After 68% Gain in ’13, Lynch Model Likes These 10 Stocks

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Peter Lynch-inspired strategy, which has averaged annual returns of 10.0% since its July 2003 inception vs. 6.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Lynch-based investment strategy.

Taken from the March 28, 2014 issue of The Validea Hot List

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”.

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Hot List: The 2014 Outlook

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John examines three key reasons why he remains bullish on stocks as we move deeper into 2014.   

Excerpted from the Jan. 17, 2014 issue of the Validea Hot List newsletter

Reasons for Optimism

While flows into domestic equity funds picked up in October and November, they have since fallen off rather sharply. And, while there are fewer disaster-type fears hanging over investors’ heads, the general mood is far from ebullient, with many expecting a weak year for stocks after 2013′s stellar — perhaps too stellar? — performance.

I wouldn’t be so sure. Of course, in the short term anything can happen, and no one knows just how much the market will return in 2014. After all, think how many people actually predicted that the S&P 500 would return close to 30% in 2013. But I do see reasons for optimism heading forward — signals that tell me this is not time to cut back on equities if you are a long-term investor. Here a few of those reasons.

The Economy: Yes, the economy still has a lot of lingering problems and growth is far from gangbusters. Unemployment — in terms of both the headline and broader measures — remains high, most notably. But there were a lot of really good signs in 2013, particularly in the second half of the year. Housing starts were more than 33% above where they stood a year ago in November (the latest data available). New home sales, meanwhile, were up about 18% through November, according to the Census Bureau. Manufacturing activity surged in the second half of the year, increasing in December for the 7th straight month, and at close to the fastest pace in two years, according to ISM. The group’s manufacturing sub-indices for both new orders and employment are at high levels. ISM also said the service sector expanded in December for the 48th straight month. And the latest revisions show that GDP increased at a greater than 4% rate in the third quarter, one of the better figures we’ve seen over the past few years. All of this occurred amid the government budget sequestration that was expected to put a major crimp on growth in 2013.

Valuations: On the whole, the market is no longer cheap (though plenty of cheap individual stocks do remain). But it’s also not grossly overvalued. The S&P 500′s price/earnings ratio based on trailing 12-month operating earnings is about 17; its forward P/E (using projected operating earnings) is about 15. The index trades for about 2.6 times book value, according to Morningstar, and about 1.7 times sales. Those figures have been rising, but they indicate that we are probably merely on the high side of the fair value range — at worst very slightly overvalued. And that’s nothing to be worried about. By definition, you’re sometimes going to be on the high side of an average. It seems to me that lingering fears from the 2008 crash, and perhaps even the 2000 crash, are making investors see anything but dirt cheap valuations as a reason to worry. History has shown that simply is not the case. Stocks can and usually do move far beyond their average historical valuations during bull markets — and they often do so for quite some time.

The False Fear: Kenneth Fisher, whose writings form the basis of one of my best performing Guru Strategies, has talked about the “fear of false factors”, saying that he takes it as a bullish sign when investors are worried about issues that in reality don’t matter that much. (He has used the fiscal cliff as an example.) Right now, I see a false factor being feared — the notion that the magnitude of last year’s gains was so great that this year makes us due for underperformance. The mindset among many investors seems to be that last year’s rally was so fast and strong and unexpected that in 2014, investors will quit while they’re ahead, take profits, and drive the market downward. But history shows that big years for the market do not, in fact, tend to be followed by some sort of corrective downturn. Since 1960 there have been 18 years in which the S&P has gained more than 20% (prior to 2013). The average return for stocks the next year: 11.4%, a little bit above long-term historical norms. The worst return following one of those big years came in 2000, when the S&P lost 9.1% — not exactly a disaster. That was one of only five years when a 20%-plus year was followed with a negative return. In half of those 18 occasions, the 20%-plus year was followed by a year in which the S&P went on to gain at least another 15%.

Perhaps you’re thinking that the current situation is a bit different, in that growth wasn’t particularly strong in 2013. Perhaps in those other 20%-plus years, strong growth merited the big gains, while in 2013 the market was “getting ahead of itself”, meaning that there’s more likelihood of a pullback in 2014. Well, the data tells a different story. In those 18 20%-plus years since 1960, GDP growth on average was a mere 2.5%. In five of those big years it was actually negative. In 1975, for example, the S&P gained 37.2% while the economy shrank by 0.2%. In 1976, the index gained another 23.8%. Interestingly, in 1976 GDP jumped by 5.4%, which you might think would provide good momentum going into 1977. It didn’t. In ’77 the S&P fell 7.2% — even though GDP continued to expand by 4.6%.

Of course that 1975 to 1977 period was different in many ways from today. Factors like inflation, politics, timing (1975 was the first full year of a bull market whereas in 2014 we’ll hopefully reach this bull’s five-year mark) were all surely involved in the gains and losses of those years. But isn’t that the point? Rarely do stocks move because of one single factor. Instead the market is a complex machine that factors in a myriad of issues and data points. The notion that 2014 would be a down year simply because 2013 was such a good year just has no basis in reality — and the pessimism that this false fear creates very well may lead to a buying opportunity.

As I noted earlier, no one knows what’s going to happen in the market in the short term. So many surprises can pop up that aren’t even on the radar right now. Given that, and given the exceptional history and upside that equities offer, the question to me is not, “how will stocks do in 2014,” but instead, “do I see such risks — be they economic, valuation-related, or otherwise — that I would want to pass up a chance to benefit from what has been the best investment vehicle of all time? Right now, I don’t see that kind of risk. In fact, to the contrary, I see more potential reward than risk for long-term investors.

 

Hot List: Don’t Be Troubled By Bubble Talk

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John discusses why he thinks the talk of a bubble in the stock market just isn’t supported by the facts.

Excerpted from the Nov. 22, 2013 issue of the Validea Hot List newsletter

Bubble Trouble?

“Only by learning to live in harmony with your contradictions can you keep it all afloat. You know how fighting fish do it? They blow bubbles and in each one of those bubbles is an egg and they float the egg up to the surface. They keep this whole heavy nest of eggs floating, and they’re constantly repairing it. It’s as if they live in both elements.”

– Poet Audre Lorde

For more than five years now, the Federal Reserve has been pumping billions upon billions of dollars of liquidity into the U.S. financial system. Other central banks have followed suit with billions upon billions of their own. It’s no secret that one of the Fed’s intentions with its ultra-low-interest-rate, ultra-high-liquidity policy was to drive investors into riskier assets — like stocks — thereby creating a “wealth effect” scenario in which stocks rise, Americans feel wealthier, Americans spend more, and the economy grows at a strong pace.

The growth-generation part of the plan hasn’t been too successful. With banks hoarding much of the liquidity provided by the Fed, growth has been average to subpar for most of the last five years. But more and more pundits and analysts are saying that the wealth effect part of the Fed’s plan has been working all too well, pushing stocks higher and higher and far beyond what their fundamentals merit. Could stocks, like the fighting fish eggs to which the poet Audre Lorde referred, be supported by little more than bubbles — in this case dangerous, precarious, bubbles blown by central bankers who want desperately to live in two elements (that is, one world of feel-good, rising markets, the other of harsh economic realities)?

A growing crowd seems to think that’s the case. I’m not among them.

To understand why, let’s first look at some measures of the broader market’s valuation. The S&P 500′s price/earnings ratio based on trailing 12-month operating earnings is 17.6; its forward P/E (using projected operating earnings) is 15.4. Those figures have been climbing, yes, but neither is indicative of major overvaluation. In fact, According to Charles Schwab’s Liz Ann Sonders, those are both still shy of the 18.7 and 18.1 averages, respectively, for the past ten bull market peaks.

But by some metrics, valuations do seem high. The 10-year cyclically-adjusted P/E ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 24.9, using Yale Economist Robert Shiller’s earnings data. That’s up from 20.9 a year ago, and well above the historical average of about 18.3 since World War II. But it’s still below the 27.5 level seen in mid-2007, and far below the 44.2 seen at the height of the tech bubble. (For what it’s worth, Shiller — one of the few to recognize both the tech bubble and the housing bubble before they burst — told The Wall Street Journal last week that he doesn’t think a stock market bubble exists today.)

Other metrics show a reasonably priced market. The S&P trades for about 2.2 times book value, according to Morningstar, for example. That’s below the 1978-early 2011 average of about 2.4, according to data from Ned Davis Research and Comstock Partners. The S&P’s current price/sales ratio of 1.46, also according to Morningstar, is higher than the historical average cited by Comstock and Ned Davis. But it doesn’t seem astronomical — my James O’Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

Now, I suppose one could say that they just don’t trust the earnings and sales data these days, and that the bubble is less like the ultra-high-valuation tech bubble and more like the stealth 2007-08 bubble, in which huge amounts of leverage propped up earnings and sales to make valuations look deceivingly reasonable. And to be sure there’s a bit of that going on, with historically low interest rates helping corporations borrow money on the cheap, and letting homebuyers get very low mortgage rates. But in some cases, the low rates hurt businesses and consumers. PIMCO bond guru Bill Gross has noted several times that the low rates make for low yield spreads, which can actually hurt bank profits. And for consumers, well, just check your bank statement to see what kind of returns your cash is earning. (And, with a personal savings rate of 4.9% in October — nearly twice what it was before the Great Recession — Americans do indeed still have a lot of their money in the bank.)

As for the sea of liquidity central banks have pumped into the economy, it’s pretty well documented that banks haven’t passed a whole lot of that through to Main Street. To say that liquidity itself is artificially supporting the economy and markets, to the point that a bubble exists, thus seems a stretch. In fact, it seems many of the same people who say the Fed’s policies are creating a bubble are also the same ones who have argued that the liquidity provided by quantitative easing has been failing to make it’s way into the economy. You can’t have it both ways. I don’t think you can’t say the liquidity isn’t making it through the system and then say that things like earnings and sales and book values are being propped up by QE — not to the point that a bubble exists.

Then there’s the issue of sentiment. Back during past bubbles, investors have poured into stocks at incredible paces for extended periods. In the four years leading up to the tech bubble peak, investors pumped more than $470 billion into U.S. equity funds, according to The Wall Street Journal (citing Morningstar data). This year, investors through October had put a net of $111 billion into U.S. stock mutual and exchange traded funds — a big number, yes, but not big enough to even make up for the $134 billion they’d taken from those funds since 2009.

To me, the bubble talk seems to be more of a reflection of investors’ psyches than a reflection of reality. For most of their lives, today’s investors knew of stock market bubbles only through history books. Then, within an eight-year span, their portfolios were rocked by two traumatizing bursting bubbles, the latter of which came along with a global financial crisis that threatened to decimate the entire financial system and lead to another Great Depression. The fear that those events caused isn’t something that disappears overnight, or even over a couple years. Wells Capital Management’s James Paulsen has said, in fact, that the scars have led to a “post traumatic-Armageddon-hypochondria” among investors — just as a medical hypochondriac’s mind immediately goes to the worst-case scenario when they get a minor ache or cough, so too do many investors’ minds now go to disastrous scenarios at the slightest sign of trouble.

With the economy having weathered so many storms and appearing to be on decent footing for the moment, I think many people’s market hypochondria has shifted away from economic ailments and toward valuation. And there’s no doubt, valuations have been rising. Around this time last year, the S&P 500′s trailing 12 month operating P/E ratio was 14.2, and its forward operating P/E was 12.7. Its price/sales ratio was 1.3, while its price/book ratio was 2.0. All of those figures have increased over the past year, some by fairly significant margins. But taken in their totality, these measures just don’t paint a picture of a bubble, or anything close to it.

Confirmation bias also may be at play here. During the 2008 market crash, many pundits and prognosticators said that the U.S. economy was headed for oblivion, along with U.S. stocks. The Federal Reserve, they said, could keep things afloat for a little while, but soon things would fall apart. Well, we are now five years past the financial crisis, and the economy, while far from spectacular, continues its slow, steady improvement. And stocks have been a great investment over the past several years. Those who had been calling for doom and chaos don’t want to admit that they were wrong, so they dig their heels in deeper and deeper and look for any data that will confirm their gloomy predictions, regardless of new data that shows that the economy is hanging in there and stocks are decently valued.

It’s hard not to cling to your beliefs, even in the face of changing information. We try hard not to do that. We try to stick to the facts and figures, and right now, in my opinion, the totality of the data seems to show that the market is somewhere on the higher side of the fair value range. You might even say that it’s gotten a bit ahead of itself. But guess what? That’s what happens in bull markets. Valuations go up. They pass their historical averages — by definition, you’re sometimes going to be on the high side of an average. But “a bit ahead of itself” is not the stuff of which bubbles are made. Perhaps because they by and large missed the last two bubbles, however, the media seems to be fearful of getting blindsided a third time. The slightest hint of overvaluation thus leads to the “B” word getting thrown around.

The reality is that, while some stocks and areas of the market are looking pricey, we’re still finding plenty of individual companies whose shares are trading at very reasonable values. Take Hot List newcomer Chevron. This well-established energy giant trades for just 10 times earnings and just over 1.0 times sales, despite having grown earnings at a 26% pace over the long haul, having a debt/equity ratio of about 13%, and having a 17% return on equity.

Chevron is far, far from the only strong business with cheap shares out there. That doesn’t mean the broader market is going to continue higher without any hiccups, of course. As I always say, predicting the market is incredibly hard, particularly in the short term. Could a correction be just around the corner? Perhaps. But given all of the evidence, I feel comfortable as a long-term investor owning the types of stocks that are in the Hot List today.

Buy It Like Buffett

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Warren Buffett-inspired strategy and portfolio, which has averaged returns of 8.0% per year since its inception while the broader market has returned 5.3% per year. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas based on the Buffett investment strategy.

Taken from the November 8, 2013 issue of The Validea Hot List

Guru Spotlight: Warren Buffett

With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?

My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the “Oracle of Omaha” has used in evaluating businesses.

Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren’s ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.

Second, while most of my Buffett-based method centers on a company’s fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.

In addition, Buffett also likes firms whose products are simple for an investor to understand — food, diapers, razors, to name a few examples. In the end, however, for Buffett, it comes down to the numbers — those on a company’s balance sheet and those that represent the price of its stock.

In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company’s EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company’s long-term earnings history is solid).

Another part of Buffett’s conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.

Smart Management, and an Advantage

Two qualities Buffett is known to look for in his buys are strong management and a “durable competitive advantage”. Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett’s approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.

Another way Buffett examines a firm’s management is by looking at how the it spends the company’s retained earnings — that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company’s earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself — in other words, how well management is using retained earnings to increase shareholders’ wealth.

The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.

The Price Is Right?

The criteria we’ve covered so far all are used to identify “Buffett-type” stocks. But there’s a second critical part to Buffett’s analysis: price — can he get the stock of a quality company at a good price?

One way my Buffett-based model answers this question is by comparing a company’s initial expected yield to the long-term treasury yield. (If it’s not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)

To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company’s earnings and stock’s rate of return will be 10 years from now. One method involves using the firm’s historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock’s scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)

This notion of predicting what a company’s earnings will be in 10 years may seem to run counter to Buffett’s nonspeculative ways. But while using these methods to predict a company’s earnings for the next 10 years in her book, Mary Buffett notes: “In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders’ equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.”

Solid Performer

My Buffett-based 10-stock portfolio wasn’t one of my original portfolios, instead coming online in late 2003. Since then, it’s returned 115.1 %, vs. 66.6% for the S&P 500 (figures through Nov. 4). That’s 8.0% annualized, vs. just 5.3% for the S&P.

The portfolio has been a very strong performer over the last two years. While the broader market was flat in 2011, the Buffett-based portfolio jumped 10.2%. In 2012, it gained more than 15%, again topping the index. This year, it has gained 28.8% vs. the S&P’s 24.0%.

In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors’ eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world’s greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.

Now, here’s a look at my Buffett portfolio’s current holdings. It’s an interesting group, and some of the holdings might not seem like “Buffett-type” plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.

The TJX Companies, Inc. (TJX)

PT Telekomunikasi Indonesia (TLK)

Monster Beverage Corp. (MNST)

Coach, Inc. (COH)

Ross Stores, Inc. (ROST)

CNOOC Limited (CEO)

Hibbett Sports, Inc. (HIBB)

First Cash Financial Services (FCFS)

Advance Auto Parts (AAP)

NetEase Inc. (NTES)

The Zweig Strategy: A Conservative Growth Approach

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Martin Zweig-inspired strategy, which has averaged annual returns of 10.8% since its July 2003 inception vs. 5.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Zweig-based investment strategy.

Taken from the October 11, 2013 issue of The Validea Hot List

Guru Spotlight: Martin Zweig

Gerally, my Guru Strategies have a distinct value bias. The majority of these models — ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy — are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.

But that doesn’t mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we’ll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock’s earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently — and that their growth was coming from the right sources.

Zweig’s thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron’s list of the most successful hedge funds.

Before we delve into Zweig’s strategy, a few words about the man himself, who sadly passed away earlier this year. While some of the gurus we’ve looked at in recent Guru Spotlights — Buffett and John Neff in particular come to mind — lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan’s Pierre Hotel that was at one time valued at more than $70 million. He was also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he owned such one-of-a-kind items as Buddy Holly’s guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan’s jersey from his rookie season with the Chicago Bulls.

A Serious Strategy

Zweig may have spent his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:

Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.

Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn’t getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

While Zweig’s EPS focus certainly put him on the “growth” side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock’s price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn’t like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

In addition, Zweig wanted to know that a firm’s earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales — not cost-cutting or other non-sales measures. My Zweig model requires a firm’s revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.

Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock’s sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter’s sales growth rate (vs. the year-ago quarter).

Finally, Zweig also wanted to makes sure a firm’s growth wasn’t driven by unsustainable amounts of leverage (a key observation given all that’s happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

Macro Issues

There’s one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve’s discount rate; installment debt levels; and the prime rate. His mottos included “Don’t fight the Fed” (meaning investors should be more bullish when interest rates were low or falling) and “Don’t fight the tape” (which related to his practice of getting more bullish or bearish based on market trends).

Those rules are tough for an individual investor to put into practice; Zweig used what he called a “Super Model” that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I’ve found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired 10-stock portfolio has been a very strong performer since its July 2003 inception, returning 187.0%, or 10.8% per year, while the S&P 500 has gained just 65.6%, or 5.0% per year (through Oct. 9). After a mediocre 2012, it has been outstanding this year, surging 50.1% vs. 16.1% for the S&P. The strategy also hasn’t been much more volatile than the index — its beta since inception is just 1.07.

The model tends to choose stocks from a variety of areas — it goes where the growth is. Right now, it’s finding a lot of opportunities in financial stocks. Here are the portfolio’s current holdings:

USANA Health Sciences (USNA)

Sturm, Ruger & Company (RGR)

Blackrock, Inc. (BLK)

Cognizant Technology Solutions Corporation (CTSH)

NIC, Inc. (EGOV)

Walter Investment Management Corp. (WAC)

Affiliated Managers Group (AMG)

Amtrust Financial Services (AFSI)

HCI Group, Inc. (HCI)

JPMorgan Chase & Co. (JPM)

As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.

What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn’t look at growth in a vacuum. As you’ve seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.

Beating the Market with Growth … and Value

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the James O’Shaughnessy-inspired strategy, which has averaged annual returns of 9.8% since its July 2003 inception vs. 5.3% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the O’Shaughnessy-based investment strategy.

Taken from the September 13, 2013 issue of The Validea Hot List

Guru Spotlight: James O’Shaughnessy

To say that James O’Shaughnessy has written the book on quantitative investing strategies might be an exaggeration — but not much of one. Over the years, O’Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor’s Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.

In addition to finding out how certain strategies had performed in terms of returns over the long term, O’Shaughnessy’s study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns — what he called his “United Cornerstone” strategy.

The United Cornerstone approach, the basis for my O’Shaughnessy-based Guru Strategy, is actually a combination of two separate models that O’Shaughnessy tested, one growth-focused and one value-focused. His growth method — “Cornerstone Growth” — produced better returns than his “Cornerstone Value” approach, and was a little more risky. The Cornerstone Value strategy, meanwhile, produced returns that were a bit lower, but with less volatility. Together, they formed an exceptional one-two punch, averaging a compound return of 17.1 percent from 1954 through 1996, easily beating the S&P 500s 11.5 percent compound return during that time while maintaining relatively low levels of risk.

That 5.6 percent spread is enormous when compounded over 42 years: If you’d invested $10,000 using the United Cornerstone approach on the first day of the period covered by O’Shaughnessy’s study, you’d have had almost $7.6 million by the end of 1996 — more than $6.6 million more than you’d have ended up with if you’d invested $10,000 in the S&P for the same period! That seems powerful evidence that stock prices do not — as efficient market believers suggest — move in a “random walk,” but instead, as O’Shaughnessy writes, with a “purposeful stride.”

Two-In-One

O’Shaughnessy has revamped his strategies over the years, most recently in his new, updated version of What Works on Wall Street (which I reviewed in the Nov. 25, 2011 edition of the Hot List). I’ve chosen not to tinker with my O’Shaughnessy-based models, however, given the exceptional performance they’ve had over the long term. The models discussed here are thus based on O’Shaughnessy’s 1996 version of What Works on Wall Street.

So, let’s start with the value stock strategy. O’Shaughnessy’s Cornerstone Value approach targeted “market leaders” — large, well-known firms with sales well above those of the average company — because he found that these firms’ stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch — should hold some value stocks.

To find these firms, O’Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean.

Size and market position weren’t enough to make a value stock attractive for O’Shaughnessy, however. Another key factor that was a great predictor of a stock’s future, he found, was cash flow. My O’Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average.

O’Shaughnessy found that, when it came to market leaders, another criterion was even more important than cash flow: dividend yield. He found that high dividend yields were an excellent predictor of success for large, well-known stocks (though not for smaller stocks); large market-leaders with high dividends tended to outperform during bull markets, and didn’t fall as far as other stocks during bear markets. The Cornerstone Value model takes all of the stocks that pass the four aforementioned criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval.

The Cornerstone Growth approach, meanwhile, isn’t strictly a growth approach. That’s because one of the interesting things O’Shaughnessy found in his back-testing was that all of the successful strategies he studied — even growth approaches — included at least one value-based criterion. The value component of his Cornerstone Growth strategy was the price/sales ratio, a variable that O’Shaughnessy found — much to the surprise of Wall Street — was the single best indication of a stock’s value, and predictor of its future.

The Cornerstone Growth model allows for smaller stocks, using a market cap minimum of $150 million, and requires stocks to have price/sales ratios below 1.5. To avoid outright dogs, the strategy also looks at a company’s last five years of earnings, requiring that its earnings per share have increased each year since the first year of that period.

The final criterion of this approach is relative strength, the measure of how a stock has performed compared to all other stocks over the past year. A key part of why the growth stock model works so well, according to O’Shaughnessy, is the combination of high relative strengths and low P/S ratios. By targeting stocks with high relative strengths, you’re looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio, you’re ensuring that you’re not getting in too late on these popular stocks, after they’ve become too expensive. “This strategy will never buy a Netscape or Genentech or Polaroid at 165 times earnings,” O’Shaughnessy wrote, referring to some of history’s well-known momentum-driven, overpriced stocks. “It forces you to buy stocks just when the market realizes the companies have been overlooked.”

To apply the RS criterion, the Cornerstone Growth model takes all the stocks that pass the three growth criteria I mentioned (market cap, earnings persistence, P/S ratio) and ranks them by RS. The top 50 stocks then get final approval.

The Growth/Value Investor model I base on O’Shaughnessy’s two-pronged approach has been a one of my best performers since its inception back in 2003, with my 10-stock O’Shaughnessy-based portfolio gaining 157.7 % (9.8% annualized) since inception, while the S&P 500 has gained just 68.3% (5.3% annualized; figures through Sept. 10).

The O’Shaughnessy-based portfolio will pick stocks using both the growth and value methods I described above. It picks whatever the best-rated stocks are at the time, regardless of growth/value distinction, meaning the portions of the portfolio made up of growth and value stocks can vary over time. After leaning strongly to the growth side, the portfolio has shifted back toward a more even balance over the past year or so. Currently six of the ten holdings are growth picks. Here’s a look at the portfolio’s holdings:

TEO — Telecom Argentina (Growth)

LEA — Lear Corporation (Growth)

SNP — China Petroleum & Chemical Corp. (Value)

AFSI — Amtrust Financial Services Inc. (Growth)

RDS.A — Royal Dutch Shell (Value)

CVX — Chevron Corp. (Value)

SIG — Signet Jewelers (Growth)

NOC — Northrop Grumman Corporation (Growth)

JPM — JPMorgan Chase & Co. (Value)

RUE — Rue21 Inc. (Growth)

 

Not Just Numbers

O’Shaughnessy is a pure quant, but you should be aware that some of his most critical lessons are less about specific criteria and numbers than they are about the general mindset an investor must have. Perhaps more than anything else, O’Shaughnessy believes in picking a good strategy and sticking with it — no matter what. In What Works on Wall Street, he writes that in order to beat the market, it is crucial that you stay disciplined: “[C]onsistently, patiently, and slavishly stick with a strategy, even when it’s performing poorly relative to other methods.”

The reason involved human emotions, which cause many investors to bail on a good approach and jump onto hot stocks or strategies that are often overhyped and overpriced. “We are a bundle of inconsistencies,” he writes, “and while that may make us interesting, it plays havoc with our ability to invest our money successfully. Disciplined implementation of active strategies is the key to performance.” Wise words, whether you follow O’Shaughnessy’s approach or another proven method.

How John Neff Beat The Market For Three Decades

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the John Neff-inspired strategy. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Neff-based investment strategy.

Taken from the April 26, 2013 issue of The Validea Hot List

Guru Spotlight: John Neff

Most investors wouldn’t give a fund described as “relatively prosaic, dull, conservative” a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades. And, while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling — so dazzling that Neff’s track record may be the greatest ever for a mutual fund manager.

By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7 percent annual return, beating the market by an average of 3.1 percent per year. Looked at another way, a $10,000 investment in the fund the year Neff took the reins would have been worth more than $564,000 by the time he retired (with dividends reinvested); that same $10,000 invested in the S&P 500 (again with dividends reinvested) would have been worth less than half that after 31 years, about $233,000. That type of track record made the understated, low-key Neff a favorite manager of many other professional fund managers — an “investor’s investor”, if you will.

How did Neff do it? By focusing first and foremost on value, and a key part of how he found value involved the Price/Earnings Ratio. While others have called him a “contrarian” or “value investor”, Neff writes in John Neff on Investing that, “Personally, I prefer a different label: ‘low price-earnings investor.’ It describes succinctly and accurately the investment style that guided Windsor while I was in charge.”

To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren’t expecting much from it. Much like David Dreman, the great contrarian guru who we examined a few newsletters back, Neff found that stocks with lower P/E ratios — and lower expectations — tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn’t match investors’ expectations.

To Neff, however, the P/E wasn’t always a lower-is-better ratio. If investors knew that a firm was a dog, they’d rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40 and 60 percent of the market average.

While it was at the heart of his investment philosophy, the P/E ratio was also by no means the only metric Neff used to judge stocks. He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate — more than 20 percent — could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7 and 20 percent per year, the kind of steady, unspectacular growth that could be sustained.

Sustainable growth also meant growth that was driven by sales — not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates. (My Neff-based model interprets this as sales growth needing to be at least 7 percent per year, or at least 70 percent of EPS growth.)

One more key aspect of Neff’s strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free. He estimated that about two-thirds of Windsor’s 3 percent per year market outperformance during his tenure came from dividends.

To make sure that his analysis captured dividend payments, Neff used the Total Return/PE ratio. This measure divides a stock’s total return (that is, its EPS growth rate plus its dividend yield) by its P/E ratio. He looked for stocks whose Total Return/PE ratios doubled either the market average or their industry average.

In recent years, my Neff-inspired model has been very stringent, with very few companies passing all of its tests. Here’s a look at the stocks that currently make up my 10-stock Neff-based portfolio:

Rolls-Royce Holdings PLC (RYCEY)

Allison Transmission Holdings, Inc. (ALSN)

Validus Holdings, Ltd. (VR)

YPF SA (YPF)

CNOOC Limited (CEO)

Royal Dutch Shell PLC (RDS.A)

Questcor Pharmaceuticals, Inc. (QCOR)

Encore Capital Group, Inc. (ECPG)

Oracle Corporation (ORCL)

ZAGG Inc. (ZAGG)

I began tracking my Neff-based portfolio at the start of 2004, and it’s had some significant ups and downs. From its inception through 2007, the portfolio returned about 67%, about double the S&P 500′s 32.4% return. The 2008 crash was especially hard on value stocks, however, and the Neff portfolio fell more than 48% for the year, about 10 percentage points behind the S&P. It bounced back strong in 2009, surging 45.4%, but has struggled over the past few years. All in all, it is averaging annualized returns of 2.9% since inception, lagging the S&P 500 by about 1 percentage point (through April 24).

Just like Neff himself, the Neff-based model often treads into the most unloved parts of the market. As you can see above, many of its current holdings have a good amount of fear hanging over them, whether it be company-specific or industry- or economy-related. Because of that, a value-focused strategy can languish for lengthy periods of time. But Neff succeeded by staying disciplined and focusing on value. By ignoring the crowd and focusing on these firms’ strong financials and fundamentals, I think the Neff model will end up benefiting significantly from many of these picks and be a strong performer as time goes on.

The Zweig Approach: Growth Investing With A Conservative Streak

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Martin Zweig-inspired strategy, which has averaged annual returns of 8.4% since its July 2003 inception vs. 4.7% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Zweig-based investment strategy.

Taken from the March 29, 2013 issue of The Validea Hot List

Guru Spotlight: Martin Zweig

Today’s Guru Spotlight is a bittersweet one. While it’s always interesting and worthwhile to examine the great Martin Zweig’s approach, we’re also commemorating the recent passing of the investment guru, who died in February at the age of 70.

Zweig was an intriguing character known for putting his fortune to use in some pretty fun, flashy ways. He owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan’s Pierre Hotel that was at one time valued at more than $70 million. He was also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he owned such one-of-a-kind items as Buddy Holly’s guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan’s jersey from his rookie season with the Chicago Bulls. (Zweig also used his money for some very noble purposes — in 2011, he and his wife, Barbara, pledged $5 million gift to Mount Sinai Hospital, which went toward the Zweig Family Center for Living Donation, a facility that focuses on providing medical, surgical, and psychological care to living organ donors.)

Zweig became well known back in the 1980s as a frequent guest on PBS’s Wall $treet Week with Louis Rukeyser, where he famously called the 1987 market crash. Just one trading day before the crash, he said he expected “a brief decline, but a vicious one” that would be similar to the 1929 crash. Stocks tumbled more than 20% on “Black Monday”, but — just as he predicted — made a quick comeback, reaching pre-crash levels in just about a year.

Zweig was a growth investor, and his methodology was dominated by earnings-based criteria. He looked at a stock’s earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently — and he wanted their growth to be coming from the right sources.

Zweig’s thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9% annualized return during that time. Zweig also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron’s list of the most successful hedge funds.

A Serious Strategy

Zweig may have spent his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories, and I’ve incorporated them into the Zweig-inspired model I base on his book, Winning on Wall Street. They include:

Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

Long-Term Growth: EPS should be growing by at least 15% over the long term; a growth rate over 30% is exceptional.

Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn’t getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

While Zweig’s EPS focus certainly put him on the “growth” side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock’s price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn’t like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

In addition, Zweig wanted to know that a firm’s earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales — not cost-cutting or other non-sales measures. My Zweig model requires a firm’s revenue growth to be at least 85% of EPS growth. If a stock fails that test but its revenues are growing by at least 30% a year, it passes, however, since that is still a very strong revenue growth rate.

Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock’s sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter’s sales growth rate (vs. the year-ago quarter).

Finally, Zweig also wanted to makes sure a firm’s growth wasn’t driven by unsustainable amounts of leverage (a key observation given all that’s happened in recent years). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

Macro Issues

There’s one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks, and the indicators he used are quite relevant given today’s environment. Some included the Federal Reserve’s discount rate; installment debt levels; and the prime rate. His mottos included “Don’t fight the Fed” (meaning investors should be more bullish when interest rates were low or falling) and “Don’t fight the tape” (which related to his practice of getting more bullish or bearish based on market trends).

Those rules are tough for an individual investor to put into practice; Zweig used what he called a “Super Model” that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I’ve found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired 10-stock portfolio has been a very strong performer since its July 2003 inception, returning 118.6%, or 8.4% per year, while the S&P 500 has gained just 56.3%, or 4.7% per year (through March 26). The portfolio is having a strong start to 2013, already up nearly 15%. It tends to choose stocks from a variety of areas — it goes where the growth is. Here are the portfolio’s current holdings:

USANA Health Sciences (USNA)

Sturm, Ruger & Company (RGR)

Lululemon Athletica (LULU)

World Acceptance Corp. (WRLD)

First Cash Financial Services (FCFS)

The TJX Companies (TJX)

Netease, Inc. (NTES)

Questcor Pharmaceuticals (QCOR)

Oracle Corporation (ORCL)

V.F. Corporation (VFC)

What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn’t look at growth in a vacuum. As you’ve seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.

Hot List: Embrace The Fear

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John talks about some of the current fears in the market, and why they aren’t deterring him from buying stocks.   

Excerpted from the Jan. 18, 2013 issue of the Validea Hot List newsletter

Fear Factor

The 2013 year has started off with a bang for investors, with the S&P 500 already up about 4% (through yesterday). In many cases, a 4% gain over two weeks would be a sign that investors are feeling pretty good about things. Not so with this 4% gain, however. Clouds continue to hover over the investment world — some fear that the U.S. debt ceiling battle won’t be resolved, causing America to default on its debt for the first time ever; some say earnings estimates are still too high, and that growth is going to grind to a halt at some point this year; and some fear that turmoil in the Middle East will jolt markets sometime soon.

Those issues are all legitimate and must be dealt with. But, frankly, from an investment perspective, their presence is probably a bullish factor. All you have to do is look at the past few years to understand why. Since 2008, the financial world has jumped from fears of a global economic and financial system collapse, to fears of Middle East turmoil causing major oil market disruptions, to fears of a Eurozone demise, to fears of a U.S. default, to fears of the U.S. fiscal cliff, and now back to fears of a U.S. default. And, while all of those issues were serious ones, each time the fear turned out to be worse than the reality. We have not fallen into a depression; the Eurozone has not collapsed; the U.S. did not belly flop off the fiscal cliff. In fact, things have improved quite a bit in recent years. Unemployment has fallen from a peak of 10% down to 7.8%; the service sector has expanded every month for the past three years; housing starts are way up, as are home prices; and the stock market is up nearly 120% from its March 2009 low.

Fears being worse than reality isn’t anything new in the investment world. We humans are emotional creatures, and we tend to overreact to news (both on the downside and the upside. And in late 2008 and early 2009, things got so scary that many have become particularly prone to thinking that the worst is going to happen whenever problems emerge. The media doesn’t help — doom and gloom has been dominating the headlines for years now, drowning out the many positive signs that have emerged. Having been caught with their pants down when the 2008 crisis hit, I think most news outlets are leaning toward the negative side, fearing that they will lose more credibility if they fail to see another crisis coming. Plus, let’s face it: Negative news attracts more viewers and readers.

But remember, fear is an investor’s ally. Warren Buffett has famously said that “if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” His fellow investing great, Peter Lynch, has also stressed the importance of not giving into fear, once saying that “the real key to making money in stocks is not to get scared out of them.”

That advice goes for both the broader market, and individual stocks. In a September 2011 interview on CNBC, Joel Greenblatt, another of the great investors upon whom I base my strategies, explained the common thread among the companies that his quantitative system tends to target: “Each one of those companies is hated brutally by people,” he said. At the time, Greenblatt was very bullish on stocks, even though the marketplace was filled with fear. “It’s a very scary time to invest,” he said, “and that’s when you get your best bargains.” In the 16 months since that interview, the S&P 500 is up about 26%.

The Hot List has often benefited from other investors’ fears over the years. Perhaps most recently, it did so with its pick of Nu Skin Enterprises. Nu Skin shares were been pummeled for much of 2012, taking a particularly big hit in December. Part of the reason probably involved the fact that it’s a more economically sensitive small-cap, the sort of stock hit hard by the fiscal cliff/recession fears. Part of it was also probably the fact that Nu Skin is a similar business to Herbalife, a firm that hedge fund guru David Einhorn recently said he is extremely bearish on. Nu Skin was likely thus hurt by guilt by association.

But the Hot List was more focused on Nu Skin’s fundamentals, which were quite good when it added the firm to the portfolio on Dec. 21. Since then, its shares have rebounded forcefully, gaining about 35%.

On today’s rebalancing, the Hot List is selling Nu Skin and three other positions and replacing them with four new stocks that now rate higher. This new quartet has its fair share of clouds hanging over it. Three of the stocks — Hibbett Sports, rue21, and Guess? — are retailers. And with the debt ceiling issue and other economic concerns dogging investors, many fear retailers — which have excelled since the March 2009 bottom — have come to the end of their run.

But look at the numbers: Guess? has upped earnings per share in 8 of the past 10 years. Hibbett has done so in 9 of the last 10. Rue21 has done so in all 10. All of them increased EPS in 2008 and 2009, when the Great Recession was occurring. Together, the three companies are averaging a return on equity of nearly 20% over the past 10 years. Among them, they have a total of just $8.7 million in debt, and more than $1 billion in net current assets.

Those are some great fundamentals. But because of the economic fears, the prices of these three stocks are quite reasonable. The fourth addition to the portfolio, meanwhile, is downright dirt-cheap. Despite having about five times as much annual earnings as debt and $3.85 in free cash flow per share, Northrop Grumman shares trade for 8.6 times trailing 12-month EPS, 9 times projected 12-month EPS, and 0.65 times sales. The reason? The big budget cuts that would go into effect if Congress and the President can’t reach a compromise on the budget aspects of the fiscal cliff, which weren’t addressed by the deal reached earlier this month. Budget cuts, with or without a deal, are no doubt a legitimate threat, but current estimates for Grumman in 2013 already include a significant profit cut. In fact, even if profits fell by 40% in 2013, at its current price Grumman would be trading at a very reasonable P/E of about 15. Investors certainly seem to be overreacting.

All in all, fears may not be as intense right now as they’ve been at other points in the past four years. They remain, however, and no doubt will wax and wane at different points in 2013. But fear in and of itself isn’t a reason to sell a stock or jump out of the market altogether. Good investors have rational, systematic approaches that determine when to sell, or when to lighten up on an asset class. And, after more than a dozen years studying history’s most successful investors, I can tell you this: Far more often than not, the greatest strategists saw times of fear, or stocks that were feared, as some of the biggest sources of opportunity. However events unfold in 2013, that’s something to keep in the forefront of your mind.

Five Reasons for Optimism

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John looks at five reasons he’s optimistic about stocks as 2013 approaches, even though many investors remain fearful of equities.   

Excerpted from the Dec. 21, 2012 issue of the Validea Hot List newsletter

Five Reasons for Optimism

As 2012 winds down, the general mood surrounding the market and the economy remains one of fear. The fiscal cliff, unresolved debt problems in Europe, and the lingering scars of the financial crisis and Great Recession seem to be giving pessimism the upper hand over optimism, and keeping investors lukewarm (at best) on stocks.

But as we head into 2013, I think there are several reasons to be optimistic about where we stand. That doesn’t mean we aren’t facing some serious problems; there is no doubt that the U.S. and much of the developed world indeed have a lot on their plates. But what it does mean is that overall, a number of factors are combining to make stocks look like attractive investments right now for long-term investors. Here’s a handful of those reasons:

The Housing Rebound: It’s hard to believe that six years have passed since the housing bubble began to burst, but it’s true. And while the nascent rebound hasn’t been as dramatic as the decline was, it is significant. Housing starts are up 21.9% since a year ago. Permit issuance for new home construction is up 28.1% in that period. Existing-home sales have risen 15.5% in the last 12 months, meanwhile, and pending home sales are up 18%. Home prices are on the rise, too, having jumped 3.6% in the year ending Sept. 30 (the most recent data available), according to the S&P/Case-Shiller Home Price Indices.

That’s a big deal. Housing is usually a big part of economic recoveries, but until recently it’s been absent from this one. The sector’s impacts are so wide-ranging — impacting everything from construction companies to carpet manufacturers to home furnishing stores — that housing market improvements can lead to the creation of thousands and thousands of jobs.

Employment: It’s no surprise, then, that the housing recovery has been accompanied by a significant improvement in the jobs market. Yes, unemployment is still far too high, but we’ve seen real progress lately. The headline unemployment number (7.7%) is down a full percentage point from a year ago, and more than two full percentage points from where it was two years ago. The broader “U-6″ measure (which also includes workers who have given up looking for a job or those working part-time who want full-time work) is down 1.2 percentage points in the past year, and 2.5 points in the past two years.

More employed workers means more people with money to spend. More people with money to spend means more profits for consumer-related businesses, which drive our economy. More money for them is leading to more jobs, which leads to more people with money to spend — and so on goes the cycle. As the fiscal cliff mess gets resolved, the hiring may well increase even more. Many companies have been staying in a holding pattern until they get clarity on tax policy and government spending plans. They want to know the rules of the game — whatever the rules may be — before they start to really play. If Congress and the President can reach some sort of agreement that lays the tax and policy rules out for them — whatever it involves — businesses may have the clarity they need to start spending their cash on new employees, and capital improvements.

Global Monetary Conditions: Yes, the Federal Reserve has been sharply criticized by some for its loose money policies in recent years. And, to be sure the Fed has been far from perfect in its decisions. But whether you’re pro-Fed or anti-Fed, the reality is that the central bank — and other central banks around the globe — are doing what they can to push investors toward riskier assets by keeping interest rates so low. And while that hasn’t resulted in a deluge of cash flowing into stocks, it has no doubt helped increase demand for stocks somewhat, and it should continue to do so in 2013.

Of course, there are unintended repercussions of loose monetary policy. One is that, if conditions were right, encouraging investors away from bonds and toward stocks could lead to a bubble, with stocks becoming highly overvalued. But that brings me to my next point …

Valuations Are Reasonable: As I noted in a recent Hot List, the broader market seems to be priced somewhere near fair value. Sure, there are some valuation metrics that are flashing warning signals, like the ten-year P/E ratio and Tobin’s Q. But there are many more that are indicating the market is in the range of fair value or undervalued. Trailing 12-month P/E ratios are in the low- to mid-teens; the market’s price-to-book ratio is lower than its long-term average; the price/sales ratio is a reasonable 1.3 or so; and the stock market-to-GDP ratio has been hovering around the high end of the fair value range/low-end of the modestly overvalued range. In addition, dividend yields are significantly higher than the yields on long-term treasury bonds, a historical rarity and a bullish sign for stocks.

Also keep in mind that those figures are for the broader market. When it comes to individual stocks, there are a myriad of good companies with strong track records whose shares are trading at extremely attractive valuations, the type of stocks that the Hot List continues to target. And, as Charles Schwab’s Chief Investment Strategist Liz Ann Sonders recently noted, even if the U.S. does go off the fiscal cliff and a recession results, the reasonable valuations should help provide a cushion that would keep a bear market relatively mild.

Time: It takes time — a lot of it — to recover from financial crises. It may sound obvious, but it’s very important to remember. Every year further out we get from the epicenter of the crisis, the more bad debt gets worked off, and the more the nation’s collective bearish psyche heals. Professors Kenneth Rogoff and Carmen Reinhart have done perhaps the most extensive research on past financial crises. In examining about 15 pre-2007 financial crises across the globe, Reinhart and Rogoff said in a 2008 paper that on average real house prices fell for six years before rebounding. In very few cases did the declines last less than five years. Unemployment, meanwhile, increased on average for nearly five years by an average of 7 percentage points. Real public debt jumped 86% on average in the three years after the crises. In other words, the tepid recovery we’ve seen in the past few years isn’t a sign that we’re headed for disaster, or that America will never grow the way it used to. It is instead a sign that we are experiencing a typical recovery from a financial crisis. (In fact, in a recent piece for Bloomberg.com, the professors said that the economy has in some key ways actually performed better than the average country has in the aftermath of past financial crises).

These five factors are, I believe, creating an environment that is pretty supportive for stocks overall, and very attractive for long-term investment strategies that can identify cheap shares of good companies. That doesn’t mean 2013 will be an easy, upward climb for the market, or the Hot List portfolio. In the short term, emotions drive the market, and right now there are still a lot of strong emotions out there on the negative side. But good investing is about looking past the short term and focusing on where the best long-term opportunities lie. Right now, I think the stock market is home to plenty excellent opportunities.