path -- that is, act unemotionally, make decisions based on hard data and not hype, and always focus on the long-term.

 
Editor-in-Chief: John Reese










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The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: The Tjx Companies, Inc. (TJX), Astrazeneca Plc (Adr) (AZN), Autoliv Inc. (ALV) and Triumph Group Inc (TGI).

The Keepers

6 stocks remain in the portfolio. They are: Apollo Group Inc (APOL), Northrop Grumman Corporation (NOC), Nu Skin Enterprises, Inc. (NUS), World Acceptance Corp. (WRLD), Solarwinds Inc (SWI) and Hollyfrontier Corp (HFC).

The Newbies

We are adding 4 stocks to the portfolio. These include: Deckers Outdoor Corp (DECK), Guess?, Inc. (GES), Lkq Corporation (LKQ) and Homeowners Choice, Inc. (HCII).

Portfolio Changes



Newcomers to the Validea Hot List

LKQ Corporation (LKQ):: This Chicago-based auto part firm offers a variety of original, aftermarket, and used parts and systems. It has over 450 locations in the U.S., Canada, and the U.K.

LKQ ($5.6 billion market cap) was in the Hot List for about three months earlier this year, gaining 6.2%. Now it's back, getting strong interest from my James O'Shaughnessy-, Martin Zweig-, and Peter Lynch-based models. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.

Deckers Outdoor Corporation (DECK): This Georgia-based firm makes footwear and accessories, including the UGG and Teva brands. It has a market cap of $1.3 billion.

Deckers' shares have been hammered over the past 11 months, falling about 70% as questions about the UGG brand's future prospects, negative analyst reports, and increasing inventory have all hurt the stock. But my Benjamin Graham- and Joel Greenblatt-inspired models think it's been hit much too hard. See the "Detailed Stock Analysis" section below for more on why the stock's fundamentals are appealing.

Guess?, Inc. (GES): Los Angeles-based Guess makes trendy apparel, denim, handbags, watches, footwear and other related consumer products. It directly operates about 500 retail stores in the United States and Canada and 264 retail stores in Europe, Asia and Latin America. Its licensees and distributors operate more than 800 more retail stores outside of the U.S. and Canada.

Guess is another previous Hot List pick -- in a one-month stint during June and July it gained about 6% for the portfolio. Now it gets strong interest from my Peter Lynch- and Benjamin Graham-based models. See the "Detailed Stock Analysis" section below to learn more about the stock.

Homeowners Choice, Inc. (HCII): Tampa-based Homeowners ($220 million market cap) is the parent of Homeowners Choice Property & Casualty Insurance Company, which provides homeowners insurance in Florida. It has posted some impressive recent growth in both earnings and revenues, part of the reason my Motley Fool-based strategy is high on the stock. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.



News about Validea Hot List Stocks

Nu Skin Enterprises (NUS): Nu Skin said last week that it plans to triple the number of stores and sales support centers in China by 2017. The firm has come under scrutiny because a research group recently alleged that Nu Skin is operating an illegal multi-level marketing scheme in China, according to Reuters. But the company said it is consulting with government authorities to develop the additional distribution channel in a manner that is consistent with what the direct selling industry offers in China, Reuters reports. While the allegations haven't been substantiated, they have driven Nu Skin shares down about 7.5% (as of mid-afternoon on Sept. 27) since the portfolio picked it up on the last day of August. But my models remain high on the stock and aren't swayed by rumor, so the portfolio is holding onto the stock for now.



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

NOC   |   SWI   |   APOL   |   HFC   |   DECK   |   LKQ   |   GES   |   NUS   |   WRLD   |   HCII   |  



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.





Deckers Outdoor Corporation (Deckers) is a designer, producer, marketer, and brand manager of footwear, apparel, and accessories. Deckers markets its products under three brands: UGG, Teva and Sanuk. The Company sells its products, including accessories, such as handbags and outerwear, through domestic and international retailers, international distributors, and directly to consumers both domestically and internationally, through its Websites, call centers, retail concept stores and retail outlet stores. In addition to the Company's primary brands, Deckers' other brands include TSUBO, a line of casual footwear that incorporates style, function, and maximum comfort; Ahnu, a line of outdoor performance and lifestyle footwear, and MOZO, a line of footwear that combines running shoe technology with work shoe toughness for individuals that spend long hours working on their feet. On July 1, 2011, it completed the acquisition of the purchased assets of the Sanuk brand.





LKQ Corporation (LKQ) provides replacement parts, components and systems needed to repair vehicles (cars and trucks). The Company operates in four segments: Wholesale-North America Wholesale-Europe, Self Service and Heavy-Duty Truck. Buyers of vehicle replacement products have the option to purchase from primarily five sources: new products produced by original equipment manufacturers (OEMs), which are known as OEM products; new products produced by companies other than the OEMs, which are sometimes referred to as aftermarket products; recycled products originally produced by OEMs, which it refers to as recycled products; used products that have been refurbished; and used products that have been remanufactured. October 1, 2011, it acquired Euro Car Parts Holdings Limited (ECP). On May 27, 2011, it acquired AkzoNobel Coatings Inc.'s paint distribution business. In February 2012, the Company announced that it had acquired Pieces Automobiles Lecavalier Inc.





Guess?, Inc. (GUESS?) designs, markets, distributes and licenses apparel and accessories for men, women and children. The Company operates in five: Europe, North American Retail, Asia, North American Wholesale and Licensing. Its products are sold through retail, wholesale, e-commerce and licensing distribution channels. The lines include full collections of clothing, including jeans, pants, skirts, dresses, shorts, blouses, shirts, jackets, knitwear and intimate apparel. It also grant licenses to manufactures and distributes a range of products, including eyewear, watches, handbags, footwear, kids' and infants' apparel, leather apparel, swimwear, fragrance, jewelry and other fashion accessories. In fiscal 2012, it, along with its distributors and licensees, opened 224 stores in all concepts combined outside of the United Sates and Canada, which consisted of 120 stores in Europe and the Middle East, 89 stores in Asia and 15 stores in the combined area of Central and South America.





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.





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. In November 18, 2011, it acquired Unthink Technologies Private Ltd. In November 2011, it acquired the Florida policies of HomeWise Insurance 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


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

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

Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.