Oil Steady Around $50 a Barrel: Economic Bellwether

Dear Investor,
I hate to keep talking oil here, but the sticky stuff is a great proxy for what’s going on with the economy and the financial markets. On the one hand, demand is down considerably, even OPEC has cut production and inventories are rising to the point that some analysts are saying "…we’re swimming in the stuff…" 
Oil prices have been as low as $35 in the last couple of months – an inconceivable price just six months ago.  
But at the same time, investors fully understand that oil is absolutely indispensable to global economic growth. And alternative energy sources will not be affecting that relationship anytime soon. So oil prices have rallied on the flimsiest economic data, with no increase in demand expected in the immediate future.  
Even today, as industrial production numbers show continued weakness in the sector, oil prices are essentially stable as investors shrug off the news. The economy will recovery someday, demand will increase at some point, and oil at current prices is the place to be when it does. It really is a matter of when, not if, and investors seem willing to accept oil at $50 a barrel.  
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*****Today is Newsletter Advisors Wednesday. Today, I have an interview with John Reese, the founder and CEO of Validea.com. It’s fairly long but I think you’ll find some great insights …  
Interview With John Reese 
John Reese is the founder and CEO of Validea.com, a premium investment research web site, and co-founder of Validea Capital Management, a money management firm for high net worth individuals and institutions. He advises two Canada-based mutual funds (Omega Consensus American & International Equity Funds) and also maintains the investing blog: The Guru Investor. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies." 
Last year was devastating for most sectors, if not most companies. Were you able to find any pockets of strength? 
There really weren’t any areas of the market that showed strength for the full year. The nature of this particular decline was such that almost every industry posted negative returns for the year. Companies in all sectors had benefited from the ramped-up leverage that permeated the economy in recent years, artificially increasing earnings and, as a result, stock prices. When that leverage bubble popped, earnings fell across the board, as did stocks.  
There were, however, some pockets — but they didn’t last very long, and there were also some major discrepancies within those pockets. For example, my strategies found some great buys in beaten-down retailers at various points during 2008. But at other points, retailers got killed. And in relatively short periods when some retailers were surging 20% or 30%, others were falling by the same amount or more. Typically in bear markets, there are areas of the market that hold up better than others, but in 2008 correlations of all stock classes moved toward 1.0 and there were really no safe havens except for moving to cash.  
Once some sense of normalcy resumes in the financial world, what sector(s) do you think will lead us out of the bear and why? 
First, just to be clear, I’d note that my strategies are bottom-up, fundamental-based approaches that look at individual stocks; I don’t choose stocks by looking first at a particular industry or sector.  
As for your question, though, it’s an interesting one. It would stand to reason that, given the fact that the financial sector really caused the current crisis, a recovery there would lead us out of this. But often, the sector or industry that causes a crisis doesn’t lead the way out — tech stocks led to the 2000-2002 bear, for example, but they didn’t lead the recovery. As for the current situation, the depth of the crisis — and the fact that these problems built up over several years — suggest that it will take a lot of time for financials to really get their feet under them.  
As for who might lead the way, my strategies see a lot of value right now in several areas, with consumer and energy stocks being two of the big ones. Consumer stocks have taken a pounding — too much of a pounding, I think — because of the recession, and energy stocks were hurt a lot by the plummeting oil prices. As we move out of the recession, people may realize that they had overreacted and oversold stocks in those sectors, which could lead to a big bounce.   
James O’Shaughnessy, who is one of the gurus I follow, conducted an excellent study looking at the performance of various types of stocks coming out of recessions. He ranked stocks by P/S, Relative Strength and Buyback Yield. What he found was that the stocks that excelled coming out of the past eight recessions were those with the best fundamentals — not speculative stocks. And, those fundamentally sound stocks did particularly in well in the first year after the recession. Stocks in the best decile ranked by price/sales ratio (meaning those with the lowest P/S ratios), for example, outperformed the highest decile of P/S stocks by an average of almost 22 percentage points in the first post-recession year, 16.57 points (annualized) in the first three years, and 13.95 points (annualized) in the first five years. Results were similar when looking at relative strengths and buyback yields.   
Name 3 stocks you would buy today and why?

One of the things I’ve found with my system is that when multiple strategies score a stock highly it tends to be a good predictor of future stock price performance. I call this a "consensus" approach: basically, you look for stocks that pass the criteria of at least two to three rigorous quantitative methodologies. This type of approach is the basis for my Validea Hot List portfolio, which through April 9th, 2009 has generated a total return of 67.4% vs. a loss of 14.4% for the S&P 500 (the inception date on this portfolio was July 15th, 2003). The stocks I’m going to discuss all get top scores from multiple gurus, and in the interest for full disclosure, I want to let you know that I hold Exxon and National Presto in my private money management portfolios.  

Exxon Mobil (XOM) — This is one of the few stocks in the market that gets approval from four of my Guru Strategies — my Peter Lynch-, Warren Buffett-, Joel Greenblatt-, and Kenneth Fisher-based models. It’s been putting up great earnings growth numbers for the past decade, and even if earnings slow a bit this year, it’s still quite cheap, selling for about 8 times earnings and 0.7 times sales. Management does a good job — the company’s return on equity has averaged about 25% over the past decade. It’s also very conservatively financed, with a debt/equity ratio of only about 8%.  
National Presto Industries (NPK) — Another four-guru stock, getting the thumbs-up from my Lynch-, Benjamin Graham-, James O’Shaughnessy-, and Motley Fool-based models. They’ve got a pretty intriguing set of businesses, with the three main divisions being housewares/small appliances, defense products (such as ammunition), and absorbent products (such as adult diapers). The firm has great fundamentals; its current ratio (current assets/current liabilities) is 5.77, which is exceptional, and it has no long-term debt. The stock is cheap, at less than 11 times earnings and 1.06 times sales.  
Aeropostale, Inc. (ARO) — Consumer discretionary stocks have been killed over the past several months as fears of an economic apocalypse have grown. That’s caused a lot of good retailers and consumer stocks to get driven down much further than they deserve, and Aeropostale is a prime example. It’s been hot lately, but it’s still down about 20% from late last summer, and its fundamentals are exceptional. The company has increased earnings in every year of the past decade (even last year), its return on equity over that time is more than 30%, and it has no long-term debt. At about 13 times earnings, it’s a steal. 
If you were face-to-face with President Obama, what unique perspective could you give him regarding the markets and challenges facing investors? 
 First is that I think the President does understand the many issues facing investors today. I think the main thing I would tell him is that instilling confidence in the marketplace is critical to the recovery. It is perhaps even more critical than all of the action being taken by the government (stimulus, TALF, TARP, PPIP). It’s the "perception" that things can work, and that is what will drive stabilization in the short- to mid-term. We’ve seen what can happen when we have a crisis in confidence – in the fall of last year the markets tumbled and economic activity came to a screeching halt. Confidence in the markets, in our country’s leadership and decisions, and in our economy will allow people to feel comfortable enough to go out and spend or put money back into the market.  
It all goes to the power of people’s emotions. We know that when it comes to investing, studies have shown that investors feel the pain of loss twice as much as they feel the joy of gains. And right now, pain is fresh in most investors’ minds. If they don’t have confidence in the health and stability of the equity markets and economy, they won’t get back into stocks any time soon because there won’t be enough positive vibes to counter their fears of losing more money (and experiencing more pain), regardless of all the bargains now available. I’m not saying the President should be a Pollyanna, but he needs to be strong and calm, and inspire confidence that we’ll get through this.  
What areas of the market do you perceive as most safe today? 
I think the past year has taught us that areas of the market once considered "safe", like healthcare and defense, aren’t immune to certain types of downturns, though healthcare didn’t drop nearly as far as other sectors last year. Given its importance in our society, I’d think healthcare would continue to be one of more stable areas.  
But if you’re really looking for safety, I think you need to focus less on particular sectors or industries and more on individual companies’ balance sheets. The late, great Ben Graham — perhaps the best conservative, defensive-minded investor ever — looked for stocks with a "margin of safety" — those whose prices were already so low compared to the real value of their businesses that even poor results weren’t likely to drive their stocks much lower. Graham’s "defensive investor" strategy targeted stocks that had consistent earnings growth over a ten-year period, low debt, and net current assets that were at least twice their current liabilities. And he wanted them at relatively low P/E and price/book ratios. If you can find stocks like that you should have some fairly "safe" stocks. Fortunately for users of Validea.com, I’ve developed an investment strategy based on Graham’s methodology and have created 10- and 20-stock model portfolios that hold the top-rated stocks according to Graham’s deep value orientation. Last year, a portfolio of stocks picked using my Graham-based strategy lost 14.1%, faring much better than the overall market, which lost about 38.5%. This year, the portfolio is up 10% while the market is down about 5.2%. On a total return basis, the portfolio is my best performer – it’s up 112.8% vs. a loss of 14.4% for the S&P since mid-2003.  
What do you say to people who are tempted to buy technology, even financial stocks at these low, low prices? 
It’s fine to buy tech or financial stocks at low prices — so long as their fundamentals and balance sheets are strong. You definitely do not want to just start buying up financials or other beaten-down stocks simply because they are beaten down and selling for single-digit prices. A stock that has lost 60% of its value might be a bargain, but it might simply be a dog, and everyone knows it’s a dog. Many of the gurus I follow — Ben Graham, Warren Buffett, David Dreman, John Neff — used strategies that focused on beaten-down stocks. But they all made sure that the stocks were beaten down further than they should have been because of fear, apathy, or ignorance — not because their businesses were tanking. And to separate the former from the latter, they focused on fundamentals.  
As of right now, financials are not heavily favored by my guru-based models, mainly because last year’s earnings results were so poor. Even though valuations have come down, earnings and earning consistency has been damaged. Of all the financial stocks I analyze on Validea, only a few get high scores from the gurus. A few names: Bancolombia SA (CIB), Barclays PLC (BCS) and World Acceptance Corp (WRLD). Again, for disclosure I am long Bancolombia and World Acceptance.  
What fundamental strategy do you follow for buying portfolio positions?
I use my Guru Strategies, which are computer models designed to mimic the strategies used by many of history’s greatest and most successful investors — Ben Graham, Warren Buffett, Peter Lynch, Marty Zweig, John Neff, Ken Fisher, David Dreman, James O’Shaughnessy, Joel Greenblatt, and Joseph Piotroski. All of these gurus wrote books or academic papers laying out their strategies (except for Buffett; I base my Buffett model on a book written by his former daughter-in-law, who worked closely with him). And their approaches were either mostly or completely fundamental-based. With my background in computers and artificial intelligence, I was able to create quantitative screening models that pick stocks using the fundamental criteria these gurus were kind enough to share with us.  
On Validea.com, I track portfolios based on each individual guru’s strategy, as well as portfolios that use a combination of those strategies to pick stocks. In my money management business, I use a few different approaches that blend the individual strategies, giving greater weight to the strategies with the best risk-adjusted long-term returns. 
What investment advice would you give to someone with a 5-year horizon? 
If you have a five-year horizon, now is a great time to be buying stocks. Even very conservative valuation metrics, like the 10-year P/E ratio (which averages earnings over the past ten years to give a long-term picture of a firm’s success) and Tobin’s Q Ratio (which divides a firm’s market price by the replacement cost of its business) are low by historical standards. And even noted bears like Jeremy Grantham have said stocks are cheaper than they’ve been, on a valuation basis, in two decades. 
Throughout history, stocks have shown a remarkable tendency to revert to a 7% average annual gain, net of inflation (this comes from the research of Jeremy Siegel). Periods when stocks significantly underperform that 7% return (as they have done over the past decade) are typically followed by periods of outperformance. So for long-term investors, I believe stocks are the place to be.  
That being said, you have to consider your own risk tolerance. For many years, when a financial advisor has asked if a client would be able to sit tight if the market declined 30, 40, 50 percent, it may have seemed like a far-fetched hypothetical. But the past two years have shown us that wild things can happen in the market over the short term. You need to be prepared for that, and be willing to stick to your strategy for the long haul. If you don’t think you can do that, you shouldn’t be in stocks to begin with.

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