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It's not easy to build good models (those that backtest and perform well) focusing on large-cap stocks. It's hard to discover anything about these companies that doesn't seem to already be known by a gazillion others. And even if one is fortunate enough to come up with a truly novel insight, who knows if or when the market, which seems obsessed only with the latest news story, especially if it relates to increased or reduced earnings guidance, will ever trade on it. To paraphrase an old cliché, the masses can cling to a shallow or even incorrect assessment of a stock a lot longer than you can stay solvent. Ironically, however, that may be the key to finding large-cap ideas: work with the masses, instead of trying to out-think them.

Keeping It Simple

Using S&P 500 membership as a screening rule sounds pretty dull, and at best is likely to leave you shrugging your shoulders as you wait to see what comes next. Using S&P 500 membership as the only screening rules raises monotony to a whole new mind-numbing level.

Actually, though, it's not a completely crazy idea. It piggybacks off the S&P 500 Selection Committee, counting on them to weed out the worst fundamental basket cases and find financially viable substitutes as often as necessary which, lately, has been pretty often for what ideally should be a passive index.

As fundamental screening goes, this is hardly an aggressive approach. But if we're willing to assume that sentiment is the key driver of share price performance among large-caps, aggressive fundamental tests may be more of a distraction than a tool. Perhaps being good enough to pass S&P muster may suffice.

Under this view, the key would be, not to out-think the crowd but to detect what it's really looking at (which may not be the same as what a CNBC producer who has to fill a lot of time slots assumes is important). So as we sort among the 500 S&P stocks, we'll take our cue from the market itself. I'll work with the Portfolio123 Momentum ranking system, which examines relative share price performance over four different holding periods and the up-down ratio over three different periods.

We may be on to something

Figure 1 was created using data downloaded from the Portfolio123 backtester. It shows the result of a 3/31/01 through 5/12/10 backtest of a simple model that sorts S&P500 stocks based on the Momentum ranking system, chooses the top 10, and rebalances the portfolio every four weeks. (Click to enlarge)

Figure 1

This simple model beat the full S&P 500 index by a wide margin over the course of the test period. The brown line, which depicts the performance of an equally-weighted portfolio consisting of all the S&P 500 constituents, is included to show that the model's performance advantage does not come from the difference between equal weighting (the model) and market cap weighting (the index).

Generally speaking, I've been quite willing to get complex in both screens and ranking systems and I've had a lot of success with such models, which I use often because I like the mid- small- and micro-cap stocks they often spotlight. But if you really want big-cap firms, there may be something to be said for simplicity.

The stocks

Table 1 shows the S&P 500 stocks that pass muster as of this writing.

Table 1

The current list offers several ways to play the potential for improvement in housing.

Sears Holdings (NASDAQ:SHLD) would be a clear beneficiary since big-ticket home-improvement items are a conspicuous part of its product mix. There are, however, some other aspects of the investment case that could prove interesting. One, of course, is CEO and majority shareholder (through his hedge fund) Eddie Lampert, a polarizing figure in the investment community. He has taken heat for not running the most spiffy of operations and for being too cash flow oriented. On the other hand, for shareholders, that's supposed to be a good thing. That said, there are some potentially interesting operational moves at SHLD. One is an effort to make some of its best known "house brands" (Craftsman, Land's End, Kenmore) available through other retailers. Another is the dramatic expansion of its e-commerce, which offers thousands of products from third-party sellers and allows for in-store pickup of products ordered on line. Retail experts are divided, but SHLD's presence in this list suggest big investors are turning thumbs up.

Whirlpool (NYSE:WHR) is a lot less controversial and much more straightforward. Improvements in housing, whether new construction, remodeling or a combination of both, would be a boon for this manufacturer of major household appliances. First quarter results showed quite a bit of additional earning power through cost efficiencies following its acquisition of Maytag, enough so to lead to a big boost in earnings guidance and the huge round of estimate increases inevitably follows such an event. Meanwhile, don't underestimate the potential for product innovation, even in an area that seems as mundane as this one. Recent examples include the Kitchen Aid French-door refrigerator with a full-color LCD screen displays use and care information and even offers a kitchen timer, and suggested ingredient substitutions; and a new Whirlpool brand side-by-side refrigerator with MicroEtch Spill Control Shelves that prevent leaks, facilitate easier cleanup, and offer 25 percent more usable shelf.

When we think of housing, we usually think of ownership of private homes. But judging from the way to apartment-rental REITs, Equity Residential (NYSE:EQR) and Apartment Investment and Management (NYSE:AIV) bubbled up to the top of our Momentum ranking system, perhaps we should broaden our horizons a bit. We have to expect credit conditions to improve as we move further away from the 2008 crash, but we probably can't expect anything resembling the wild extremes in lending that led to the crisis. That may mute the magnitude of the housing recovery and push more people into rentals. Add in the echo baby boom, a large number of young adults entering their initial household formation phases, and we may wind up with a nice intermediate- or long-term boost in demand for apartment rentals. Within this field, EQR is the upscale player while AIV serves the mid- and lower-ends of the market. Neither stock presently offers the sort of high yield we expect from REITs; both have recently had to cut payouts as funds from operations succumbed to recessionary pressures. But it seems reasonable to expect pick-ups in dividends down the road, as business fundamentals improve.

The rest of the names on the list all look like they stand to benefit from improving economic activity.

One odd-ball that stands out is Dr. Pepper Snapple (NYSE:DPS), which was spun off from Cadbury in 2008. Spinoffs usually in and of themselves make for interesting "special situations," so much so that there's actually an ETF out there dedicated to precisely this theme: Claymore/Clear SpinOff ETF (NYSEARCA:CSD). The idea is that certain business can improve, often significantly, once they separate from larger corporate umbrellas where they often had trouble attracting as much management attention and resources as they really should have had. Unfortunately for DPS, this spinoff occurred just before financial disaster struck the Western World. As a result, much potential for post-spinoff improvement still lies in the future. That, actually, is the bull case for DSP; the notion that it can drive profits higher by fleshing out its product line. Right now, it has great carbonated beverage brands: Dr. Pepper, 7-Up and Sunkist. But it could probably stand to add some variations, and the company is not in some hip categories like energy drinks. Its ice tea brand, Snapple has probably been weighted down by having been acquired and divested so many times over the past generation as to make one wonder if its primary line of business was answering due diligence inquiries. There's no mystery around what DSP needs to be done to grow its brands and enhance its portfolio. Now, as a stand-alone beverage-focused company and with the financial crisis receding into the past, it should finally get an opportunity to exploit its potential.

Disclosure: No positions in stocks mentioned

Source: Large Cap Investing: Don't Outthink the Room