Now Not The Time For Strategy Shift

11/28/2016


In this space and elsewhere, I've highlighted discipline and humility as the keys to successful long-term investing. A disciplined approach means you can learn from mistakes and repeat past winners. Humility means you remember that no system is perfect, that a run of strong returns does not prove you've figured anything out.

Staying humble has not been difficult in 2016; with the exception of our Top 15 Utilities Portfolio, our buy lists have underperformed this year, partly because several seemingly cheap stocks got even cheaper on bad earnings news. The way we underperformed, however, was enough to test the discipline of any stock picker.

While our buy lists have outperformed the S&P 500 Index since June 30, all three lost ground steadily in the first half of the year. With investors interested in low-volatility bond substitutes and a few bulletproof growers like Facebook ($121; FB) and Amazon.com ($785; AMZN), our growth-at-good-price approach was exactly the wrong place to be.

As shown in the table below, stocks with the cheapest valuations and best expected growth rates performed worst in the first half of the year. Stocks with the lowest expected growth and lowest Overall Quadrix scores performed best, as did those with the lowest volatility.

WHAT'S WORKING: A MIDYEAR SHIFT
------------------------------- Average Total Return By Decile -------------------------------
Best
(%)
2
(%)
3
(%)
4
(%)
5
(%)
6
(%)
7
(%)
8
(%)
9
(%)
Worst
Quadrix Overall Score
12/31 to 6/30
(4.3)
5.2
4.6
7.1
5.5
6.9
8.2
9.0
11.6
11.8
6/30 to 11/21
10.9
15.0
13.0
15.0
12.1
12.3
11.2
9.4
7.6
12.4
Quadrix Value score
12/31 to 6/30
0.0
5.4
6.8
8.0
6.0
7.5
8.4
8.3
6.8
8.4
6/30 to 11/21
21.0
20.3
17.7
15.2
15.4
10.6
9.2
4.3
2.1
2.9
Price/earnings ratio
12/31 to 6/30
(2.0)
3.9
4.1
8.1
11.3
8.9
8.6
3.2
8.9
6.2
6/30 to 11/21
22.8
20.1
14.8
14.4
10.2
8.7
6.2
4.8
5.8
6.6
Long-term expected profit growth
12/31 to 6/30
0.4
0.6
3.7
3.8
5.2
8.4
4.8
7.2
13.8
15.6
6/30 to 11/21
10.3
12.1
11.7
11.4
12.9
12.5
14.2
10.3
9.9
7.6
Beta (volatility)
12/31 to 6/30
14.2
9.9
8.4
8.9
5.0
5.7
4.1
2.8
2.0
3.2
6/30 to 11/21
(2.1)
4.0
9.1
7.4
9.3
16.4
11.7
17.7
23.0
21.7

Typically, our buy lists do not fully reflect the signals sent by Quadrix, as we limit sector and industry exposures to dampen risk. In hindsight, we should have done more of that in the first half of 2016, when our returns suffered from exposure to health-care and industrial names. Also, we should have exited some out-of-favor names earlier.

However, we don't think this year's disappointing returns mean it is time to change our basic approach, for four reasons:

• First, no approach works in every type of market environment. If you constantly shift your style to what's working now, you're likely to be whipsawed as that strategy falls out of favor.

• Second, history suggests our Overall Quadrix score tends to rebound strongly after losing streaks. Reversion to the mean is a powerful force in the stock market, and we expect attractively valued growth stocks to play catch-up over the next year. Relative to the low-volatility and glamour names that did best in the first half, our growth-at-a-good-price stocks remain attractively valued versus historical norms.

• Third, we are already seeing a reversal. Since June 30, when bond yields and economic optimism reached a low ebb, the top one-fifth of S&P 1500 stocks based on Overall score have outperformed the bottom one-fifth and the average for all stocks. The cheapest stocks (with the best Value scores) have handily outperformed since June 30, a trend that has accelerated since Election Day. Meanwhile, the lowest-volatility stocks have actually declined since June 30, partly because investors became less interested in bonds and bond-like stocks.

• Fourth, we're pretty good at what we do. This year's relative returns have been poor, and we'd expect to fare better even when our approach faces headwinds. But we're not closet-indexers; we don't strive to keep our sector and industry exposures in line with the indexes, and we don't worry a lot about the risk of lagging the index for a quarter — or even a year. We do worry about the risk of losing money, so we never let one or two groups dominate our portfolios.

OUR RETURNS SINCE 2000
Focus
List
(%)
Buy
List
(%)
Long-Term
Buy List
(%)
S&P 500
Index
(%)
Since 2000 †
108.8
122.4
148.6
49.9
2016 †
(3.7)
(2.7)
(0.8)
7.8
2015
(2.7)
(1.6)
(1.4)
(0.7)
2014
22.1
20.2
18.7
11.4
2013
36.0
42.8
42.7
29.6
2012
14.2
16.0
15.8
13.4
2011
(4.8)
(9.1)
(4.2)
0.0
2010
19.5
12.7
10.3
12.8
2009
40.0
37.6
30.6
23.5
2008
(48.8)
(46.3)
(36.5)
(38.5)
2007
22.8
19.2
10.8
3.5
2006
12.9
16.9
9.7
13.6
2005
8.1
13.2
4.1
3.0
2004
17.5
22.4
9.0
9.0
2003
20.2
29.2
24.6
26.4
2002
(28.9)
(25.8)
(18.2)
(23.4)
2001
(16.0)
(15.6)
0.3
(13.0)
2000
14.0
(1.4)
5.0
(10.1)
Notes: Returns are fully invested and exclude dividends and transaction costs. Buy List and Long-Term Buy List returns reflect target weightings for individual stocks  † Through Nov. 22.

Over the long haul, our approach has worked quite well — even though we've lagged behind in some periods. Since 2000, the year we introduced Quadrix, our Buy List has gained 122.4% on a fully invested basis excluding dividends and transaction costs, versus 108.8% for the Focus List and 148.6% for the Long-Term Buy List. In comparison, the S&P 500 Index has gained 49.9%.

Conclusion

The first half of this year was an unusual period for the stock market, one uniquely unsuited for our style of investing. But the market has seen a major rotation since midyear, and our buy lists have begun to outperform again. With investors looking to play offense because of an improving outlook for corporate earnings and the global economy, we expect our approach to pay dividends over the next year and beyond.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com