Marc Gerstein's  Instablog

Peter Lynch may be one of the most beloved among the investment all-stars. Back when his he ran the Fidelity Magellan fund, his track record served as a whopping in-your face to academicians who taught that nobody could consistently outperform the market. But Lynch was never the only great stock-picker, as is evident from other all-stars whose work has inspired us and others to create models based upon their ideas. Numbers aside, when it comes to just-plain lovability, it's always seemed to be a neck-and-neck race between Warren Buffett and Peter Lynch, with affection for the latter springing from the backyard investing with which he's most readily associated. Actually, though, the nuts and bolts of the Lynch strategy probably owes a lot more to the haystack than to the yard itself.

Putting the back yard into perspective

Yes, it's true. Peter Lynch really does advocate discovering companies based your day-to-day activities. It's in Chapter 6 of One Up on Wall Street.

But that chapter contains an important and often-overlooked sentence: "The average person comes across a likely prospect two or three times a year -- sometimes more." How much more? It's hard to say. But whatever the case, it's not likely to be enough to be the core of a consistent investing strategy, especially one that is properly diversified. (The average person is likely to mainly encounter consumer-facing companies and those in the industry in which he or she works and many of the latter might be privately owned or small subsidiaries of larger companies and hence, unavailable as investment plays.)

Elsewhere in his book, Lynch mentions many kinds categories of attractive stocks not likely to be discovered through day to day life. One example is spinoffs. Here are the winners he lists in Chapter 8:

Argonaut
American Ecology
AP Green
Gotaas Larsen
Masco
Premark
Intertan
SSMC
American President
Acme Steel
Imo Delval
International Shipholdings
Kenner Parker
York International
Temple Inland

How many of these might you, or even the typical fund manager, have discovered during the ordinary course of day-to-day life?

It's not that I have anything against the backyard approach. In fact, I picked up Green Mountain Coffee Roasters (GMCR) in precisely this manner, made enough to take all my initial investment off the table through a reduction in the position, and am now still riding nicely with a stock I essentially own for free. Many readers probably have similar experiences with particular stocks. But as good as it feels, it's just an occasional thing. If you encounter one as you live your life, by all means, go for it. (I'll continue to do that.) But this can't be the core of a properly diversified day in and day out investing strategy. So I'm not at all disappointed by the fact backyard investing does not lend itself to screening or multi-factor ranking and, hence, could not be incorporated into our Lynch model.

The haystack

I don't recall if Lynch ever used the word haystack in his book, and given that I only have a hard copy text, I'm not inclined to search for the word. But even if he didn't, he could have. Finding needles in haystacks is a big aspect of what he does, so much so that this might even be the true core of his strategy. I'm not absolutely sure Lynch would endorse the phrase, but even if he were to demur, I suspect he'd at least have to give the matter serious thought.

Lynch loved companies that were under-owned or completely un-owned by institutions and under-followed or not followed at all by Wall Street analysts. Given that stock prices are determined by supply and demand, the appeal of such a strategy should be apparent. If you can find a good company whose stock is in low demand, you're likely to be able to get it at a bargain price and, hopefully, sell later for much more (Lynch's ideal was a "ten-bagger") when others discover it causing demand for the shares to overwhelm supply.

Another important aspect of the Lynch strategy is to favor stocks that are unloved. Investors know about these firms, but they dislike the stocks either because of the nature of the company's business (the company is boring, the company's business is repulsive to ordinary sensibilities, etc.). And there's the hot company in a cold industry. Wall Street tends to paint with a broad brush so if an industry is lagging, investors tend to disdain all stocks in the group often ignoring the fact that oddball firms here and there might be doing well. To continue my haystack image, we're not looking here for needles in haystacks, but bigger objects that investors chose for one reason or another to bury there.

The key to all this is that fundamentals be sound and that valuation be reasonable, and our model addresses both in ways that seem consistent with Lynch's writings. But I don't think it's the numeric analysis that made his approach special. Arguably, he may have been one of the earlier proponents of the PEG ratio, which allows a value investor to get in on growth companies. But that sort of thing certainly is not special today given how well known PEG has become.

I believe if you want to really try to apply Lynch's teachings, you need to be rummaging through the haystack. As to the numerical analysis, use the concepts mentioned by Lynch, use similar concepts you pick up elsewhere, mix and match, just do something reasonable. It's the haystack that will give your fundamental and valuation work a Lynch flavor.

Implementation in the 21st Century

The first edition of One Up on Wall Street came out in 1989. Lynch ran the Fidelity Magellan fund from 1977 through 1990. Since then, he has not invested n a public setting, such as a mutual fund.

We're not accustomed to thinking of Lynch as a classic from another era, like we are with Ben Graham. Actually, though, as we consider how to implement the Lynch strategy, we may have to start thinking of him this way.

The investing world in general and the equity markets in particular are vastly different from the way they were even in 1990, and more so when we look at how things were during the bulk of the period in which he managed Magellan. A complete list of changes would be huge, but there are two that are important to implementation.

One is the increasing institutionalization of the stock market. Of the 8,439 stocks in the Portfolio123 database as of this writing, there were only 541 that had no institutional ownership, just 6.4% of the database.

Some of the largest are ADRs issued by foreign corporations that are probably un-owned have been discovered but are bypassed as a matter of choice or policy. If I eliminate ADRs with market capitalizations above $1 billion (the ones most likely to be known), the non-ownership number is 522 out of 8,033. In this latter group of 522, the average market capitalization is $78.4 million. If I get a bit less literal and allow institutional ownership to climb, say to 10 institutions or less, the number of candidates soars to 3,956. But the average market capitalization grows only marginally, to $80.9 million.

Clearly, when it comes to market capitalization, the institutional radar is reaching very far down the size scale.

Another major change is the growth of Wall Street analysis. Believe it or not, there was a time when pronouncements of sell-side analysts could not move a stock, and nobody holding a job like that had a prayer of getting his or her face on TV. But like institutional ownership, Wall Street research has become much bigger than it was in Lynch's day.

Of the 8,033 stocks (excluding again the larger more-likely-to-be-known ADRs), there were 4,455 that had zero analyst coverage. That's a lot. But the average market capitalization is just $105 million. There were 6,395 companies covered by up to 5 analysts. The average market capitalization here is $285 million.

As with institutions, we see the Wall Street research radar reaching very far down on the size scale.

I think you can see where I'm going with this. If you want to do Lynch-type investing, you need to be willing to invest in very very very small companies. It's not absolutely necessary. There are big firms that were shoved under the haystack because they are unloved. But unless you're willing to go small, you're missing out on a major aspect of what Lynch did. It's the difference between a model based on Lynch versus a model based on fundamentals and valuation that looks like a whole bunch of other models based on fundamentals and valuation.

Strictly speaking, this should not be a problem. Lynch liked small companies - a lot. Here are some quotes from Chapter 7 of One Up On Wall Street, where he discusses different categories of companies:

The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you've taken an interest? Specific products aside, big companies don't have big stock moves. In certain markets they perform well, but you'll get your biggest moves in smaller companies.

Page 109 of the 2000 Fireside edition.

Everything else being equal, you'll do better with the smaller companies.

Id at 110.

Lynch's sentiments are very valid even today. Many Portfolio123 users have seen how quickly backtested performance results can fall when one increases minimum market-capitalization rules.

The challenge for many today is how to define small. Usually, I start with a minimum threshold of $250 million. But that obviously is not going to produce a full-fledged Lynch-style haystack portfolio. What we're going to have to do is adjust our thinking regarding trading liquidity.

With electronic trading, we've become spoiled by the notion that we can get any stock we want at a good price just by clicking a mouse a few times, and then see our confirmations by refreshing a web page a few seconds after our last click. To invest Lynch style, we're going to have to pull back from that sort of thing. We're gong to have to travel back in time to an era when we had to think about how, or even if, we could get a stock we want once we decided we wanted it.

Our Lynch model has no minimum size requirements. That means that when we find stocks on the list we want, we'll sometimes need to be a bit thoughtful. Most of the time, there will be enough liquidity to allow us to trade in the usual rapid-fire way. But we have to stay alert to situations where we'll need to be patient in executing, and perhaps even willing to pass based on liquidity alone. I suspect Lynch, and other all-stars from that era who liked to go small, had to think this way. We need to do so as well.

The details of our Lynch model, consistent with the themes discussed above (solid fundamentals and valuation overlaid on a haystack strategy coupled with a willingness to go as small as we must) can be found here. (I'll add that we omit utilities and the often-utility-like telecom services group because these seem to fit the slower-growth category to which Lynch was less favorably disposed.) Note that our model consists of a Lynch screen with passing companies sorted based on our Lynch ranking system. We select the top 15 stocks.

Figure 1 and Table 1 show how the model (the top 15) performed when we ran it through the backtester (assuming rebalancing every four weeks) on StockScreen123.com, a new easy-to-use screening-backtesting application just launched by Portfolio123 for individual investors.

Figure 1

Table 1

As noted, execution issues may surface from time to time. But on the whole, we believe the backtest results support the usefulness of this model as an idea-generator for case-by-case study and selection.

(StockScreen123 users who want to expend their range of choices, in deference to potential execution snags with some of the top 15, can simply set the portfolio size to a different number and re-run the backtest. An increase in list size to 25 still backtests quite well.)

Here are some examples of what you can find among the current list of top 15 Lynch stocks:

Monarch Cement (MCEM): If you read Chapter 8 of Lynch, entitled "The Perfect Stock, What A Deal!" you may recall part 9, entitled "It's Got A Niche." To illustrate potentially attractive niche firms, Lynch wrote: "I'd much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock pit has a niche. . . . [I]f you've got the only gravel pit in Brooklyn, you've got a virtual monopoly, plus the added protection of the unpopularity of rock pits." Given that, how could I resist when I saw Monarch Cement among the model's top 15. It's not exactly a gravel pit in Brooklyn - it's a cement company serving Arkansas, Iowa, Kansas, Missouri, Nebraska, and Oklahoma. But you get the idea. Contractors in Nebraska are unlikely to bring in cheaper cement from India or China. Fundamentals and valuation ratios are fine considering the horrible construction cycle. And as far as size, market cap is OK. Volume, however, is very lean, much more so than a couple of years ago, when some still were optimistic about building construction, so when it comes to trade execution, think 1979, not 2009. In other words, use limit orders and be patient. And be prepared to hold pending a turn in the cycle. I'm guessing that today, it'd be a lot easier to find sellers than buyers (something to think about if you wanted to buy for a four-week trade).

U.S. Lime & Minerals (USLM): To paraphrase a pop song, "whoops we did it again." After moving my eye down the list, I spotted anther rock-pit type stock that sells limestone and related products in the southwestern and south central portions of the U.S. Its fundamentals and valuation are also good all things considered. Its market cap is near 4225 million. Volume isn't massive, but individual investors ought to be able to trade it 2009 style.

Span-America Medical Systems (SPAN): This is another niche company: polyurethane and foam products used mainly by the medical-care industry to control patient positioning (specialized mattress pads, seat cushions, and other gadgets to position certain body parts at particular angles). With all the uncertainty in the economy and in health care, providers are limiting spending as much as they can, so like many companies, SPAN is experiencing down results. But it's still solidly profitable, the balance sheet looks strong and returns on capital remain excellent. The consumer end of its business took a little hit by the failure of Sam's Club to select it to continue providing mattress pads (SPAN was one of three possibilities after a previous supplier's bankruptcy). But SPAN is gaining in other consumer channels such as Bed, Bath & Beyond and it continues to sell to Wal Mart. SPAN's market cap here is around $38 million. Volume can be lean at times, with some days at a few hundred shares or less. But those spells don't persist too long and with patience, you can get some better days. Use limit orders if you trade.

For those who may be feeling a bit of execution fatigue, a challenging but very real aspect of a vintage-2009 Lynch-style haystack strategy, here are two stocks that can easily be traded using all the speed and impatience we've come now to cherish.

Brookfield Properties (BPO): Another section of Lynch's chapter on the attributes of ideal stocks was entitled "It Does Something Disagreeable" or put another way, "[s]omething that makes people shrug, retch, or turn away in disgust" (page 132). Lynch used, as an example, Safety-Kleen, a firm that sold machines used to wash greasy auto parts. But in this day and age, I think we can top that. How about real estate! BPO looks, on the surface, like a REIT. Actually, though, it's a real estate operating company, one that is allowed to reinvest some profits back into the business (REITs have to pay out nearly everything as dividends). When looking at real estate, it's interesting for investors to debate the relative merits of low-quality firms (whose shares usually have high yields) versus high-quality, safer, outfits that may feature better growth prospects. BPO is clearly planted at the upper end of the quality range specializing in the better-grade downtown high-rise office buildings. Even this segment is depressed right now, and so, too, are the hares of the firm. If you can get either of two types of real estate exposure at depressed prices, why not go for quality. So far, BPO's dividend has been holding up. That may not continue of the slump persists indefinitely, but it's impressive that BPO has been able to keep things going thus far.

When times are tough investors and members of the financial media love to bash analysts and corporate executives, especially when it comes to issues relating to accounting. After all, it's still less than a decade since some once-mighty corporations were brought low by accounting scandals. But please, please, please don't go overboard and assume that accountants are the ones who are always providing the most helpful information. Notwithstanding some occasional abuses (every profession has some bad apples), security analysis in general is honest work and can provide insights that are much more useful to investors. Unfortunately, however, it's GAAP that sometimes obscures economic reality.

Back in June 2009, I wrote about the problems with the way operating profit is reported, specifically, how this item can be heavily distorted by unusual gains and expenses. I showed why it's important for analysts to create an alternative measure of profits that provides a more useful basis for making assumptions about the future, a practice inspired directly from the most revered masters of security analysis: Graham and Dodd.

Today, I want to explore a different aspect of this issue, the impact on trailing 12 month (TTM) EPS, this being a figure widely used by pundits who discuss trends in corporate earnings in general, and earnings-based stock valuation in particular. This is not to say that everybody with a soapbox talks about TTM earnings. Knowledgeable investors and commentators prefer forward-looking estimates which do not suffer from the same informational defects. Often, though, those who most loudly trumpet TTM earnings tend to have agendas, usually involving a desire to beat up on analysts, to beat up on stock valuations, or both. It's important that investors look critically at such commentary, much the way they needed to do so back in 2002-03, the last time Wall Street critics bombarded us with rhetoric about how crazy it was for stock prices to climb when earnings were so horrible and about how analyst projections for '03 and '04 were so far out of line.

As I wrote in June, I do not dislike accountants. The issue I raise reflects the nature of the accounting missions; tracking and disclosure. These are critical. We need to know what the company has done and have confidence in the truth of the facts presented to us. But for investors, this is only step one. Ultimately, we live or die based on the assumptions we make about the future. The type of information we need to do that, and the nature of the presentation we require, can differ quite substantially from that which is necessary to track and disclose.

EPS trends - a first glance

Looking at analyst estimates for the current fiscal year, it appears that trends have stabilized following the brutal series of downward revisions we saw in 2008.

Figure 1

Next, look at Figure 2. It shows how the estimated results compare to TTM EPS.

Figure 2

The data sets are not strictly comparable. TTM measures the last four quarters which at this time, for calendar-year companies, would likely be the 12-month period ending 6/30/09 or 9/30/09 depending on who reported the third quarter and who didn't yet do that. Meanwhile, the estimate is for a fiscal year; for calendar-year companies, it's the 12-month period ending 12/31/09. But the disparity doesn't cloud the ultimate point, to wit, that analysts are, on balance, projecting massive gains above the TTM levels. Numerically, we're talking about a projected gain of 638% for the S&P 500.

Are these expectations plausible?

That's a loaded question. Actually, nobody really believes that economically speaking, S&P 500 companies are going to see earnings gains anywhere near that magnitude. Analysts and professional investors are looking at much more moderate percentage gains with differences among them based on how each chooses re-cast the historical figures.

Earnings as an art as well as a science

The question for today is whether it's reasonable to making any sort of adjustments to reported earnings. A decade ago, this practice became much reviled as legitimate accounting phrases like pro forma earnings gave way to justifiable sarcastic variations such as EBE (Earnings Before Everything or Earnings Before Expenses).

Forget the old labels. Pro forma is a technique that can be used to project backwards to see how two separate companies would have performed had they been merged into a single entity. It's most common use is to help investors assess proposed corporate mergers. The phrase was used inappropriately back in the day and is completely irrelevant to today's topic.

To get to the heart of the issue, start with Table 1, which summarizes the magnitude of the TTM EPS percent changes among companies that experienced declines.

Table 1

Those are incredibly brutal numbers and seem to mesh well with the red trend line we saw in Figure 2.

So what, exactly, is going on here? Was business really that bad? Let's look at Table 2, which shows the same information for Revenues.

Table 2

What a difference! The magnitude of the declines here are certainly noteworthy, enough so to make it obvious that the economy has been troubled. But the revenue changes are nowhere near as dramatic as the nightmare we saw with EPS. So let's go down the income statement a bit and see if we can locate the land mines were.

Table 3 shows the trends in gross profit which, generally speaking, is revenue minus cost of sales; the costs most directly associated with the production of revenue (i.e. raw material, salaries of employees involved in producing goods or providing the services, etc.).

Table 3

Clearly, we see some deterioration. And that's to be expected. Many items classified under cost of sales are variable, but in life, the variation with revenue is not strictly one-to-one. The decline in these costs is usually less than the decline in revenue, hence the greater shrinkage in gross profit. So to this point, we're following the script.

Let's look at Table 4, which shows operating profit. This is gross profit minus selling, general and administrative cost (often referred to as overhead) and depreciation. These items are more fixed than is the case with cost of sales. But the magnitude is not usually that great, so the change in operating profit would, one would think, move more or less based on changes in gross profit (with a bit more of a decline in operating profit).

Table 4

Ouch! That's disaster is grossly disproportionate to what we'd expect based on what we saw with gross profit. But it is very much in line with the mess we saw with in Table 1 for EPS.

It looks like we found the land mines. Something happened between gross profit and operating profit. And whatever it was, it was way too large to be attributed to traditional operating expense items (selling, general and administrative expense and depreciation).

The answer: "unusuals." One example would be losses on the disposal of a business. Another might be expenses incurred in connection with the shutdown of a subsidiary or plant. It might be an accounting entry to adjust for the diminished value of an asset. This is not an exhaustive list of possibilities, and unusual gains happen too. But you get the idea. The common element is the unusual nature of these items.

Who, if anyone, should we criticize?

For analysts, recalculating earnings without these unusuals is second nature. Graham and Dodd told them to do it. But it wasn't a hard sell. Common sense dictates it as well. Analysts are looking for those elements of the financials that help them formulate expectations for the future. Unusuals don't fit. It's important that accountants calculate and disclose them. But when we're formulating future-oriented investment expectations, we need to put them on the shelf. (See prior article for more on this topic.) So don't criticize analysts for doing it.

Similarly, it would not be appropriate to criticize management for logging these unusuals. Life is complex. When something odd happens in a business, whether its due to management mistakes, events beyond management's control, or whatever, we want it properly recorded.

If there's to be a beef with anyone, perhaps it's the standard-setting body within the accounting profession.

There is a category of items referred to as extraordinary. Those who design financial databases all understand this and are quite proficient at presenting Earnings and EPS excluding extraordinary items. The problem is that the extraordinary category is defined very narrowly, meaning it's very hard for management to classify an item under this heading (the cumulative impact of a change in accounting policy would be one example). If we're to get the red line in figure 2 to make analytic sense, it would probably require a formal re-definition of extraordinary items.

Interestingly, a February 2007 article in The CPA Journal proposes the opposite solution: elimination of the Extraordinary classification. Even more interestingly the author cited the same problem I referred to; the excessive narrowness of the category and expressed particular frustration about a ruling that went so far as to prohibit companies from reporting losses relating to the September 11, 2001 attacks as extraordinary. I definitely share the author's feeling about the issue, but I differ with his conclusion. to an accountant, the Extraordinary category is little more than a seldom used irritant. But to an investor, it's a vital but horribly under-utilized classification that needs to be properly used as a way to categorize exactly what the label suggests it ought to categorize; items that are not ordinary. And in my thesaurus, ordinary is a synonym for usual. Therefore, extraordinary means unusual.

So let's stop bashing analysts and corporate executives and start advocating for change where it's needed, with Generally Accepted Accounting Principles.

It’s been about a year since the stock market fell off the cliff and every strategy seemed to go bad. Can we finally put that to rest and go back to modeling?

The late-2008 stock-market collapse was pretty bad, especially last October. We all know that. But even more frustrating, imagining that anything can be more frustrating than the vigor of the decline, was the way supposedly prudent strategies failed to help investors mitigate the collapse.

Figure 1 shows the result of a 3/30/01-present performance test of a Portfolio123 Value model (combining a screen and then selecting the top 25 stocks as per a balanced fundamentals ranking system).

Figure 1

It illustrates how bad late-‘08 was even for a strategy one might regard as conservative.

It’s tempting to wonder about the details of this particular value strategy and whether the more defensive performance we’d wish for could have been achieved had our model been “better.” Actually, though, the particulars are almost irrelevant since Figure 1 looks pretty much like what we got in late-2008 from just about all strategies, growth, value, fundamental quality, sentiment, momentum; you name it, Figure 1 more or less shows it. Nothing at all seemed to work. Now that’s frustrating!

It wasn’t this way during the collapse we experienced in the early 2000s. Back then, the market was much more willing, so to speak, to recognize supposedly reasonable strategies. Figure 2 shows how this particular model performed back then.

Figure 2

The strategy had its bad moments, but on the whole, it outperformed the S&P 500 with plenty of room to spare.

So where does that leave us now? Have we entered into a new dark-age in which the market will no longer reward good strategies or punish bad ones? Outperforming on the downside is certainly not nirvana. But it’s a heck of a lot more tolerable than the blast-everything mess we were experiencing a year ago.

It’s still far too early to give definitive answers. But early indications suggest the market is in the process of elbowing its way out of the strategic cave.

Let’s start with Figure 3, which provides a close-up of how this same value strategy performed since the recent market trough.

Figure 3

It wasn’t spectacular, but it did beat the S&P 500 and certainly does enough to raise hopes that a “better” model might provide more reward.

Figure 4 below, which looks at a multiplicity of strategies, adds to the sense of 2008 being an aberration from which we’re in the process of moving away. It summarizes the performance of the PowerShares Dynamic ETFs, the ones that attracted notoriety by using proprietary indexes compiled using fundamental rules designed to outperform standard benchmarks. This is a hodge-podge of different strategies, some of which would be expected to work at a particular point in time and some of which should be expected to falter. The average return is not important for our inquiry. What we’re interested in right now is the standard deviation, the measure of how widely varied the individual observations are.

Figure 4

The key takeaway from 2008 is not so much the horrible return but the narrowness of the standard deviation, particularly standard deviation as a percent of return. 2009 is likewise narrow, but at least it’s wider than it was in 2008. That’s consistent with the idea that the market is trying once again to distinguish among strategies, rewarding some and punishing others.

Figure 5 provides a slightly different perspective. It examines the iShares style-oriented index funds. These funds don’t claim to try to outperform anything, but they do slice and dice established indexes like the S&P 500 into style (growth versus value), and size categories. There are also some “core” offerings that blend everything. If the market is treating some strategies differently than others, we should see some noteworthy standard deviations here as well.

Figure 5

Indeed, we do see a very narrow standard deviation in 2008 and a wider one so far in 2009.

So where does that leave us now? Can we calmly go back to modeling and invest happily ever after? Or must we still worry about the ghost of 2008?

There are really two separate issues here.

One is the state of the economy. Are we really poised for recovery, or is the good news that’s been propelling the market just a cruel illusion? Many have spoken or written on the topic expressing a wide variety of opinions. Speaking for myself, I’m still in the I-don’t-know stage, leaning a bit toward the positive side of the fence.

Today, though, I’m more concerned with the second issue. Has the market returned to a state wherein some strategies work and others don’t? It appears to be in the process of doing that. This doesn’t mean the sort of stylistic convergence we saw in 2008 won’t recur. But it does seem that ’08 was unusual and that it took one heck of a crisis to get the market to simply dump everything, style be damned. It seems reasonable to assume it would take a comparable extreme (crisis, or possibly something extremely good) to generate that sort of convergence.

Disclosure: No Positions

As all-star investors go, Warren Buffett is, perhaps, the most intriguing. Many of us think we know what he's all about: value, good company management, best-in-class companies that will be on top forever, etc. Actually, though, there can be wide gaps between the homespun folksy image that's been built around him and the modern reality, which in some ways, can look more like an aggressive hedge fund. But once we come to grips that no quantitative model can actually turn us into Buffett clones, we find that we can still use certain core Buffett philosophies to come up with an interesting model that, performance-wise, can hold its own in Omaha, New York, or even the moon.

Be careful about the Buffett image

Did you know that Warren Buffett buys derivatives? I'm not talking about something unique to the insurance businesses Berkshire Hathaway owns. I'm talking about buying derivatives on behalf of Berkshire Hathaway as investments, purchases made because he thinks he'll get a good return. Doesn't it seem odd that Warren Buffett buys financial weapons of mass destruction (a phrase he coined)?

Believe it! Check the 2008 Berkshire Hathaway Chairman's letter. You'll see that he had 251 such contracts as of the time of the letter, and that he bought them because, in his words, they seemed "mispriced at inception" (i.e. because he thought they looked like an attractive opportunity).

Yes, this is the same Warren Buffett who is the subject of the Robert Hagstrom books, the one who people flock to Omaha to see once per year, the one who is the inspiration behind Morningstar's perennial quest for wide moats, etc.

Those who dig can find countless contradictions over the years: speculation in silver, investing in companies that turned out to have been ethically tainted (does anybody remember Salomon Brothers?), investments in one of the most hard-to-predict industries, airlines, etc., etc., etc.

I am not raising any of these issues to paint Buffett in a negative light. Actually, I believe him to be one of the most brilliant investors of this era and have incredible admiration for all he's accomplished. So, too, do many others. The problem, though, is that many carry the admiration to non-constructive extremes, almost to the point of deification. That's a problem. Once you're dealing with a God, every utterance you encounter becomes sacrosanct; absolute and unchangeable. That's a terrible context for development of an investment strategy, especially if the deity being followed never actually wrote a book organizing his teachings and setting them down in one place.

Mr. Buffett is a human being; a pretty good human being, but a human being nonetheless. Having never written a book (all the Buffett books are written by others who describing their perceptions of Buffett), his teachings are, unfortunately, all over the place, spread among many Berkshire Hathaway annual reports (and even spread around within each report), many speeches at Berkshire Hathaway annual meetings, and countless answers given to shareholder questions in the hours-long Q&A sessions at the annual meetings. Adding to the ambiguity is the fact that Mr. Buffett, like many successful humans, has evolved over time and has acted in different ways in different situations. Hence all the contradictions we can perceive.

So actually, there is no firm set of Warren Buffett commandments and as investors, we do ourselves a dis-service if we try to act as if such a thing exists. Case in point: the Buffett-esque mutual fund, Legg Mason Growth Trust (LMGTX), created by Robert Hagstrom, author of some of the most popular among the Buffett books and managed based, supposedly, on Buffett principles. Check its performance record. Let's just say if this was the best I could do, I would not present a Buffett-based all-star model.

Building a Buffett model

Step one: Accept the notion that no matter what goes into the model and what's left out, somebody somewhere is going to be able to nit-pick the details citing something Buffett has said and done over the years. That's inevitable. We must learn to live with it.

Step two: Recognize that Buffett's success, while it does owe much to individual genius that can't be reduced to specific rules, still stands upon a very solid and well articulated philosophical foundation, something we can use as a basis for modeling. That foundation may not explain each and every thing Buffett has said and done over the years, but it does explain quite a lot, and as we'll see later, even helps resolve the contradictions we think we perceive.

Step three: Build a model based that core philosophical foundation.

The foundation begins with Ben Graham, who was Buffett's inspiration. Actually, though, the relationship was more than that. Graham was Buffett's teacher. Our Buffett All-Star model starts with the Graham model. If you scan both models quickly, you'll notice a lot of similarity: close attention to value and an emphasis on corporate survivability even during bad times.

But like students of many a great teacher, Buffett brought something important of his own to the table, the essence of which I heard him present verbally at a Berkshire Hathaway annual meeting, when he explained how thankful he was that he was living in a time and place wherein his one real talent in life, being good at allocating capital, can actually be beneficial. (He then mused how in a different time and place, such a talent might have enabled him to become nothing more than dinner for some animal.)

Ben Graham certainly knew all the ratios that could be used to evaluate how well a company allocates capital (there are plenty of them in the classic Graham-and-Dodd textbook). He may be the one who taught them to Buffett. But when Graham articulated his strategies in The Intelligent Investor, capital allocation proficiency doesn't come off as a big deal. Conversely, if you read or hear Warren Buffett's words directly, you can't help but come away with the understanding that to him, capital allocation is not one thing, it's THE thing.</p>

Interestingly, once you recognize that Warren Buffett is, actually, capital allocation with hands and feet, you notice that all the contradictions seem to wither. Why would Buffett, the supposed inspiration for economic-moat mania invest in airlines, precious metals, or complex derivatives? That's easy: He did it because in his view at a particular point in time and looking at particular set of opportunities, those seemed to be the best possible ways to invest capital. He didn't always turn out to be right. But the vision was always consistent and he was right often enough to become a living legend.

The Portfolio123.com Buffett All-Star model is stocks-only. So our capital-allocation efforts will be played out on a much smaller stage than Buffett himself uses. Specifically, our Buffett model is Graham plus a hefty dose of capital allocation proficiency. The Graham-like screen we start with (discussed in a 7/31/09 Seeking Alpha article) is supplemented by two very stringent ratios used to evaluate a company's success in allocating capital.

We insist that return on equity, averaged over a five year period, be in the top 25% relative to industry peers. Notice that ROE, Buffett's chosen metric, is not necessarily the best for evaluating business profitability because it can be influenced by decisions having nothing to do with the business; i.e. financing strategy. But it is consistent with Buffett's core capital-allocation focus. He evaluates the totality of capital allocation, including the way returns can be leverage up using debt.

We impose the same requirement (top 25% in industry over the course of five years) regarding "sustainable growth rate," which is ROE times the percent of earnings left over after payment of dividends.

We use industry-only comparisons because we want to eliminate companies whose high ratios come abut through dumb luck; being in the right business at the right time. We're willing to accept industries that are cold right now if we can get management teams that prove their mettle in capital utilization by consistently showing they can do it better than most others who share the same external business environment.

The ranking system we use to sort the results of the Buffett screen starts out by considering Graham-esque factors relating to stability and value (the Buffett model has a bit more in terms of non-EPS valuation metrics, since EPS is not his preferred metric) but includes also a large (one-third) weighting in a different factor: the five-year rate of book-value growth. To Warren Buffett, this is the key standard for use when assessing the progress of a company. He told me so back when I covered Berkshire Hathaway stock for Value Line. And it's obvious from his subsequent Chairman's letters that he still tracks progress this way. (How many other CEOs open their letters by presenting a chart comparing growth of the S&P 500 to growth of their company's book-value per share.)

That's our Buffett model: general Graham-esque stocks limited to those managed by demonstrably successful capital allocators whose companies measure up based on the same criteria used by Buffett to evaluate Berkshire Hathaway.

One more variation: company size. Graham specifically refrained from imposing a minimum-size requirement. Buffett uses one, sort of. In his listings of criteria to be considered by Berkshire Hathaway as it evaluates acquisitions, he puts the floor at $75 million in annual profit, saying it's not worthwhile to deal with anything smaller. Giving deference to that, but recognizing he might consider going smaller if he were to just make a stock-market investment (as opposed to bringing the firm into Berkshire as an operating subsidiary), I added a $250 million minimum market capitalization rule to the screen.

Click here for more details regarding the Portfolio123.com Buffett model.

Click here for general background on the Portfolio123 approach to All-Star models such as thos one.

Putting the Buffett all-Star model to work

Figure 1 shows the result of a backtest covering the latest 12 month period (as with all of our all-star models, we limit results to the model's top 15 stocks; the test assumes rebalancing every four weeks).

Figure 1

To see the results of the backtest stretching back to 3/31/01, as well as a more detailed explanation of the model, click here.

As to the kinds of stocks that make the grade, don't necessarily expect to see the big names usually listed in the Buffett equity portfolio; you know the ones, Coca Cola, American Express, Washington Post, Johnson & Johnson, etc. Such names may appear from time to time, but they won't be the staple of the lists. When we use quantitative rules, we tend to see that smaller firms are more likely to meet the tests. Buffett's big-name investments reflect whatever quantitative measures he chooses to use (if any) plus his own non-reproducible subjective judgment as to whether or not these firms are worth a share of the capital he's allocating.

Remember, too, that the lists of Berkshire-owned stocks are far from complete. They include equity investments for which the Berkshire stakes were worth at least $500 million as of the reporting date. That excludes many equity investments for which the stakes were valued below $500 million. And, of course, we it excludes the investments we must also consider businesses for which Berkshire's stake amounted to 100% of the equity; these are discussed elsewhere in the annual reports, as operating subsidiaries.

So If you want to understand where Buffett puts Berkshire Hathaway's money, it's important to recognize it's not just the big names most readily bandied about nor is it just about the warm-and-fuzzy consumer-friendly subsidiaries that strut their stuff at the Berkshire Hathaway annual meetings (See's Candies, Nebraska Furniture Mart, Borsheim's Jewelry, etc.) It's also about Scott & Fetzer (commercial and industrial products), Johns Manville (insulation and building products), Shaw Industries (carpeting), CTB International (livestock equipment), MidAmerican (electric utilities), etc. etc. etc.

So as you see the stock lists, and the many unfamiliar unglamorous names that appear, remember that we're trying to get at the total flavor of what Buffett's philosophy can produce in the equity arena, the big-name equity stakes we know about, the other equity stakes that are undisclosed, and the 100%-owned operating subsidiaries.

The stocks

Figure 2 shows the stocks that presently make the grade under our Buffett model.

Figure 2

Two names jump out immediately as having been discussed last week based on their prominence in the Ben Graham All-Star Model: architectural glass-maker Apogee Enterprises (APOG) and chemical (and firearm) producer Olin (OLN).

We also see two health insurers, Humana (HUM) and HealthSpring (HS), both of which focus on Medicare-related plans. Nowadays, in terms of political uncertainty, this area is brutal. Nobody knows what's going to happen except that we need something but have no clue how we're going to pay for anything. However much analysts may look at companies like these and run under the table, we've seen before how fearless Buffett can be when it comes to entering financial combat zones. Witness, for example, his involvement with Goldman Sachs and GE during the most panic-prone part of the latest financial crisis. Witness, too, his having seriously considered getting involved in the late-1990s Long Term Capital Management debacle. He didn't because unlike the recent GE and Goldman situations, he ultimately didn't like the opportunity presented. But he didn't avoid LTCM as a matter of doctrine; he gave it very careful consideration. So as long as HUM and HS prove their mettle in terms of capital utilization (which they do), they have legitimacy as potential Buffett stocks (subject, of course, to whatever subjective judgment he might also bring to bear).

Speaking of financial combat, you'll notice that the list is topped by Satyam Computer Services (SAY), a well-known India-based information technology outsource firm. The numbers look great, but the CEO resigned last winter amidst discussion of accounting fraud. Often over the years I've been asked how those who follow rules-based numeric strategies should cope with the risk of fraud. My answer, unfortunately, is that there isn't much you can do. Anybody can get caught by corporate ethical problems, even the Warren Buffetts of the world (remember Salomon Brothers!). The best we can do, at least, is stay out when we know upfront that there are concerns. Interestingly, SAY seems to be flourishing under new management and there is, now, a new controlling corporate shareholder (Tech Mahindra). However at this point, we can't really say if the current management is as proficient at capital utilization as the old numbers suggested former management was.

But as far as Indian IT goes, the list does have Patni Computer Systems (PTI), a smaller entrant in this industry. Small though it may be, though, PTI a specialist in just a few "verticals" (financial service, insurance, media and manufacturing) boasts long-term rleationships with some pretty big clinets, GE being number one. Return on equity is in the upper echelon relative to industry peers notwithstanding that returns are being depressed by a cash-heavy debt-free balance sheet which, considering the present econimic risks, may well be a pretty decent way to allocate caital after all.

Archer Daniels Midland (ADM) may raise eyebrows among some Buffett fans. As a processor of agricultural products, it has lots of exposure to commodity prices. But Buffett himself is not behind any anti-commodity sentiment; to the extent it exists, it comes from others who write about him. Actually, one of Buffett's $500 million-plus stakes is Kraft Foods (KF), which is now being plagued by rising commodity costs. ADM's returns, however, are light years ahead of those generated by KF. Also on behalf of ADM, it's the world-class leader in its field, and an important field at that. The ups and downs of ethanol have introduced some recent volatility into its profit streams, but considering other things Buffett has been doing, such as a major purchase of ConocoPhillips at oil's peak (which elicited a noteworthy Buffett mea culpa in the 2008 Chairman's Letter), one can do a heck of a lot worse than to look at ADM at a time when oil is down and ethanol less hip.

Moving over to apparel retailing, women dominate, as is apparent from the number of store chains devoted solely to them. Fashion habits are obviously a factor, as is a general tendency on the part of men to dislike shopping. When we think of apparel chains dedicated to the men's market, The Men's Wearhouse (MW) often comes to mind. But it's the other one, the smaller chain (about half the market cap and about half as many stores) that passes the Buffett model: Jos. A. Bank (JOSB). One area, though, where JOSB is more than twice the size is short interest (measured as a percent of float). Frankly, though, that's been the case for this stock for as far back as I can remember. Currently, there's certainly reason to be concerned about JOSB: weak economy, lackluster demand for suits, heavy marketing and promotions. But when evaluating a stock, Buffett doesn't game the next quarter or even the next year. When it comes to return on equity, JOSB blows MW, and many other apparel retailers, to smithereens. When times are tough, it's easy for a retailer to collapse, but with no debt and lots of liquidity, JOSB has staying power. And by the way, when it comes to the current economic climate, something that does concern many aside from Buffett, JOSB's strategies must be accomplishing something; recent year-to-year EPS comparisons have been up and the estimates are a bit higher than where they were a quarter ago. If the recession persists, who knows if that can continue. But it's interesting to see how well the company has handled the challenges it has faced thus far.

Titanium Metals (TIE) is one of the world's leading manufacturers of titanium-based products. These are distinct based on corrosion resistance, high strength-to-weight ratio and ability to handle high temperatures. Aerospace is the leading end use (aircraft components) and commercial aerospace is especially important to TIE. And yes, that market is horrible right now, and given long lead times, it's likely to remain pretty depressed for another couple of years at least. But unlike Buffett's peak-market foray into ConocoPhillips, we're not being asked to pay top dollar for TIE. Its stock sells for about 11 times very depressed trailing 12 months EPS and 24 times the stupendously depressed estimate of current-year EPS. Knowing Buffett's willingness to pursue an opportunistic price for derivative contracts, how hard is it to accept a Buffett-based model offering an opportunistic price on shares of a debt-free, strong-ROE, leader in products we know will be in big demand down the road when airlines finally get around to those new-generation planes they've been panting about and will have to buy (every passing year increases the urgency). After all, there's a wide gulf between Warren Buffett and, say, Martin Zweig ("the trend is tour friend").

Disclosure: Long Berkshire Hathaway Class B shares

When it comes to all-star investors, Ben Graham is iconic, being half the Graham-and-Dodd team widely credited with inventing fundamental stock analysis back in the 1930s. But don't think, for even a single minute, that his approach is quaint, old fashioned, or anything like that. The stocks now favored by the Portfolio123.com Graham model, depressed cyclicals and oilfield service firms, are not glamorous. But the performance record of this model shows returns that ought to be snazzy enough by anyone's standards.

Playing offense by playing defense

Ben Graham was a value investor. We all know that. But he doesn't always get as much credit as he should for his attention to company quality. His classic, The Intelligent Investor, wasn't about cigar-butt value (buy a bad company at a price that's so low as to still leave room for you to prosper). In addition to his desire for a good stock price, he also wanted a good company.

What's interesting is how he determined whether a company was good. He was very much attuned to basic survivability; the ability of a company to stay in business even when times were tough. Nowadays, we like to think way beyond that (super growth rates, positive earnings surprises, etc.). But considering when he professionally came of age, the 1930s, I suppose we should understand why he thought as he did. (For details on the Portfoilo123 Graham model, click here.)

This emphasis on survivability is what may cause some to see his approach as quaint. But there's no way we can take a patronizing view of the returns recently generated by the strategy we created based on his strategy. Figure 1 shows the result of a backtest covering the past year (as with all of our all-star models, we limit results to the model's top 15 stocks; the test assumes rebalancing every four weeks).

Figure 1

Figure 2 provides a close-up of how the model performed during the market's recent recovery since 3/31/09.

Figure 2

So yes, lots of stocks surged recently off the market's bottom. But the Graham stocks surged much more vigorously.

Perhaps there's something to be said for not-going-broke as a measure of company quality.

And by the way, this isn't confined to a post-recession early recovery (or mid-recession bounce, depending on your point of view). The model performed very well since 3/31/01, even in the bullish periods. Click here for details.

The stocks

Table 1 shows the stocks that presently make the grade under our Graham model.

Table 1

There are some very small companies on the list. You might expect to see this with some of the more aggressive all-star models, but find it surprising with a Graham strategy. Actually, Graham did consider the issue of size, but decided to refrain from specifying any minimum, reasoning that the risk we usually associate with extremely small companies ought to be mitigated by their having passed his other basic financial-viability requirements. (For what it's worth, though, adding a requirement that market cap be at least $250 million wound up adding about 11 percentage points to the hypothetical portfolio's 3-31/09 - 7/30/09 backtested performance.)

Looking at the list, we find oilfield services (mainly contract drillers) to be very well represented. Activity in the oil patch has been weak, which seems according to script given the reversal of the oil surge of a few years ago and the giving way to recession, which reduces demand for energy. The firms listed here have incredibly low P/Es, generally at single-digit levels and are suffering huge year-to-year declines in sales and EPS. Similar scenarios can be observed for many other oil-related situations. The ones listed here are distinguished by their ability to withstand industry storms; i.e., by meeting the Graham-inspired survivability tests.

An interesting variation on the oil-service theme is Tidewater (TDW), which operates a fleet of boats that serve offshore drillers by transporting people, equipment and supplies. The company also provides some related services such as pipe laying, cable laying and seismic work. Its results have actually been up year to year through the March quarter. revenues slipped modestly in the June period, but EPS would have been up had the company not recorded an unusual charge relating to the seizure of some vessels in Venezuela. (And you're worried about the risks you face!) Meanwhile, the company carries minimal debt and its returns on investment have been comfortably and consistently in double digits and have even been trending upward. So let's say this is a case of survivability plus.

Outside of energy, we find the likes of Olin Corp. (OLN), which may be a bit recognizable for its Winchester firearms subsidiary, but makes most of its money through chlor alkali products, which, skipping all the mundane details, find their way into such end products as paper, swimming pools (chlorine), household cleansers, bleach, plastics, wastewater treatment products and . . . you get the message. This is a garden-variety cyclical company. Actually, though, it seems to have been becoming a better one lately, having unraveled itself from conglomerate status a decade or so ago and culminating in the 2007 sale of a sizable metals operation. The slimmer company we now see features less debt, comfortable liquidity, improving margins and improving returns on capital.

For Japan-based power-tool maker Makita - ADR (MKTAY), sales have been falling off a cliff. Considering how weak housing is and considering the company makes power tools, what can one expect! But when it comes the Graham model and its quest for cope-ability, MKTAY is a star. Debt is modest. The current ratio is above 5 and the more stringent quick ratio is above 3. Margins have been holding up quite well all things considered as have returns on capital. We have survivability and then some combined with a single-digit P/E and a price-to-book value ratio near 1.00. Classic Graham! If you're intrigued by the MKTAY theme but would prefer something domestic, take a look at Apogee (APOG), primarily a manufacture of glass "skin" for commercial buildings. Yes, it, too, is feeling the bunt of horrible industry conditions. But it, too, is a fundamental-financial power. And it is working to cushion some of the cyclical storm by pursuing more smaller-scale international projects and developing proficiency in energy-efficient building skins, to get in on the desire to go green.

Lately, anything vehicular can give nightmares to even the hardiest of investors. And no, that wasn't the downward segment of a roller-coaster your dreams; it was the a recent income statement for Spartan Motors (SPAR). But at least this company isn't a carmaker. It makes chassis for recreation vehicles (Was that supposed to make us feel better?), ambulances, fire trucks and the kinds of military vehicles that should be able to drive over an exploding land mine and survive (they actually do that). OK. I really don't want to think about RVs, but I'll force myself. The demographic group, older Americans, who like them is growing, and there is a reason we use the phrase "business cycle" instead of "business s perpetual." (It's a cycle: What we see now won't be the case forever.) Meanwhile, the fire and emergency markets are OK by comparison. Military depends on government procurement, but as of now, there are a lot of SPAR vehicles in the field, thereby enabling the company to build a nice spare parts business. As to the numbers, it's starting to sound like a broken record after the other companies discussed: great balance sheet, strong liquidity, margins and returns holding up, and, of course, incredibly low valuation metrics. Cope-ability on the bargain counter, classic Ben Graham.

Finally, about those single-digit P/Es I mentioned: it's normal to see them if EPS are expected to fall off a cliff. Actually, though, most of these companies already have one or two deeply depressed quarters in the count. So the single-digit multiples are being measured on earnings that are already well below peak levels. Do don't dismiss them too quickly.

Disclosures: No positions

Brand names . . . we buy them all the time. We do it with food. We do it with clothing. We do it with personal care products. We do it with electronic products. Etc., etc., etc. Many also like to do it with investing strategies. In this latter arena, the brand names refer to people; famous investors whose portfolios have performed well over prolonged periods and who have garnered the respect and admiration of large segments of the investing community. The "products" are strategies that aim, to the extent practicable, to mimic their methods.

The temptation to imitate the practices of legendary investors has always been there. But it took concrete form as those individuals spoke and wrote publicly about their approaches and as stock screening applications arose enabling others to translate those principles into specific screening rules.

Caveats

It may seem a bit of a downer to lead with a discussion of caveats and limitations. But when it comes to this sort of investing, it's important because it's so easy to get the wrong idea of what this is all about.

We start by recognizing that "All-Star" strategies, whether presented on Portfolio123 or elsewhere (such as at aaii.com, validea.com or The Guru Investor, a new book co-authored by John Reese, founder of Validea) were not specifically articulated by the "All-Stars" themselves. The models are the creations of others based on their interpretations of the works of the All-Stars. There is no indication that any of the All-Stars have ever seen or specifically approved any of these models (in fact, some passed away long before the models were created). So the case for using such a model cannot be based on All-Star endorsement.

An All-Star model must stand on its own and depends on two considerations. First, the user must find the overall strategy, the concepts, appealing. Second, the implementation should represent a reasonable expression of the most important ideas.

The first factor is almost automatic. For any investor to achieve "All-Star" status, many would have to respect the strategy.

The challenge lies in the second factor, implementation. It is probably impossible for anybody, other than the All-Stars themselves, to create a screen-based model that perfectly captures every aspect of his or her strategy, or, rather those aspects of the strategy that can be quantified at all.

For one thing, many All-Stars do not use screens, and indeed, many of these strategies were created long before stock screening tools came into being. And even among those who do use screening or ranking, and those who use similar approaches without actually entering rules into a screening-type tool, it's highly unlikely they will publicly disclose so much detail about what they do as to render themselves redundant. For example, it's one thing for an All-Star to talk about the importance of EPS growth. It's quite another for an All-Star to say exactly how that is to be defined. A compound annual EPS growth rate over five years? What about companies that were in existence for only four years? What about peer comparison? If the latter is important, is the benchmark to be a median, a percentile rank, a mean, a cap-weighted average, etc. How do we define EPS? Should we use the GAAP numbers? Do we adjust for accruals, non-recurring items, etc. How rigid should we be with close-but-no-cigar situations? Etc., etc., etc. When it comes to such issues, some All-Stars provide a lot of guidance. Some provide little. Others provide none. But it's unlikely any have or would publicly disseminate perfectly complete ironclad rules. (There's even more to the now-famous "Magic Formula" than is apparent on the book jacket! And even among All-Stars who seem to disclose quite a lot, such as William O'Neil, creator of CANSLIM, the key down-to-earth details remain proprietary.)

Moreover, many aspects of many All-Star strategies cannot be expressed at all through quantitative rules.

Consider, for example, "scuttlebutt," the key aspect of much of the way legendary growth investor Philip Fischer learns about companies. You can't quantify that. You simply have to communicate with a lot of people, and hopefully, develop skill at differentiating between genuine insight versus personal agenda and outright manipulation. (You also need to guard against getting involved with the kinds of communications that could be illegal.)

Peter Lynch talks much about discovering businesses based on where you live, work and shop. To follow that strategy, you have to do just that, observe as you live, work and shop. You can't create a screening rule.

Warren Buffett talks much about understandability. That, too, is something that does not lend itself to expression as a quantitative rule. And actually, it's pretty personal. Your life experiences may differ from those of Mr. Buffett so you and he may have very different notions of what is understandable. Perhaps you’re a pharmaceutical researcher and know biotech like the back of your hand, but can’t make sense of property-casualty insurance, or, heaven forbid, reinsurance, both of which are old hat to Buffett. Also, Buffett also talks in terms of the inevitable; companies that are likely to retain their strength many years into the future. That is a judgment call, not a screening rule (and Buffett would be the first to admit, he’s made some bad calls).

What you can get from an All-Star strategy

First and foremost, you can expect to get a rules-based protocol. If you like rules-based investing (as is the case with those who use at Portfolio123, who have seen how powerful these can be) continue to read on. If this approach does not appeal to you, stop right here. Whatever subjective judgment may be brought to bear here (as would be the case if a model is run, not to generate an automated portfolio but to uncover ideas for further research) will necessarily be your own, not that of the All-Star.

Second, you should expect the rules-based strategy to be reasonably consistent with important aspects of the philosophy of a prominent investment strategist whose ideas you respect. Even if these rules cannot capture everything done by a particular All-Star, it is often possible to depict enough to steer you in a general direction that would help you in your efforts to apply what you can from what the All-Star teaches. Consider, again, the Peter Lynch example. As noted, it is not possible to screen for stocks you can discover based on where you live, work, and shop. But there are many ways to model another important aspect of Mr. Lynch's strategy: the quest for strong-performing companies that are in lackluster or even hated industries. As to Warren Buffet, we definitely can model factors like return on equity and growth in book value, both of which are important to him.

Although it may seem that this section pales in comparison to the one on caveats, the fact is that what you can get amounts to quite a lot.

For starters, rules-based investing is, in and of itself, an excellent approach, as testing and performance monitoring has shown over and over again. So even before any All-Star concepts are brought to bear, you're already starting out at a pretty good place. Second, however important subjectivity may be to an All-Star, the investors who achieve such stature tend to build upon a very strong, well-conceived base of fundamentals. So as rules-based models go, the ones that are built around All-Star ideas tend to be pretty darn good, and that's because the All-Stars themselves tend to be pretty darn good.

The last sentence is the key to what you should expect to get: a pretty darn good rules-based model.

In other words, don't use a Warren Buffett All-Star strategy because you think you'll get what you could if Mr. Buffett himself were calling you up to give you ideas. Instead, use a Warren Buffett All-Star strategy because you're impressed with it as it stands on its own. The fact that it may have been inspired by someone's interpretation of what Buffett does is a matter of background, and, perhaps, indicative of an approach you may want to take as you subjectively evaluate the ideas produced by such a model. Ultimately, though, the model must stand on its own, and be worthy of use even if named after John Doe.

The Portfolio123 approach to All-Star strategies

The Portfolio123 All-Star models are combinations of screens and ranking systems that are designed to work together. Generally speaking, the screen uses some broad rules to refine the stock universe while the main work is really done by the ranking system which, in all cases, is designed to produce lists containing 15 stocks.

This means that except under very extreme conditions (more extreme than anything encountered in any of our backtests), you will always see a practical, actionable, list for each All-Star strategy, a list large enough to provide reasonable choice or diversification yet small enough to buy in its entirety or research one at a time. We do not have lists that are too large to be useful. nor will we have models that go for months on end with lists containing one, two, three, or even zero stocks.

Another issue related to the stand-on-their-own nature of these models deals with freshness.

Suppose, for example, a particular All-Star says he won't invest in a stock with a P/E greater than 8.00 based on trialing 12 months EPS. That's clear and easily lends itself to a screening rule. Suppose, though, that this comes from material (a speech, a book, whatever) dating back to 1977. How seriously should we take the 8.00 threshold? Back in the late 1970s, 8.00 would have struck many as a very reasonable standard. But nowadays (the late 2000s), it seems consistent only with distress situations. Unless the All-Star is still active and speaking publicly, we can't be certain he'd still be sticking with the 8.00 limitation. They are all human and they all observe and deal with the world in which they live. There is nothing to prevent them from modifying their approaches as time passes.

Consistent with our goal of creating stand-on-their-own models, we opt for adaptation. We do not mean to suggest this is what the All-Star would do. We are, however, expressing our belief that adaptation is appropriate for stand-on-their-own models. In fact, the question of All-Star-adaptation was brought very much to the forefront by Thomas Au in his 2004 book A Modern Approach to Graham & Dodd Investing. Perhaps, over time, we'll see more such works addressing other All-Stars. (This will most likely come after the current generation of All-Stars passes on. It's easy to understand why an author and a publisher might be a bit shy about this sort of thing when it comes to an All-Star who is living and, possibly, still active, even if he or she is now publicly silent.)

Here, then, is the current Portfolio123 collection of All-Star-strategists:

Warren Buffett
Benjamin Graham
Joel Greenblatt
Peter Lynch
William O'Neil
Joseph Piotroski
Martin Zweig

The links will take you to articles explaining, in detail, how the models are built.

Further articles in the Portfolio123 Blog section and on Seeking Alpha will emphasize discussion of noteworthy stocks that make the lists.