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Eliminating Ego And Emotion - Rationale For Formularized Investing

Ego and emotion have derailed more good investors over the years than any other factors except, perhaps, excessive leverage. Acknowledging that historical fact when I established Mission's equity selection process in the mid-1980s, I vowed not to fall prey to either of those stumbling blocks. I didn't want to depend on our investment team having to properly interpret hundreds of variables that can dictate investment success or failure. And I certainly didn't want equity selections that were heavily influenced by fear or greed-- emotions that dominate Wall Street near price extremes.

After reviewing many decades of fundamental stock selection criteria, I put together a formula incorporating several measures that have over the long term identified stocks with strong potential of outperforming major stock market indexes. These measures are all valuation-based and have served us well for most of the past 27 years. Since the January 1, 1986 inception of the equity selection process through December 31, 2012, all the stocks we have owned produced an annualized return of 16.9%. Over the same period of time, the S&P 500 returned an annualized 9.9%. That big a difference in equity-only performance is almost unheard of. In fact, one investment consultant told us that she would have ignored our numbers had Mission not been verified by one of the national firms that authenticated Mission's compliance with Global Investment Performance Standards (GIPS®).

Notwithstanding that stellar equity selection record, we have spent the past few years researching a new method to expand our equity allocation. Several years ago, the Federal Reserve began to dominate the securities markets with unprecedented money creation and massive direct securities purchases. Their actions produced a situation in which very few companies exhibited the attractive fundamentals that had been prevalent in prior decades. As a result, very few companies met our strict valuation-based selection criteria. Because there is no way to know how long the Fed will be able to dominate the markets, we felt compelled to find an additional way of identifying opportunities for profiting from equities without forfeiting the defensive characteristics that have always typified Mission's portfolio management style.

Over the past year, we have found and back-tested a very broad collection of measures and studies that, in the aggregate, have outperformed the S&P 500 with fewer and smaller losses than that index has experienced over the past 32 years. True to our belief that successful management requires the elimination of ego and emotion from the investment process, we have built these data into two formularized investment processes. We have begun to offer them to those clients who want to increase the potential for profitable equity exposure while still retaining considerable protection against significant losses.

These newer approaches differ from our traditional valuation-based equity selection process primarily in the time frame in which data are measured. Our traditional process assesses valuations over the full scope of market history. And we are strong believers in reversion to historical means. The two new processes measure data over short to intermediate time frames, using moving averages and volatility bands.

We evaluate a broad collection of data in such major categories as: money supply, interest rates and direction, availability of funds for investment, inflation, Federal Reserve stance, advancing and declining stocks, investor optimism, valuations, new highs/new lows, economic conditions and stock earnings yields. Most importantly, we give heavy weight to stock price direction and stock price momentum. Especially in an era of Fed dominance, heavy weighting of price activity prevents remaining too long in a position supported by fundamentals, yet contradicted by price action. That weighting has been integral to preventing substantial losses over the 32 years of back-testing.

The objective of each process is to outperform the S&P 500. The 2-mode process is designed to own stocks when equity markets are advancing and to keep assets safely in cash equivalents when markets are declining. The 3-mode process attempts to provide a positive return in both rising and falling equity markets. It attempts to own stocks in the most attractive market environments, to keep assets safely in cash equivalents in uncertain market environments and to short stocks in the weakest market environments.

The following table provides a picture of the two formularized processes' performance history over the past 32 years from January 1981 through December 2012.

  S&P 500 2-Mode 3-Mode
Annualized Performance 10.6% 14.6%* 15.2%*
       
Number of Loss Years (Calendar) 6 3 3
Worst One Year Loss (Calendar) -37.0% -3.4% -6.8%
Worst Quarter -22.5% -11.6% -8.6%
       
Number of Positive Return Quarters 89 107 100
Number of Negative Return Quarters 39 21 28
       
Annualized Returns in S&P 500 Up Quarters 31.0% 23.3% 15.0%
Annualized Returns in S&P 500 Down Quarters -24.9% -2.9% 15.8%
Click to enlarge

* Trading costs are not included.

There can, of course, be no certainty that what has worked very successfully for 32 years will continue to perform as well in the future. We expect, however, that there is a strong probability of continued success for three primary reasons: 1) the success of the formula was quite consistent over nearly a third of a century and not simply due to a few periods of significant outperformance; 2) the data studied are numerous and diverse, reducing the potential that a few measures becoming less well correlated with future stock market progress will substantially reduce the effectiveness of the formulas; and 3) the heavy weighting of price direction and price momentum has quite effectively prevented staying too long in a position recommended by fundamentals, but which is performing badly.

By applying these data in historically tested formulas, we are removing the destructive forces of ego and emotion from the decision-making process. In an era in which central bankers have done serious damage to time-tested valuation measures, we are confident that these new approaches will allow us to seek returns from equities without sacrificing important protection against significant losses. And that protection could still be critically important with our Federal Reserve and other world central banks increasing debt levels as though there will be no negative consequences.

Please contact us if you would like additional information about the processes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.