The strategy most likely to perform in this market

John Kimber

Funds management should look a lot different at the end of 2017. Fewer funds, lower fees for index huggers and more rewards for active managers. Underperformers should start to look more like ETFs. Cross shareholdings rationalized. We dream that the 20 per cent of managers doing better than the index will be rewarded. A growing discount to NTA of underperformers will compound. Opportunities and rewards for active managers will be much greater in 2017. Because more than 40 per cent of all activity is computer driven and the FED has become the central economic planning authority for the world, we outline which of six famous stock picker models are most likely to benefit, (Buffett, Lynch, O’Shaughnessy, Zweig, Graham and O'Neill) and give specific examples of investments they would be considering right now.

Indexing has been likened to the socialization of funds management and even the fostering of communism.

Indexing is the favourite territory of compliance managers, the banks, large funds managers, and the biggest index managers who have managed to convince a growing number of investors that active management should be avoided and the best solution is a robot adviser, which ignores everything except indexes and the program.

Indexing has been strongly criticized recently by academics, Schmalz, Raina, and the law schools at Yale and Chicago amidst howls of protest from the major sponsors of indexing.

Some of us are old enough to remember Bernie Cornfeld and his Fund of Funds which imploded in the bear market of the early seventies after ten years in the sun. We are not predicting a similar fate for ETFs, far from it. They perform the valuable function of dragging money from expensive underperformers into less expensive average performers. The rest should be taken over by managers smart enough to convince apathetic shareholders.

Fortunately, active managers who do not hug the index and deliver outperformance have not gone away and still manage to attract a big following willing to pay big fees. Active versus passive is not a binary choice. The opportunities and rewards for investors prepared to follow people who really know how to get a result have never been better. There is still a place for index investing.

As a specific example of the opportunities in Active Management, a recent study by Independent Research on 20 infrastructure ETFs described a 38 percent differential in the 12 month performance of the Alerian Energy Infrastructure ETF (ENFR) and the IShares Utilities Index (XLU). Of course, these two ETF’s are in different industries, but both could be classified as infrastructure ETFs, which averaged around 15 percent for the year.

This year, tax changes will drive plenty of investment decision making, none of which is within the ambit of financial advisers who are specifically warned against giving tax advice. Active funds managers are not subject to the same constraints.

Firstly, the index huggers were left behind when Donald Trump was elected on Nov 5. Stuck behind computer models reading only The Economist and watching only CNN, the pollsters and the markets failed. How could Hilary have possibly lost? It's a complete mystery. The markets had been anaesthetized by the Fed's low interest policies and peer pressure. America will now be run like a corporation. It is now a market for stockpickers.

Secondly, rising interest rates will sort the wheat from the chaff amongst stocks, managements and the investors prepared to back them. The leading stocks in any new bull market are never the same as the last market.

Thirdly, currencies are a much bigger deal now that the US Dollar is preeminent, commodities have suddenly started moving in unexpected directions and international affairs and inflation have turned around.

Fourthly, tax rates will be cut and when the US corporate rate drops below 20 per cent, there will be a flood of money from low tax countries back into the USA and then into buybacks and big dividend payouts in the USA. Another tax driven event that only active managers can exploit.

Finally, the movement between asset classes has begun. Currencies, bonds, commodities, and the 200 different equity asset classes we follow are all headed in new directions.

For an old hand in such a new environment it is difficult to forget our schoolboy French "plus ca change plus la meme chose" (The more things change the more they stay the same).

In other words Active Management is not going away any time soon.

We present six different methodologies for picking stocks of which only one or two will be successful in 2017. (All books mentioned are available on Amazon).

Buffett

Warren Buffett has never published any of his specific formulas for picking stocks. There have been plenty of comments recorded from the annual reports of Berkshire Hathaway and appearances which can be found on YouTube. Cunningham’s anthology about Buffett records many principles including the relationship between price and value.

Only the book “Buffetology” by his former daughter in law comes close. In the book, we can find an emphasis on formulas for past long term growth and potential for an investment. Buffett likes to buy good stocks cheap. We particularly like his advice to go for a walk if you can’t find what you want.

Zweig

Martin Zweig likes to buy growth and avoid stocks that are expensive. His book “Winning on Wall St” details Zweig’s preference for strong earnings growth coupled with a share price that is rising strongly combined with low financial multiples.

O'Neill

William O’Neill is the publisher of Investors Business Daily, associated research publications and books on investing. O’Neill is famous for the CANSLIM principles of earnings growth, new products, and momentum indicators. His iron clad rule is to take losses immediately at no more than seven percent of cost.

Lynch

“One Up on Wall Street” by Peter Lynch documents his growth at a reasonable price or the Price Earnings to Growth Ratio (PEG) at the successful Magellan Fund. He is best remembered for his common-sense purchase of Hanes Brands after his wife (how else could he know?) bought a pair of ladies’ stockings, L’Eggs, in a supermarket.

Graham

Benjamin Graham is the father of value investing. He is the author of “Security Analysis” and “The Intelligent Investor”. He likes low Price to Earnings ratios and a low Price to Book multiple. Mr Graham was always active at the bottom of a bear market.

O’Shaughnessy

If you like numbers and small cap stocks, you will love the quantitative masterpiece “What Works on Wall Street”. Surprisingly for such a large book, it arrives at a small number of criteria for stock selection.

In the following formulas, we have attempted to distinguish the numbers from the poetry and to distill the known information about the investment process into measurable rules that are followed.

A quick word on screening: It is always tempting to add and keep adding criteria until like the paralysed expert, we know more and more about less and less, until eventually we know everything about nothing!

Volume, volatility and momentum will be far bigger determinants of sharemarket profits in 2017 and will far outweigh any model, which although valuable, will be swamped by computer trading, the FED, and world events. ETFs have had an impact on momentum and volatility. We have seen numbers indicating that ETFs own more than ten percent of at least 400 of the 500 companies in the S&P 500.

A big drop in the market will be the time to buy stocks from a pre-determined screen. A big rise in the market will be the time to exit stocks that no longer fit the criteria for the screen.

The screens are intended as a summary to understand certain investment processes based on books and publications generally available.

Buffett

  • Sustainable Operating Profits growth. Recent losses must be one off
  • Margin and Profit Margin greater than the competitors
  • Debt/Equity lower than industry median. Long term debt less than five times net profit.
  • Recent earnings growing faster than five year earnings growth
  • Return on Equity greater than 15 per cent now and over last 5 years
  • Expected sustainable growth more than 15 per cent

(For more information see Buffetology by Mary Buffett and David Clark)

Graham

  • No losses in last five years
  • Earnings greater than 4 years ago
  • Paying a dividend
  • Current assets 1.5 times current liabilities
  • Long Term Debt no more than working capital
  • Price/Book between 0 and 1.2
  • In the lowest decile of PE ratios

(For more information see Security Analysis by Ben Graham)

Lynch

  • No Finance or Real Estate stocks
  • Price Earnings versus Growth (PEG) less than 0.5 after dividends
  • Price Earnings Ratio less than the 5 year average for the company
  • In bottom half of Price Earnings Ratio for the group
  • Debt ratios less than the industry
  • Under owned by Institutions

(For more information see “ One Up on Wall Street” by Peter Lynch)

Zweig

  • No Financial stocks
  • Stock price and volume greater than S and P 500 over 6 months
  • Price/ Earnings no more than 150 per cent of the S and P 500
  • Positive growth in sales and earnings growth in last 12 months.
  • Earnings and sales growth better than 15 per cent a year over 3 years.
  • Accelerating earnings and sales growth in latest results

(For more information see “Winning on Wall Street” by Martin Zweig)

O’Neill

  • Earnings Per Share rating in top 20 percent
  • Relative Strength in top 20 percent
  • Sales and Earnings growing at better than 20 percent in last quarter
  • Trading at about 15 percent below its previous high
  • Volume greater than 50 day average volume
  • More than 5 institutional investors

O’Shaughnessy

  • Price to sales less than 1.5 times
  • Earnings greater than prior year
  • Price rising faster than average for sector over three months and six months
  • Stocks with the biggest gains over 12 months

(for more information see “What Works on Wall Street” by James O’Shaughnessy)

As we said earlier, volume, volatility and momentum in the current market dominated by computer trading and the FED will swamp any attempt to prescribe outcomes from a pre determined list.

O’Shaughnessy’s model places the greatest weight on relative strength and momentum and as it turns out, produces far more stocks in the current market environment than any of the other screens.

The Stocks

The following stocks, based on the criteria created above are the sort of stocks these stockpickers would be considering. (We have not spoken to any of the following and the following stocks are our own interpretation). WE REPEAT, all these stocks, regardless of their intrinsic worth, can be swamped by volatility, volume and momentum issues.

Buffett

Edwards Life Sciences (EW)

Graham

Dillards (DDS)

Zweig

Priceline (PCLN)

O’Shaughnessy

1800 Flowers (FLWS)

O’Neill

Stamps.com (STMP)


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