An Outline of Three Stock Investment Strategies
Most of the following was sent in a Strategy Update to our investment advisory clients. Some modifications were made for publishing on this Web site.
We have designed three new strategies for those who are interested. One of these new strategies is value-based, one is a growth strategy, and one is a mutual fund strategy. Incidentally, the development of a new strategy does not imply anything about any pre-existent strategies. Also, the returns of a strategy rigorously followed reflect only on that specific strategy, and do not reflect on any other strategy. An investment manager can have several different strategies that achieve extremely different results. The situation is similar to when an individual decides to invest in a mutual fund. When he investigates a fund company, he discovers that the company has many funds from which to choose. Each fund will be managed differently, with a unique style, objective, methodology, and risk profile. In a given year, one of these funds might gain 40% while another might lose 15%. They differ because their selection criteria are different. However, just because a fund had better performance in a given year does not mean it is the best fund for a particular investor. The fund that lost money might actually give more satisfactory results over the long haul, if its methodologies and risk profile are a better match for the investor.
As those who are past investment advisory clients may recall, we already have a value-based utility strategy that I call the "Optimized Utility Portfolio," as well as a value-based general stock program I call the "Optimized Stock Portfolio." The utility program returned about 21% a year for about 15 years before an anti-value sentiment began to dominate market psychology. The non-utility program averaged over 26% a year for five or six years, then it too was torpedoed by the shift in market mentality. Shifts like this have occurred before, but value investing was still able to prosper. However, the magnitude of the shift had, to my knowledge, never been this extreme. Top value-oriented mutual funds at first failed to match the performance of the major market indexes. Later, they began to lose money. Those managers who stayed with their value-based strategies eventually lost huge amounts of assets as investors moved their money elsewhere. Later, of course, value styles of investing have become profitable again.
A Value-Based Strategy
One of the three new strategies has been in the works for a long time now, and it is a value-based strategy. It is similar to the "Dogs of the Dow" strategy that involves investing in the 10 Dow stocks with the highest dividend yield, but this strategy should give much better returns. The "Dogs of the Dow" strategy evaluates the thirty Dow stocks once a year, each time placing the 10 highest yielding stocks in the portfolio. As the price of a dividend-paying stock goes down, its yield rises. Hence, the most depressed stocks will tend to have higher dividend yields and are the most undervalued. In our strategy, we would invest in the highest yielding stocks in the S&P500 (excepting the utility stocks). Instead of selecting the highest ranked 10 out of thirty, we will be selecting the highest ranked 10 or 20 out of more than 400. It will be more than 10 times as difficult for a stock to make the cut than in the "Dogs of the Dow" strategy, and all of the Dow stocks are included in the S&P500. Also, readjustments can be made weekly or as necessary rather than yearly, to dramatically increase the odds of being able to catch a trending stock near the beginning of an upward trend and of selling it early as the trend begins to reverse. Stock trends last an average of about 6 months. Adjusting once a year means that stocks could run for a 30% gain and lose it all before they are replaced at the next adjustment. Like the "Dogs of the Dow" strategy, this strategy has a built-in selling strategy. Stocks that no longer make the cut are automatically sold and replaced with stocks that do. There is no need to agonize over a selling decision. Unlike the "Dogs of the Dow" strategy, additional screens can be employed to increase returns further without eliminating nearly all the candidates. Instead of ending up with only a few stocks that qualify, there are still enough left after screening to diversify a portfolio.
A "Relative Strength" Strategy
The second of these new strategies is a growth strategy that makes heavy use of relative strength. However, other factors may also be used to further enhance returns. The study to which I referred in the first paragraphs suggests possibilities for achieving greater returns at less risk than might be obtainable by using a pure relative strength model (one of the best performing stand-alone strategies tested). To simplify for the sake of easy comprehension, I would rank the 500 stocks of the S&P500 by the use of proprietary measurements of relative strength (standard measurements would not be as useful for our purposes). The RSI will not be adequate for this strategy. Instead, use the strength rankings shown in The Valuator. The Valuator strength rank for the more than 500 stocks in the publication can be sorted just as with any other Excel spreadsheet. Those 10 to 30 stocks (depending on portfolio size) which rank highest and which also satisfy certain other criteria, are placed in the portfolio and monitored. Any stock whose strength declines to the point where it is no longer in the top 200 is immediately sold and replaced with the highest-ranking stock not already in our portfolio. Because most trends tend to continue awhile, stocks will likely spend much more time among the top 100 than among the second 100, resulting in much higher returns than is likely to be achieved by the index as a whole. The reason we let a stock drop to the 200th in a list of 500 is that we want to give stocks enough breathing room for them to undergo moderate pull-backs. Stocks will often take a temporary breather as profit-taking sets in. It is only when that profit-taking is sufficient to change a stock’s overall trend that we want out of the position. You can draw the line at some number other than 200 according to how aggressive you want to be.
When the S&P500 achieves a return of 15% for a year, it is well to remember that the return is the average return of 500 stocks. Half of those stocks will have performed more poorly, and half will have performed more spectacularly. For the S&P500 to achieve a 15% return, the top 250 stocks may have averaged far more than 20%. Our portfolios will be built around stocks that are top-ranked when they are selected. It is my belief that keeping all our investments in the top 200 stocks of the S&P500 will allow us to far outperform the index as a whole. For example, if the mid-cap and small-cap stocks (which account for more than 250 of the stocks included in the index) are outperforming the large-cap stocks, then they will automatically become our selection pool. On the other hand, if the large-caps are performing best, they will be the ones that dominate our list of candidates. Whatever the profile of the laggards, they will tend not to be in our portfolio to put a drag on performance. However, the performance of the S&P500 will be dragged down (relative to our model) by the impact of the bottom 300 stocks. Like the strategy given above, this one has a built-in selling strategy. It is not necessary to agonize over whether and when to sell a stock. If a stock does not satisfy the selection requirements, it is automatically sold and replaced with one that does. Even when a stock no longer qualifies to be in our portfolio, it is still a better performer than 60% of the stocks that make up the index. Also, more than 100 different industry groups are represented in this selection universe. If a particular sector is doing especially well, it will be represented in the portfolio.
A Mutual Fund Strategy
The third new strategy employs mutual funds. Here the term "mutual funds" should be understood to mean "ETFs." In this strategy we employ a database of ETFs including a wide assortment of sector funds, small-cap growth funds, small-cap value funds, large-cap growth funds, large-cap value funds, aggressive growth funds, growth funds, growth and income funds, equity income funds, index funds, global equity funds, international equity funds, emerging market funds, pacific equity funds, Europe equity funds, balanced funds, high quality corporate bond funds, high yield corporate bond funds, general government bond funds, mortgage-backed government bond funds, US treasury bond funds, precious metals funds, and others. These are all ranked using proprietary measurements of their relative strength. This Web site does the ranking for you. The five or ten highest ranking funds are selected and held until they are no longer among the top 30 or 50 mutual funds. You might draw the line at the top 20 if you are more aggressive. When they drop out of the top "X" funds list, they are replaced with the top ranked funds not currently in the portfolio. We draw the line at the top 30 funds rather than the top 200 as in the stock program because a mutual fund pull-back represents the decline of an entire portfolio and is thus more significant than a similar pull-back of an individual stock. This is so even if the fund and stock each represent equal investment amounts for us. It is natural for a stock to have a greater range of movement than a fund, all other things being equal. An ETF’s actual strength of performance will determine whether or not it is included in a portfolio. ~ Dr. Felt
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