What This Strategy Aims To Do
The Model aims to own “value” stocks, which is not necessarily the same as owning “cheap” stocks. Genuine value involves the relationship between what we pay and the quality of the merchandise, the stock, we have bought.
Why It’s Worth Considering
Who wouldn’t want to pay 80 cents to purchase a $1.00 bill? The quest to buy something worth less than what one pays is as old as humanity itself. So, too, is the opposite: Who would want to pay $1.20 to purchase a $1.00 bill? Value makes sense. Value is good. Period. That’s so when you buy a house. That’s so when you buy a car. That’s so when you pay for a vacation. That’s so when you buy clothing, furniture, food, anything.
Yet, when we observe the stock market, we find many who do not describe themselves as value investors, and also quite a few who are downright scornful of this approach. Even among the many who do recognize the legitimacy of value investing, we frequently hear that sometimes the market favors value and that at other times, it prefers a different style. So it seems we have a disconnect between what logic tells us must be true, and between what we observe every day.
The snag relates to the assessment of what we’re buying. If we are purchasing a $1.00 bill, we all know, with perfect certainty, exactly what it is worth. No buyer has any incentive to pay one cent more than $1.00 and no seller has any incentive to accept one cent less. It’s a bit more challenging with houses, cars, clothing, etc. Sometimes most people can readily recognize when a transaction was made at a reasonable price. Other times, there will be disagreement, negotiation, second-guessing, and so forth. But through the interaction of sellers (supply) and buyers (demand) in a marketplace, we usually work it out, even if not always perfectly.
The stock market works the same way. What makes it seem different, and harder to succeed in, is the fact that it’s so much more challenging to figure out what a company is actually worth. The true value of a company cannot be observed today because it depends entirely on what will happen in the future. It depends of future sales growth, future risk, and future market conditions, future margin trends, etc. (For more on this, see Portfolio123 White Paper #1.)
Therefore, when you hear someone say “I don’t do value,” you can, in your own mind, translate that to “I give up on trying to cope rationally with the unknowns that impact value.” When you hear somebody say “Value is OK, but the market is not favoring value now,” you can mentally translate that to “Most investors are finding it harder than usual to address the unknowns relating to value, so, at present, they’re not trying.”
We recognize, as we must, that there are, indeed, times when value stocks won’t perform as we believe they should. But on the whole, we believe the logic of value is so compelling, an investor with a big-picture perspective will be better off addressing it in his or her portfolio. Simply put, value is too compelling to ignore. Our task is to address the unknowns in a sensible way.
How We Do It
We start by filtering a large-capitalization universe to limit consideration only to stocks that have low valuations relative to this particular universe. We do it by using a ranking system that considers a variety of well-respected widely-used ratios: Price Earnings (PE), PEG (PE to Growth rate), Price to Sales, Enterprise Value to Sales, Price to Free Cash Flow, and Price to Book Value.
While we deem some ratios to be more important than others (i.e., we weight some higher in our ranking system), the larger point is the variety of ratios we consider. In our view, no single ratio is “it.” As we explain in Portfolio123 White Paper #1, each ratio is driven by a different set of fundamental considerations and all are equally valid. We want stocks to demonstrate value but we are not judgmental as to how they do it, nor are we partial to whether they are value specialists (outstanding in one or two ratios) or generalists (reasonably sound in many ratios).
Considering all we said above about value being more than just low ratios, the reader should wonder why we start our selection by zeroing in on relatively low valuations. We don not have to do this and other models we offer pursue different approaches. What we have to do is try to identify stocks whose ratios, whether high or low, are lower than they should be given the merit of the company. This is not a matter of mathematics. It’s a matter of Wall Street behavior, and this model aims to take advantage of experience and study that leads us to believe success is more likely among stocks whose valuation ratios lean lower. Put another way, lower valuation ratios suggest less Wall street optimism regarding the companies and we often see mismatches at the lesser end of the spectrum (companies not being as lackluster as Wall Street skepticism suggests) than at the higher end, where high ratios are more likely to assume a generally strong company is stronger than it really is. Those who would like pursue stock mis-pricing at the upper end can consider some of our other Models (Potential for Growth, Swinging for the Fences, Following the Smart Herd).
Having identified our list of value candidates, we select the top 30 based on notions of justified value.
Valuation is justified or not depending on how it relates to growth prospects and risk-company quality. There are countless variations in the number of ways these factors can be defined and combined. Consistent with our tendency to be less judgmental as to the precise manner in which stock demonstrates merit (so long as it does, indeed, show merit somehow or other), this Model establishes justification through a ranking system that measures analyst sentiment (which we deem a worthy proxy for expert expectations regarding future growth, something we prefer to reliance on historic growth which often do not persist) and quality. Or assessment of Quality consists of two parts. One involves consideration of a constellation of standard fundamental ratios involving margin, turnover, financial strength and return on capital). The other involves consideration of size which, in and of itself is related to stability given that larger firms are more capable of absorbing fixed operating and capital costs. That subjects them to less intense profit swings than those experienced by small firms even given same degree of fluctuation in revenue. Also, business stability at larger firms tends to be enhanced by greater operational and customer diversity. (Even supposedly single-industry companies can, when large, make a very wide variety of products or offer a wide variety of service to a wide variety of potential kinds of customers/clients).
The model is refreshed weekly and stocks are sold under criteria relating to changes in valuation. We have also designed the strategy to limit turnover.
Is It Suitable For You?
This is a stock strategy so we cannot consider it as being one of below average risk (that is mainly for fixed income). But as equity strategies go this one is fairly mainstream. We designed this Model in a way that we expect to result in low portfolio turnover, so it should be cost effective for you if your trading fees are typical or better.
Investing In This Model
As is often the case for rule based models that depend on data to keep positions aligned with strategy, investors will have to monitor turnover. However, this particular strategy does contain some rules designed to reduce turnover relative to other data-driven approaches. Even so, turnover is sufficiently high to make commissions an important factor.
It is also preferable to follow this model in a tax deferred account to avoid paying short term capital gains taxes. However due to the turnover and relatively high number of positions, contributing small amount each month an be very inefficient depending on your broker.