Our Ugly Model Portfolio Strategies Continue to Generate Great Looking Alpha

by: Stephen Castellano

"Low-Quality" Stocks Outperform "High-Quality", Once Again

For the month ended April 30, 2010, "low-quality" stocks in our unlevered model portfolio rose 4.20% and "high-quality" stocks appreciated by 2.31%, driving results for a market neutral model portfolio down 1.82%. A 120-80/80-120 moderate long/short model portfolio declined 0.53%, and a 200-0/50-150 aggressive strategy returned 4.53%. This compares to a 1.48% gain (1.58% with dividends) in the S&P 500, a 2.16% gain in the Russell 3000 and a 0.80% rise in a mutual fund that is supposed to reflect S&P Quality Rankings.

Unleveraged "high-quality": 56 stocks, +2.22%
Unleveraged "low-quality": 52 stocks, +4.20%
Unleveraged focus list, "high-quality": 11 stocks +4.14%
Unleveraged focus list, "low-quality": 7 stocks +4.97%
Market Neutral Model Portfolio: -1.82%
120-80 / 80-120 Model Portfolio: -0.53%
200-0 / 50-150 Model Portfolio: +4.53%
S&P 500*: +1.48% (+1.58% w/ dividends)
Russell 3000* +2.16%
S&P Quality Ranking...Trust* +0.80%

*(We note a more relevant benchmark would track all stocks and ADRs with market caps above $2.5b that trade on major U.S. stock exchanges.)

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Model Portfolio Strategies and Indices Peak on April 23, and Sell Off as Allegations of Fraud and Fears of Potential Sovereign Debt Defaults Spread
On April 23, the S&P 500 peaked with a 4.09% return, our moderate strategy peaked at 3.34% and our aggressive strategy peaked at 15.27%, with the market neutral strategy peaking the day before with a 0.71% return. The sharp sell-off that followed was driven by fraud allegations against Goldman Sachs Group, Inc., spreading fears of sovereign debt defaults and a feeling of "too much too soon" despite a number of favorable company-specific reports showing an improving economy. These two big news stories reminded investors that nothing has been done to fix the lack of oversight that drove the current underlying economic crisis, and that a domino effect of sovereign debt defaults remains a looming possibility.

April began the month positively, with U.S. nonfarm payrolls showing an increase of 162,000, the largest increase since March 2007. Also in April, February pending home sales were reported to be higher than expected, U.S. retailers posted strong March sales, a consumer confidence index showed better than expected results, and a number of positive earnings reports were heard from various sectors showing a general pickup in the economy. A Federal Open Market Committee near the end of April left interest rates unchanged as the economy seems to be improving, despite the continued backdrop of high unemployment and low income growth. Companies continue to be reluctant to add significantly to payrolls, and a survey showed that around 50% of CEOs would make no changes to payrolls, and only 20% planned on adding to them. FOMC minutes from its previous meeting showed that members remained concerned about the sustainability of the incremental economic recovery due to the continued high unemployment rate, which is still at 9.7%.

Stock Highlights of the Month
The top performing stocks in the "high-quality" model long portfolio of 41 stocks included Chipotle Mexican Grill, Inc. (NYSE:CMG) up 19.7%, SanDisk Corp. up 15.0% and Kinross Gold Corp. (NYSE:KGC) up 11.0%. The worst three stocks included NBTY Inc. (NTY) down 15.2%, Freeport-McMoran Copper & Gold Inc. (NYSE:FCX) down 9.6% and Jabil Circuit Inc. (NYSE:JBL) down 5.4%.

Only 17 out of 52 low-quality stocks declined during the month, and eight of them actually appreciated by double-digits. Purchasing "low-quality" stocks instead of shorting them would have continued to produce outstanding returns. The top three performing stocks in the "low-quality" model short portfolio included Bunge Ltd. (NYSE:BG) down 14.1%, Arcelor Mittal (down 11.6%) and Focus Media Holding. (NASDAQ:FMCN) down 8.1%. The worst performing short ideas included MGM Mirage (NYSE:MGM) up 32.4%, EOG Resources (NYSE:EOG) up 20.6% and Harley Davidson. (NYSE:HOG) up 20.5%.

Focus List: A Narrower Focus on Fundamental Metrics Produced Significant Gains in April
Some of the best returns by a significant margin in April were driven by high-quality "focus list" stocks in the "high-quality" long portfolio, which moved up on average by 4.14% for the month. Results were driven by stocks like SanDisk Corp. (SNDK) up 15.0%, Warner Chilcott Limited (NASDAQ:WCRX) up 11.1% and Domtar Corporation (NYSE:UFS) up 10.0%.

Unfortunately for quantitative holy grail seekers everywhere, some of the best returns in April also came from the 7 "focus list" stocks in the "low-quality" short portfolio, which appreciated on average by 4.97%. The best short ideas in this group were China Telecom Corp. Ltd. (NYSE:CHA) down 6.3% and Sims Metal Management Limited (NYSE:SGM) down 4.2%. The worst idea to short in this group was Martin Marietta Materials Inc., which rose 14.8%.

Strategies Remain Net Long...For Now
A proprietary technical indicator we use to allocate our long/short weights in our model portfolios show a rising possibility of moving to a net short position in about 7-8 trading days as of this writing - perhaps by around May 12 or 13. Despite this, some of the economic commentators we read have noted the recent sell off in the markets but, whether a bull or bear, none have materially changed their stances. However, we did find it interesting that Jeremy Grantham, the Chief Investment Officer of GMO known for his consistent negative outlook on the markets, penned in his most recent newsletter that there could actually be a 30% chance for a sustained recovery. If Grantham is any indication, perhaps there is an increasing number of portfolio managers and strategists that remain negative on the markets and economy, but are increasingly positioning themselves to be "positively surprised" on the upside - or were doing so up until last week.

56 "High-Quality" Stocks in the Long Model Portfolio
There are 56 stocks in the long portfolio this month, as of the close of April 30, 2010, an increase of over 15 stocks from last month. They include ROST, BIG, GCI, GPS, ESI, DV, TJX, DLTR, FDO, M, TUP, BBY, KMX, CMG, SBUX, RGC, BBBY, LTD, SHW, THI, DLM, ARCC, PGR, CM, NYB, ACF, JPM, LFC, BNS, BMO, TROW, ABC, HUM, NVS, STJ, HON, STX, SNDK, MU, INTC, TXN, FLEX, WDC, JBL, CHKP, UFS, FCX, LZ, ASH, KGC, ATR, BMS, ALB, AMX, NRG and DPL.

30 New Stocks
The 30 stocks new to the list include GPS, ESI, TUP, KMX, RGC, BBBY, SHW, DLM, ARCC, NYB, ACF, JPM, LFC, TROW, ABC, HUM, NVS, STJ, HON, MU, INTC, TXN, WDC, CHKP, ASH, ATR, BMS, ALB, NRG and DPL.

Leaving the Long Portfolio
The 15 stocks leaving the long model portfolio include: AZO, TSN, NTY, FMX, KOF, UGP, SAN, BAP, TRV, PCL, GILD, WCRX, OSK, TW and V.

14 Focus List "High-Quality" Stocks
There are 14 "focus list" stocks as of April 30, up from 11 stocks last month. In theory, these stocks should have a particularly good chance of outperforming this month: TUP, KMX, RGC, SHW, NYB, ACF, JPM, TROW, MU, INTC, TXN, CHKP, ASH and ALB. In March, long focus portfolio stocks averaged a return of 4.24% versus 1.48% in the S&P 500.

52 "Low-Quality" Stocks in the Short Model Portfolio
There are 52 stocks in the short portfolio this month. TRI, MGM, SNE, PC, TM, TOL, ADM, PDE, HK, NBR, RRC, ERF, EOG, WFT, SUN, NDAQ, LAZ, CMA, REG, BK, CPT, PLD, DDR, JOE, PKI, GENZ, ERJ, MAS, TXT, RHI, TRMB, ATVI, ERTS, MLM, HUN, RS, GOLD, MOS, AA, AU, NIHD, SCG, POM, FE, LNT, TAC, PPL and EQT.

21 New Stocks
The 21 stocks new to the short portfolio include: SNE, ADM, ERF, CMA, REG, CPT, PLD, DDR, PKI, ERJ, MAS, RHI, HUN, RS, GOLD, MOS, AA, AU, LNT, TAC and PPL.

25 "Low-Quality" Stocks Leaving the Model Short Portfolio
The 22 stocks leaving the short portfolio include : FMCN, HBI, DAI, FO, HOG, BG, BRFS, AVP, ACI, SU, BJS, PXP, VLO, DRE, STI, OSIP, MDRX, MT, NUE, SMS, CHA, CHU, FPL, SO and GXP.

Three Focus List "Low-Quality" Stocks
Only three of these stocks go on the Focus Short List, down from seven stocks last month. In theory, these stocks should have a particularly good chance of underperforming the market over the next month. These include PLD, GOLD and TAC. In April, short focus portfolio stocks appreciated on average 5.03%, much higher than the S&P 500 return of 1.48% (excluding dividends).

Model Portfolio Sector Allocation as of April 30, 2010

Entering April, the model long portfolio continues with overweighted positions in Consumer Discretionary, Financial and Material Stocks, and has no positions in any Energy stocks. The model short portfolio has overweighted positions in Consumer Discretionary, Materials, Energy, Financials and Utility sectors. By definition, an equal-weighted strategy will overweight or underweight sectors in which it finds more or less stocks that meet its required factors. We are finding so far in ongoing back tests that applying this allocation strategy to ETF sector allocations is working very well.

Market Neutral Portfolio
Unleveraged returns of stocks in the "high-quality" portfolio moved up 2.31% for the month and unleveraged stocks in the "low-quality" portfolio appreciated up 4.20%. The corresponding market neutral portfolio, long "high-quality" and short "low-quality", declined 1.82%. Since "inception" on 12/31/2004 a market neutral portfolio has generated a 135.76% return versus -2.08% for the S&P 500, excluding dividends. These returns do not assume any expenses.

Moderate Long/Short Model Portfolio
The Moderate Long/Short Model Portfolio, which is either long/short by 120%/80% or 80%/120% any given day, ended the month down 0.53% after peaking at 3.34% on April 23. Since "inception" on 12/31/2004, excluding estimated expenses, this model portfolio has generated a cumulative return of 204.66% versus a negative 2.08% return for the S&P 500 (excluding dividends) over the same period. The maximum drawdown it experienced was 13%, its Sharpe Ratio is calculated at 1.12x and correlation with the S&P 500 is -37.7%. This portfolio has been in a net long position since February 26.

Aggressive Long/Short Model Portfolio
If shorting stocks has been a terrible strategy for most of 2009 and 2010, and there are no signs of this dissipating, why do it at all? In answer to a fund of funds managers question, we used the same stock picking algorithms and weighting signals as the original moderate strategy, but applied different long/short weights at 200/0 or 50/150. This strategy returned 4.35% in April, is up 14.84% YTD and up 653.05% since 12/31/2004. Using leverage in this way is highly volatile - this strategy peaked with a 15.27% return on April 23 only to finish the month more than 10 percentage points lower. By our calculations, this strategy has a 1.34 Sharpe Ratio, a -5.7% correlation with the S&P 500. Its max drawdown was 17%. This strategy has been net long since February 26, 2010.

A pdf report with more detail is available on Scribd

Disclosure: None