This Model aims to own S&P 500 stocks that are more likely than not to be valued too low given a sentiment-based growth expectations supported by considerations of risk-quality.
That the Standard & Poor's 500 index is one of the most watched and respected stock market indexes out there is among the world's worst-kept secrets. While there are many occasions when many investors would prefer to trade other issues, in the big picture long-term sense, it's hard to deny the sensibility of equity exposure based on this group, consisting, as it is, of issues characterized by large size, massive trading liquidity, and companies with sound business prospects (as determined through quantitative rules and the judgment of S&P's selection committee).
Many believe this 500-stock "portfolio" is so sound, it makes little sense to invest actively in an effort to achieve superior performance. In one way, we agree: We are not traditional active investors who try to beat the market by using supposedly superior insight, intelligence, inspiration, etc. to develop better forecasts of the future. We believe, however, that it's not a matter of either/or, of active-versus-passive. We believe and have seen that study and analysis of various data characteristics can help us identify a better subset of an already-strong group. This involves no magic, no tea leaves. We rely on objective information available in plain view of all investors who want to examine and use it, but which is often overlooked or under-appreciated due to emotion, bias, a tendency to get carried away by fads, etc.
Value works. We know that. Deep down, everybody else knows it too, although there may be times when many suppress this knowledge. (See White Paper #1.) So it seems logical to assume we can outperform the S&P 500 if we limit ourselves to favorably valued stocks drawn from that group.
The fly in the ointment that often leads to the unsuccessful implementation of value strategies is that we often treat low-price-based ratios as ends in and of themselves. We often don't pay any attention, or nearly as much as we must, to the merits of the merchandise we think we're buying at bargain prices. As explained in White Paper #1, our goal is not to buy cheap stocks but stocks whose valuations seem lower than they should be given the companies' growth prospects and fundamental quality-risk profiles.
Future growth is critical but is very hard to predict since historic trends, the only thing we can actually observe, often do not persist into the future. But we can and do, in this case, use Sentiment indications (based on the work product of Wall Street analysts) as proxies for expert judgments regarding future prospects. Therefore, we narrow the S&P 500 "universe" to a small subset that have favorable valuation ratios and which are marked by relatively favorable indications of analyst sentiment. With regard to the latter, we're not jumping onto or off of anything because of news-type anecdotes. We don't rush to buy because we hear that so-and-so raised an earnings estimate, or sell because so-and-so lowered a target price forecast. Instead, we carefully filter all relevant data, newsworthy or not, and accept only stocks that measure up under the objective standards we establish. .
As to risk-quality, we address this implicitly, by narrowing consideration to S&P 500 constituents. Large size alone tends to soften earnings (and through that, share price) volatility. That's because larger firms are better able to cover and absorb fixed operating and capital costs. In other words, size alone makes it more likely that a big company will experience less intense profit swings than small firms even given the same percentage fluctuations 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). From within this blue-chip group, we test each stock under each of two ranking systems, one based on value and the other on sentiment. We narrow down to those that rate highly in both respects.
These ideas make sense, are in line with classic financial theory, and are consistent with what many investors believe in. Our innovation is in the execution: We work from objective data and rules, not ad hoc or seat-of-the-pants assessments. We believe our edge comes, not from re-inventing financial theory or fundamental analysis but from the implementation that removes emotion, bias, etc.
Having identified eligible candidates for investment, we choose the 10 stocks ranked highest in a "generalist" ranking system that combines Quality, Value, Momentum and Growth characteristics.
While we use this ranking system to identify the best, we're non-judgmental as what criteria might be referenced in order to determine if a stock is elite. Some may excel in terms of Momentum (another proxy for future marketplace expectations) and be middling at best in terms of Quality, Value (so long as it at least meets our minimum threshold) or Growth. Others may not be spectacular in any single respect but pretty good in a lot of ways. We're impartial, so long as our initial set of Buy rules is satisfied.
We refresh our model each week to determine which if any stocks should be replaced. Our Sell criteria are straightforward and are triggered if a stock slips below the top tier in our Sentiment ranking system.
This is an aggressive strategy in that it refreshes weekly, meaning we keep stocks on a short leash when it comes to faltering data profile, as reflected in our single Sell rule that aims at the Sentiment rank. Also, the number of positions held here, 10, is small enough to place the strategy toward the higher end of the return-risk profile. We strongly recommend that you not allow this to be the sole or even a substantial portion of your equity allocation.
This model has high turnover, based not only on its being a rule-based model of the sort that depends on data to keep positions aligned with strategy but also due to weekly trading and reliance on often-changing Sentiment factors. Due to the turnover, commissions could play a major factor in the returns.
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 a small amount each month can be very inefficient depending on your broker.