Prior articles presented recession-oriented equity strategies based on quality, value and growth applied to a group of so-called defensive-business. Backtesting pinpointed several comparably viable single-style approaches. Today, we'll consider a more generalist protocol that combines styles. The backtest results here are slightly better than what we've seen up till now, and beyond the numbers, many may find it easier to sleep owning a multi-strategy portfolio.
The rotation dilemma
How many times have you considered a strategy, refined it, tested it, and confirmed its underlying logic only to find that it stops working the day you implement it with real money?
Assuming you were sincere about confirming the logic (i.e. you weren't data mining), the reality usually isn't that bad. If you stick with a sound strategy that suddenly seems to stop working, it usually will come around again within a reasonable time frame. But it still hurts, especially if "reasonable" stretches to a period that might be more compatible with the Warren Buffetts of the world than the Jim Cramers.
We're seeing, here, the impact of style rotation.
Rotation is an old familiar phrase on Wall Street, but we usually see it applied to sectors. "Tech is in now, consumer staples are out." "Tech has had it's run, now we're moving into energy." Etc. etc. etc.
This same sort of rotation can be observed with different investing styles. One day value is in. Next time, growth takes the lead. Etc. You don't usually hear this kind of rotation discussed in the media, but you do encounter it when commentators caution against picking mutual funds solely by chasing last year's winners. (Sometimes, managers change from hot to cold, but more often, it's the style.
In theory, one can shuffle a portfolio to match ongoing style rotations. But that's easier said than done, since it can take a while to recognize that a formerly hot style has receded to the background and to identify the one that moved to the forefront. By the time you catch up and shift your portfolio, there may be a new rotation. In other words, you think you try to catching shifting waves but in fact, find yourself getting whipsawed.
Another approach is patience. When your style encounters some turbulence, do what you do on a plane. Fasten your seatbelt and wait it out. This is the reaction counseled by many investment gurus and textbooks. And in fact, for those who are able to withstand bad periods, this course of action has often proven successful.
Another approach is to diversify stylistically: look for stocks that make the grade under more than one approach. Few, if any, stocks are perfect, so you're unlikely to wind up with what practitioners of a particular style would refer to as the best of the best. For example, the best growth stocks may be overpriced or financially strained. But you should be prepared to own a collection of solid generalists; stocks that are reasonably good in a variety of respects. Maybe they'll be spectacular in one or two as well. Or maybe not. You're aiming to be reasonably good across the board.
Viewed a different way, consider the two by-now-archetypical investors with widely disparate styles and comparably dedicated fans that were referenced above; Jim Cramer and Warren Buffett. Many assume if you follow one, you have to shun the other's methods. But suppose you're a Buffett fan looking for new ideas. You find ten candidates, all of which hold appeal to the Buffett devotees. Suppose two of those issues also appeal to the Jim Cramer wing of the market. Why not favor those, even if you vehemently disagree with everything Cramer says. After all, stock prices are set by supply and demand, and the more people who are likely to demand your shares in the future, the better off you'll be. Put another way, when it comes time to take profits, you don't have to like the person who buys the shares you're selling.
Testing stylistic diversification
Table 1 shows the results of a variety of backtests conducted using multiple styles. These are the same approaches as were presented previously in this recessionary-investing series, and they are summarized in the appendix at the bottom of this article. The tests were conducted using the Portfolio123.com advanced back-tester to create hypothetical portfolios at the start of each week between 3/31/01 and 9/13/08. All were then "held" for only four weeks. In other words, portfolio 1 ran from day 1 through day 28; portfolio 2 ran from day 8 through day 35, portfolio 3 ran from day 15 through day 42, and so forth. The results reflect the average performance of the 390 four-week portfolios thusly created.
Computations are for stocks with market capitalizations of at least $250 million. Defensive Groups includes filters described in a previous blog
Here are some key observations:
- When applied to all stocks in general, these are reasonable up-market models. Under normal conditions, when one expects the market to advance more often than it slips, these models seem worth considering. But when we're cautious, adjustments seem in order.
- In down markets, it remains the case that confining selection to defensive-businesses confers a large benefit. The degree of outperformance in down periods is modestly enhanced by the models. However these models remain beneficial insofar as they limit the number of stocks to an investable level (20 in this study).
- The more aggressive multi-strategy models, the ones that seek top-ranked stocks, as opposed to the middle ground, turned in comparable downside protection but most added the benefit of offering the ability to outperform the market even during up periods.
- The upside-downside balance seen in the more aggressive multi-strategy models is far better than anything seen in any of the single strategy protocols.
So on the whole, it appears that the top-ranked multi-strategy approaches rule the roost. But in narrowing to a single winner, I'll go with the three-prong strategy. It's not unambiguously superior in terms of back-test results; in this regard, all are pretty much in the pack. But beyond the numbers and looking ahead, it's the three-prong strategy that seems best able to cope with style rotation.
Table 2 shows the stocks currently selected by the three-prong model.
Each factor within a particular style is equally weighted.
In the two-prong tests, the two styles used are each weighted 50 percent. In the three-prong test, each style has a one-third weighting.
- EPS and Sales Growth, latest quarter
- EPS and Sales Growth, trailing 12 months
- EPS and Sales Growth, last 5 years
- EPS and Sales Growth, last 10 years
- Earnings Yield
- Enterprise Value/EBITDA
- Enterprise Value/Estimated EPS
- PEG Ratio
- Trailing 12 Month (TTM) Return on Equity
- 5-year Return on Equity
- TTM Return on Investment
- 5-year Return on Investment
- TTM Leveraged Return
- 5-year Leveraged Return
- Trailing 12 Month (TTM) Operating Margin
- 5-year Operating Margin
- TTM Pretax Margin
- 5-year Pretax Margin
- Trailing 12 Month (TTM) Asset Turnover
- Trailing 12 Month (TTM) Inventory Turnover
- Trailing 12 Month (TTM) Receivables Turnover
- Current Ratio
- Quick Ratio
- Trailing 12 Month Interest Coverage
- Debt-to-Capital Ratio
Click here for the article that describes the defensive-business list.
Click here for the article that describes the Quality style.
Click here for the article that describes the Value style.
Click here for the article that describes the Growth style.
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