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Medium-term horizon, long/short equity, research analyst, portfolio strategy
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Summary

  • The portfolio construction methodology is clarified, portfolio performance is reviewed and despite a correction, the portfolio is in front.
  • Suggestions as to which stocks to liquidate and which to consider as replacement.
  • It is strongly suggested to review earnings as a core process in stock selection.

I would like to start this week by referencing some comments to my previous article which described my efforts as the "ultimate black box." I don't see it that way. All that is being done here is the identification of underperforming stocks using a slightly different measurement technique, which is then followed by an assessment of whether that underperformance is justified on earnings (or other fundamental) grounds. This is not far off the idea of identifying stocks which are "on sale, or mispriced."

Part of the rationale behind presenting a list of 10 stocks is that it is based on a statistical likelihood of performance over a three month period, so there are bound to be winners and losers and all that we are seeking is a better than 70% win ratio on a consistent basis, and that an equal weighted portfolio beats an index by around 5% in the period. If the original holdings are reviewed on say a two week basis then it may result in a rolling return which betters the original expectations.

In terms of strategy, the stocks included here are a mix of small to large. The system as set up does not differentiate by any metric other than underperformance differentials. In terms of long-only strategy, I think its best use is in selling put options at times when a major correction is unlikely. The analysis is, I believe, more likely to identify these situations than alternative measures and more importantly it is relatively easy to implement and maintain, and therefore operationally cheap and efficient. The only real question to answer is, is it effective?

The portfolio performance in the period 18 June 2014 to 7 July starts this process, and is shown below.

VVIViad Corp3.60%
WNSWNS (Holdings)4.30%
MOVMovado group2.40%
RKTRock Tenn Co-1.50%
CQBChiquita Brands Int.-0.10%
HGRHanger Inc.-4.80%
SMASymmetry Medical7.20%
RDYDr Reddy's Laboratories9.60%
DINDineequity-0.40%
OMGOM Group6.30%
IJRiShares S&P Small Cap0.60%
SPYSPDR S&P 5000.60%

As mentioned above, stocks are drawn from the NYSE board without regard to size. For a fair comparison I look at the performance of both the large and small cap ETFs. The equal weighted portfolio above records 2.7% as against SPY/IJR returns of 0.6%.

While creditable so far (in my opinion), the performance of HGR in particular has dragged down portfolio performance in the period. This is an unfortunate but unavoidable risk in forming small portfolios. Enough on the background and on to the next phase of actionable content.

The 18 June portfolio resulted in 6/10 stocks outperforming SPY/IJR and one major disappointment. As of 3 July, that figure was 9/10 outperformance, but 7 July was a bad day for all of the selected stocks. Putting aside the effects of one or two days, from experience, stocks which do not perform within two weeks may continue to underperform. Stocks which fell into this category were Dineequity and Hanger, Inc. and so, I think it is a good idea to consider alternatives to DIN and HGR even though this analysis is based on a 3 month time frame.

It is also worth considering whether to hold the better performing stocks for a longer time frame, these being Dr. Reddy's and Symmetry Medical. Once again, on a statistical basis, few stocks do better than 10-15% returns in the period.

If the idea is to run a rolling portfolio, then selling a stock which may not be working out requires new and better ideas. After two weeks, the following stock list presents these ideas. Of course, this list is of itself a new portfolio.

NWYNew York & CoApparel Retailers
SAMBoston BeerBrewers
CXWCorrections CorpBusiness Support Services
AHSAMN HealthCareBusiness Training & Employment Agencies
WABWabtec CorpCommercial Vehicles & Trucks
JAHJarden CorpDurable Household Products
NUSNu Skin EntFood Products
CSUCapital Senior LivingHealth Care Providers
ABRArbor RealtyMortgage Real Estate Investment Trusts
EXHExterran HoldingsOil Equipment & Services
NPNeenah PaperPaper

The second leg of this process relies on some measure of fundamental research. Sources of this additional information abound in the public space, and this includes articles on Seeking Alpha.

I am not aware of any analysis which has more explanatory value than earnings trends. It is always a good sign if a stock is in an earnings upgrade cycle, and that information is first and foremost in my selection process. It is the best insurance policy against large devaluation in stock price. One great advantage of investing in US markets is that there are many businesses which march to their own drum.

As an example in the above list, Boston Beer serves as an example of both earnings upgrades and a generally favourable narrative from SA contributors.

Source: Evolving Portfolio - Identifying New Ideas