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Executive Summary June 6, 2014

The Economy

Some of the major market indices are continuing to set new highs, bolstered in part by solid data from the employment, manufacturing, and service sectors.

In May, for example, the private sector added 179,000 jobs, according private payroll processor ADP. That wasn't quite as good as the past three months, when the figure averaged 202,000, but it's still a solid increase. Small businesses led the way, accounting for nearly half of the new jobs. The government's May jobs report is due out today, and will no doubt be watched closely by Wall Street.

The manufacturing sector expanded in May for the 12th straight month, and did so at an accelerating pace for the fourth straight month, according to the Institute for Supply Management. The survey's New Orders sub-index also rose and remains at a very healthy level. The Employment sub-index showed that conditions continued to improve, though at a slower pace than they did in April. The Prices sub-index, which last month showed that the rate of price increases fell to the slowest place of the year, jumped back up in May. Prices have now been increasing for 10 straight months, doing so at a pretty strong clip most of that period, something to keep an eye on.

The service sector also expanded in May for the 52nd straight month, doing so at the fastest pace since last August. The New Orders sub-index continued to rise and is now quite high -- only 10 percent of ISM survey respondents said new orders declined vs. April. The Employment sub-index rose a bit, indicating that employment conditions in the sector keep improving. Inventory levels, which had jumped sharply the previous month, rose at the same rate in May. Prices increased at a very strong rate for the third straight month. Again, something to keep an eye on.

Personal income rose at a good pace in April, increasing 0.3 percent, according to a new government report. Real disposable personal income rose 0.2 percent. After increasing their spending more quickly than their income was rising in each of the past two months, consumers tightened their belts in April, with real personal consumption expenditures falling 0.3 percent. That helped boost the personal savings rate from 3.6 percent in March to 4.0 percent in April.

Overall since our last newsletter, the S&P 500 returned 2.5%, while the Hot List returned 2.7%. For the year, the portfolio stands at -10.8% vs. 5.0% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 224.6% vs. the S&P's 94.0% gain.

The Valuation Situation

The market is continuing to climb, with the S&P 500 making several recent record highs. For a value investor, that can be a bit disconcerting. Value investors like Benjamin Graham, Joel Greenblatt, Warren Buffett, and the other gurus I follow tend to get excited when prices are falling - not rising - because they're always on the hunt for bargains.

So with the market's continued rise, how do things stand, valuation-wise? Are there bargains left? First, let's check in on broader market valuations.

As always, let's start with earnings. As of June 5, the S&P 500 is trading for about 19.4 times trailing 12-month as reported earnings per share, up from 18.4 times last August, when last we check in on valuations. Using projected earnings for next year, the P/E is 15.6. The forward P/E is above the 5-year average forward 12-month P/E of 13.2, and above the 10-year average forward 12-month P/E of 13.8, according to FactSet. Overall, P/Es are thus a bit on the higher side. But these earnings-related valuations are from from exuberant; they're within what I'd say is "fair value" range, particularly in a low-interest rate environment.

The S&P's price/sales ratio, meanwhile, is 1.65, according to Morningstar.com, up from 1.4 back in August. Its price/book ratio is 2.33, up from 2.1. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners, so that figure stacks up well. The current price/sales ratio is higher than the historical average cited by Comstock and Ned Davis. But again, it doesn't seem exuberant -- my James O'Shaughnessy - based growth model considers P/S ratios of up to 1.5 to be indicative of good values, so 1.65 is probably still in the fair value range.

Dividend yields remain attractive, with the S&P yielding 2.3%. That's up slightly from 2.2% in August.

One figure that is a bit disconcerting is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It is now 119.3%, up from 111.8% in August, according to GuruFocus.com. That puts it in the "Significantly Overvalued" range (over 115%), based on the site's analysis of historical data. It's also more than double what it was at the beginning of the bull market.

The 10-year cyclically adjusted price/earnings ratio also remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 25.8, using Yale Economist Robert Shiller's earnings data. That's up from 23.9 last August. It's also well above the 16.5 historical average (which dates back to 1871). As I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is about 18.3 (after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor). Still, the figure is quite elevated, as it has been throughout almost the entire bull market.

The Q Ration also indicates that the market is significantly overvalued. Developed by Nobel Laureate James Tobin, the "Q" is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Research provides data needed to make the calcuation on its Flow of Funds Account report, though that is only released once per quarter. As of the most recent report, which came at the end of Q1, the Q ratio was 1.11, up from 1.08 last August, according to an analysis done by Doug Short of Advisor Perspectives. That was significantly higher than the historical average of 0.68 using the arithmetic mean and 0.63 using the geometric mean. As has been the case for some time, the recent Q indicates the market is significantly overvalue, but it's not nearly as high as it has gotten at some market tops. The current Q is 64% above the historical average; back at the height of the tech bubble, it was 141% above the mean.

All in all, the broader market's valuation continues to climb. Looking at the totality of the data, we're probably on the high end of the fair valuation range, or perhaps a bit overvalued. That's not a big cause for concern, though -- this is what happens in bull markets. Prices rise, and valuations go from cheap to average to above average. But we're not seeing wild exuberance in the valuations. Perhaps some areas of the market are bubbly, but based on the data, I don't believe we are experiencing a bubble in the overall market.

But keep in mind that as the broader market valuations climb higher, stock-picking strategies become even more important. There are still bargains out there to be had, even in a market that's making all time highs, but they're not as easy to find as they once were. Quantitative screening strategies, like those used by the Hot List, come in hand in that regard. They can scan through thousands of stocks in a matter of seconds to find the picks that remain attractively valued.

Take Hot List newcomer Coach, Inc. The luxury retailer, one of four stocks being added to the portfolio today, trades for just 11.9 times trailing 12-month earnings. Its earnings yield, using the EBIT/enterprise value metric my Greenblatt-based model uses, is a stellar 13.7%, which puts it among the 50 cheapest stocks in the market. And for that great price you're getting a company that has upped earnings per share in all but one year of the past decade; has no long-term debt; and has a 40% return on equity. Throw in a 3.5% dividend yield, and my models see a lot to like.

While the Hot List has struggled in the early part of 2014, its long-term track record indicates that the weak performance will be short lived. Over the long haul, by investing in strong companies with cheap shares, like Coach, I expect the portfolio will continue to extend its significant long-term outperformance of the broader market.

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: Drew Industries, Inc. (DW), Netease, Inc (Adr) (NTES), Bofi Holding, Inc. (BOFI) and Northrop Grumman Corporation (NOC).

The Keepers

6 stocks remain in the portfolio. They are: Agco Corporation (AGCO), Bed Bath & Beyond Inc. (BBBY), Robert Half International Inc. (RHI), Valero Energy Corporation (VLO), Anika Therapeutics, Inc. (ANIK) and Smith & Wesson Holding Corp (SWHC).

The Newbies

We are adding 4 stocks to the portfolio. These include: Williams-sonoma, Inc. (WSM), Nu Skin Enterprises, Inc. (NUS), Usana Health Sciences, Inc. (USNA) and Coach Inc (COH).

Portfolio Changes

Newcomers to the Validea Hot List

Williams-Sonoma Inc. (WSM): This San Francisco-based cookware and kitchen supply store, which also owns home products and furniture stores like Pottery Barn and West Elm, has nearly 600 stores across the U.S. and Canada.

Sonoma ($6.4 billion market cap) gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section below.

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 fared well since then. The $11-billion-market-cap firm and past Hot List member 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.

Nu Skin Enterprises, Inc. (NUS): Utah-based Nu Skin ($4.4 billion market cap) is a direct selling company that sells personal care, nutrition, and technology products, such as skin creams, supplements intended to fight aging, and a biophotonic scanner that measures carotenoid antioxidant activity. It sells its products through a network of more than 750,000 independent distributors and preferred customers around the world.

Nu Skin gets approval from my Peter Lynch-, Joel Greenblatt-, and James O'Shaughnessy-based strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section below.

USANA Health Sciences, Inc. (USNA): Utah-based USANA makes nutritional and personal care products such as vitamins, nutrition bars, and skin and hair cleansers. It has customers in the U.S., Canada, Australia, New Zealand, Mexico, the U.K., and a number of countries in Asia. Its subsidiary, BabyCare, Ltd., has a direct selling business in China.

USANA ($1 billion in market cap) gets strong interest from my Peter Lynch-, Warren Buffett-, and Joel Greenblatt-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section.

News About the Validea Hot List Stocks

Northrop Grumman (NOC): NOC has won a five-year contract valued at up to $9.9 billion from the U.S. Air Force to modernize and support the B-2 stealth bomber, Reuters reported. The indefinite-delivery/indefinite-quantity contract cover a range of enhancements, software maintenance, and other support services. The base contract runs through May 2019, and includes an option that would extend it through 2024.

AGCO Corp. (AGCO): AGCO has agreed to acquire Intersystems Holdings, an Omaha, Neb.-based manufacturer of commercial material handling solutions sold to grain operations globally. Terms of the deal, which is subject to certain regulatory approvals, were not disclosed. AGCO officials said the move would allow it to expand its grain handling and storage business in the fast growing off-farm segment.

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

ANIK   |   VLO   |   SWHC   |   NUS   |   RHI   |   WSM   |   COH   |   BBBY   |   USNA   |   AGCO   |  

Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

Smith & Wesson Holding Corporation (Smith & Wesson) is a manufacturer of firearms. The Company manufactures a range of handguns, modern sporting rifles, hunting rifles, black powder firearms, handcuffs, and firearm-related products and accessories for sale to a range of customers, including gun enthusiasts, collectors, hunters, sportsmen, competitive shooters, individuals desiring home and personal protection, law enforcement and security agencies and officers, and military agencies in the United States and globally. It sells its products under the Smith & Wesson brand, the M&P brand, the Thompson/Center Arms brand, and the Performance Center brand. The Company manufactures its firearm products at its facilities in Springfield, Massachusetts and Houlton, Maine. In May 2014, the Company through Deep River Plastics LLC, subsidiary purchased substantially all of assets of Tri Town Precision Plastics Inc.

Nu Skin Enterprises, Inc. is a global direct selling company with operations in 53 markets worldwide. The Company develops and distributes anti-aging personal care products and nutritional supplements under its Nu Skin and Pharmanex brands, respectively. As of December 31, 2012, the Company had more than 950,000 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, 2012, approximately 89% of its revenues came from its markets outside of the United States. The Company's ageLOC skin care products accounted for 23% of its total revenue and 43% of Nu Skin sales during the year ended December 31, 2012.

Robert Half International Inc. provides specialized staffing and risk consulting services. The Company operates in three segments: temporary and consultant staffing, permanent placement staffing, and risk consulting and internal audit services. The Company, through its Accountemps, Robert Half Finance & Accounting, and Robert Half Management Resources divisions, is a specialized provider of temporary, full-time, and project professionals in the fields of accounting and finance. OfficeTeam specializes in skilled temporary administrative support personnel. Robert Half Technology provides information technology professionals. Robert Half Legal provides temporary, project, and full-time staffing of attorneys and specialized support personnel within law firms and corporate legal departments. The Creative Group provides project staffing in the advertising, marketing, and Web design fields. Protiviti is a global business consulting and internal audit firm.

Williams-Sonoma, Inc. is a multi-channel specialty retailer of products for the home. The Company is an e- commerce retailer with brands in home furnishings. It operates retail stores in the United States, Canada and Puerto Rico, and franchises its brands to a third party in a number of countries in the Middle East, including Bahrain, the Kingdom of Saudi Arabia, Kuwait and the United Arab Emirates. Its products are also available to customers through its catalogs and online worldwide. The Company operates in two segments: direct-to-customer and retail. The direct-to-customer segment has seven merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, PBteen, West Elm, Rejuvenation and Mark and Graham) which sell its products through its seven e-commerce Websites and eight direct-mail catalogs. The retail segment has five merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation) which sells products through its retail stores.

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.

Bed Bath & Beyond Inc. is a chain of retail stores, operating under the names Bed Bath & Beyond (BBB), Christmas Tree Shops (CTS), Harmon and Harmon Face Values (Harmon), buybuy BABY and World Market or Cost Plus World Market (World Market). In addition, it is a partner in a joint venture, which operates three stores in the Mexico City market under the name Bed Bath & Beyond. The Company sells a range of domestics merchandise and home furnishings. Domestics merchandise includes categories, such as bed linens and related items, bath items and kitchen textiles. Home furnishings include categories, such as kitchen and tabletop items, fine tabletop, basic housewares and general home. During fiscal year ended March 2, 2013 (fiscal 2012), the Company opened a total of 38 stores, including 12 BBB stores throughout the United States and Canada, five CTS stores, one Harmon store and 18 buybuy BABY stores, and six World Market stores throughout the United States and closed one BBB store.

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.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

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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