- The Dow portfolio is doing exceptionally well.
- In the S&P portfolio, Coach turned into a pumpkin.
- Forty percent of the USA portfolio (American companies only) had to be "deported.".
Last year I conducted a trial run of a portfolio selection strategy that was intended to run against the "Dogs of the Dow" strategy - although I had portfolios selected from the Dow Jones Industrials ("DJIA," or "the Dow") and the S&P 500 ("S&P"). Neither of my portfolios outperformed their benchmarks, as both indexes did extremely well last year.
At the beginning of this year I rolled over the earnings from last year's runs to continue the trial against both the Dow and the S&P; a third portfolio - taken from the U.S. stock market as a whole - was added, using a combination of the NASDAQ Composite and the New York Stock Exchange Composite as its benchmark.1
I thought that mid-year would be a good time to check the performance of the three portfolios to see how fundamentals-based selection criteria are faring against their respective benchmarks. I also wanted to consider whether a mid-year correction might be in order - something that was not done last year.
For those who are unfamiliar with my testing of "PIC," it is a set of fundamentals-based criteria for identifying companies that are financially sound, effectively managed, and efficiently operated. The criteria are:
- Return on Assets ("ROA") > 0;
- Return on Equity ("ROE") > 0;
- Return on Investment ("ROI") > 0;
- Operating Margin (or EBITDA Margin) > 15%;
- Total Debt-to-Equity (D/E) Ratio < 1;
- Quick Ratio > 1;
- Dividend Cover > 1 (or Payout Ratio < 100%);2
- Performance (Trailing Twelve Months - TTM) > 0;
- Performance (Year to Date - YTD) > 0.
The criteria are designed to be used as filters in a screener; in practice, in order to narrow down selections, one can alter the criteria - increase the returns or operating margin, for instance, or decrease the D/E ratio.
If the number of companies selected by PIC is greater than the number desired, and any fine tuning of the criteria reduces the list by too much, another criterion may be used. For purposes of the PIC trials, those ten companies offering the highest dividend yield were chosen.
These criteria can also be applied in examining the fundamentals of any company one is considering investing in.
The PIC of the Dow
The ten companies chosen for the Dow PIC portfolio are:
- Cisco Systems, Inc. (NASDAQ:CSCO)
- Chevron Corporation (NYSE:CVX)
- Walt Disney Co. (NYSE:DIS)
- Intel Corporation (NASDAQ:INTC)
- Johnson & Johnson (NYSE:JNJ)
- McDonald's Corp. (NYSE:MCD)
- 3M Co. (NYSE:MMM)
- Merck & Co., Inc. (NYSE:MRK)
- Nike, Inc. (NYSE:NKE)
- Pfizer, Inc. (NYSE:PFE)
The portfolio was initially assigned $10,000 in 2013, with the money divided equally amongst the companies. At the end of the year the portfolio was up 26.49%, to $12,648.94 (including dividends). The portfolio funds were divided equally among the ten companies.3
As of the end of 2Q14, the portfolio results were:
As a whole, the portfolio
- Has a value of $13,790.65, a total return of 9.03% thus far in 2014;
- Has seen share values increase by a total of $764.38, for a performance of 7.71%;
- Has substantially outperformed the DJIA's performance (YTD) of 1.51%.4
The Dow PIC has managed to increase its lead over the DJIA consistently, month-to-month, as shown by the following chart:
While the chart above compares the PIC's total return data to the Dow's performance, I can't help but feel somewhat vindicated for last year's loss considering that - calculated from the January 1, 2013 start - the Dow PIC has now outperformed the DJIA 37.91% to 28.41%.
The PIC of the S&P
The ten companies chosen for the original S&P 500 PIC portfolio were:
- Analog Devices, Inc. (NASDAQ:ADI)
- Altera Corp. (NASDAQ:ALTR)
- Coach, Inc. (NYSE:COH)
- Helmerich & Payne, Inc. (NYSE:HP)
- Johnson & Johnson
- KLA-Tencor Corporation (NASDAQ:KLAC)
- Linear Technology Corp. (NASDAQ:LLTC)
- Eli Lilly & Co. (NYSE:LLY)
- QUALCOMM Incorporated (NASDAQ:QCOM)
- Xilinx, Inc. (NASDAQ:XLNX)
The portfolio was set up under the same terms as the Dow PIC - $10,000 divided equally. By December 31 the portfolio was up 32.37%, at $13,237.35, which was split evenly amongst the 2014 S&P PICs.
Unfortunately, there was a casualty among the new PICs: Coach, which has lost over 39% in share value in the first two quarters, dropped to $34.18 from $56.11, and was dropped from the portfolio. There was no immediate prospect of Coach improving enough to undo the damage to the portfolio (shares would have to increase by somewhere in the vicinity of 70% just to get back to its starting point),5 so I replaced Coach with Microsoft Corporation (NASDAQ:MSFT). The new portfolio looks like this:
As a whole, the portfolio has
- Realized a total return of $14,335.31, for an increase of 8.29%;
- Increased in share value by 7.41%, to a value of $13,788.56;
- Outperformed the S&P 500 YTD performance of 6.05%
Since the inception of the trial portfolio, the S&P PIC has realized a total return of 43.35%, compared to the S&P's return of 37.45% over the same 18-month period.
The following chart illustrates the performance of the S&P PICs compared to the S&P 500 (YTD):
The PICs did extremely well during the first quarter, achieving a total return of 10.67%, but the market is a tough task master and forced a major correction on the portfolio in April.
The PIC of the USA
Not every PIC portfolio did well so far this year. The portfolio of PICs from American companies ("USA PIC portfolio") did so dramatically bad as a whole that four companies were replaced.
The companies that were retained from the original portfolio are:
- Computer Programs & Systems, Inc. (NASDAQ:CPSI)
- Simulations Plus, Inc. (NASDAQ:SLP)
- United-Guardian, Inc. (NASDAQ:UG)
- USA Mobility, Inc. (NASDAQ:USMO)
The companies that were dropped from the original portfolio are:
- Espey Manufacturing & Electronics Corp. (NYSEMKT:ESP) (down by 23% YTD)
- Evolving Systems Inc. (NASDAQ:EVOL) (down by 12% YTD)
- The Female Health Company (NASDAQ:FHCO) (down by 35% YTD)
- Pfizer, Inc. (down by 3% YTD)
These companies lost an aggregate of $654 of the original $10,000 investment, or 6.54% (part of the loss of share value was recovered through dividends).
In order to provide an appropriate benchmark for the USA PIC portfolio I combined the NYSE composite with the NASDAQ composite, as the companies in the portfolio belong to one or the other of the two exchanges. The resulting benchmark (which I've designated "NANY" for NASDAQ and NYSE) is a very reasonable reflection of the two exchanges.
The following chart compares the USA PIC portfolio to the NANY benchmark:
Given the degree of the discrepancy between NANY and the PICs, the April surge notwithstanding, I thought it appropriate to make major changes. The following companies have been added to the USA PIC portfolio:
- Federated Investors, Inc. (NYSE:FII)
- Rockwell Automation, Inc. (NYSE:ROK)
- Snap-on, Inc. (NYSE:SNA)
- Stryker Corp. (NYSE:SYK)
The portfolio looks like this:
One might notice that I retained Pfizer (and Nike) in the Dow PIC portfolio even though they were performing negatively, while dropping Pfizer from the USA PIC portfolio; on the surface, the decisions seem inconsistent with one another.
This is perhaps a matter of minimizing interference with a portfolio. The Dow PICs are performing very well, and Pfizer and Nike are not really dragging the portfolio down. If the two stocks had not changed from their original price, the portfolio as a whole would move up by approximately 40 basis points (less than one-half of a percentage point). Both companies have reasonable prospects, so it seems appropriate to leave the portfolio alone.
In the USA PIC portfolio, on the other hand, the four losing companies are dragging the portfolio down, and - while Pfizer is by no means the worst-performing stock of the four losing holdings - there would seem to be a need to replace all four companies to increase the likelihood of getting the portfolio back on track. There is no guarantee that the strategy will work, but left alone the portfolio is going nowhere.
All changes were made by using the PIC criteria on the screener at FINVIZ.com.
Is a mid-year correction enough? Should changes have been made at the end of the first quarter? At that point, Female Health Company was down significantly (the other three USA PICs were down, as well), as was Coach. A change then might have at least minimized losses, and could have made USA PIC profitable instead of ending up just below "zero." This is a consideration I will have to examine as the year progresses.
For the individual investor, transaction costs can become significant when dealing with a strategy that involves regular portfolio adjustments (particularly a restructuring and rebalancing once each year). Excessive quarterly or even semi-annual changes risk wasting profits. It is wisest to change holdings only when it becomes clear that the portfolio as is, is malfunctioning.
1 "Dogging the Markets: End-Of-Year Update," Seeking Alpha, January 2, 2014. The decision to combine the NYSE with NASDAQ was made when it became obvious that, with companies from both exchanges in the portfolio, either composite by itself would be inadequate as a benchmark.
2 Dividend cover and payout ratio are actually the inverse of each other. "Dividend cover" (more frequently used in the United Kingdom) is acquired by dividing EPS by dividend, while "payout ratio" is acquired by dividing dividend by EPS. Conceptually, the information is aimed at determining the extent to which earnings (quarterly or for the fiscal year) are adequate to cover dividends being paid. As stated, the criterion requires that earnings be greater than the dividends - I find the "dividend cover" formulation to be more intuitive of that.
3 The only change made to the portfolio was to replace IBM (NYSE:IBM) with Nike as determined by PIC.
4 All data is as of June 30, 2014.
5 In fact, had Coach simply maintained its original value, the S&P PIC would have had a total return of 12.10%! One poorly performing company can have a substantial effect on an otherwise excellent portfolio.