Seeking Alpha

Marc Gerstein's  Instablog

Marc Gerstein
Send Message
Marc H. Gerstein (http://twitter.com/#MHGerstein or if already on Twitter, search for @MHGerstein) is an independent investment analyst/consultant specializing in rules-based equity and ETF investing strategies, with particular emphasis on small-cap equities and leveraged ETFs. Many of is views... More
My company:
Portfolio123 and Ariston Advisors
My blog:
Forbes Low-Priced Stock Report
My book:
Screening The Market
  • Portfoilio123 All-Star Stock Strategies 0 comments
    Jul 30, 2009 5:48 PM

    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.

Back To Marc Gerstein's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Most Commented
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.