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Market Strategies - Rules Of The Game

Patrick Henry was right when he proclaimed that the only way to judge the future was by the past. As self directed investors, in order to make the best investment plans for the future, investors need access to long term performance results. It doesn't matter if you are an aggressive or conservative investor, Growth or Income, or Value or Momentum investor. You need to know what worked and what made it work. Then you need to determine if it will continue to work going forward.

This instablog is a continuance of the thoughts, ideas and results of the research done by John O'Shaughnessy and published in his book, "What Works On Wall Street."

I'm well aware that past performance doesn't guarantee future results, but try applying for a job without a resume. Your resume represents your past performance. Your resume tells that employer who you are and what you are all about. A stock's past performance doesn't guarantee future performance, but neither does your resume guarantee your future performance.

If I know your past performance, I have something to measure your current and future results against. If you aren't living up to your resume, I know it and I know it a lot sooner than if I had nothing to measure your progress against.

People want to believe the present is different from the past. People want to believe that strategies that worked 30 or 40 years ago won't work today. That simply isn't true. The reason history repeats itself is because people possess the same human emotions today that the Pilgrims, the Romans and the people of the ancient Chinese Dynasties possessed. Situations may differ, human activity based on emotion doesn't. We may be more sophisticated in our approach, but emotions don't change and emotions drive people, for better or for worse.

If we apply these concepts to the market, the price of a stock is still determined by people. As long as people let fear, greed, hope and ignorance cloud their judgment, they will continue to misprice stocks and provide opportunities to those who use simple, time-tested strategies to pick stocks. Names may change, Industries may change, styles may come in and out of fashion, but the underlying characteristics that identify a good investment remain the same.

It took me a lot of years of trying various methods before the light clicked on. It isn't about how well a stock performs, it's how well your strategy performs! Do the components that make up your stock selection process work in all market conditions?

Please take the time to read the above paragraph. It's the essence of this instablog.

Long term success, or the lack of it, is determined by how well your strategy performs! Do the components that make up your stock selection process work in all market conditions? Strategy is job one!

O'Shaughnessy went on to say that all models must use explicitly stated rules. There must be no ambiguity in the statement of the rule to be tested. There is no allowance for a private or unique interpretation of the rule.

People are always willing to share the time they ignored a rule or guideline and succeeded. That is a very dangerous concept to wrap yourself around as it helps solidify false motivation and undermines your strategy. What we won't hear from these same people is the number of times they ignored a rule or guideline and ended up losing.

The odds are high that by making exceptions, it won't work in all market conditions, and it certainly won't produce consistent positive results. A good system needs to be consistent at all times. It's why computer models continuously beat the money managers. Models apply a consistent application of the rules.

O'Shaughnessy tested scores of strategies over a 40 plus year period. He tested strategies that focused on Price to Earnings, Price to Sales, Return on Equity, Earnings Per Share, Relative Strength, Book Value and several other criteria. He also mixed and matched them.

He then went on to test this criteria with small cap, mid cap and large cap stocks. He tested dividend paying against non-dividend paying. He tested absolute return vs risk adjusted return. The results might surprise some of you.

The most successful strategy over the long term was small cap growth that included "all stocks." That really shouldn't surprise people. The problem with that strategy, and O'Shaughnessy points it out, is that price volatility is so intense, most people can't withstand the huge drawdowns. To most of us, it doesn't create an income either. So we move on.

Since most of us are looking for income, while minimizing risk, I looked to the strategies that produced the best risk adjusted returns. What won't be a surprise to most here is that when it came to best risk adjusted returns, dividend paying stocks fared well. O'Shaughnessy found that over the longer term, dividends counted for more than half the market return, something that is confirmed by the Ned Davis research and that of others.

You should know this, there is such a thing as good yield and bad yield. First the bad yield; O'Shaughnessy found that if you were to focus on "all stocks" (Large, Mid and Small), and went with the highest yields, that over 10 year rolling periods this strategy created negative returns. His studies showed that the strategy was successful just 18% of the time. Think about that! Just an 18% success ratio.

O'Shaughnessy found that the returns of high yielding, large stocks were entirely different. He clearly states that large stocks with high dividend yields offer the best risk adjusted returns available.

By focusing on market cap, buying the larger well-known companies, they showed to have the stronger balance sheets and longer operating histories that make dividends, and dividend growth, possible.

It was stated that 50 stocks, equally weighted, with dividends reinvested, and rebalanced annually fared best. This strategy was successful in rolling 10 year periods 91% of the time.

You did notice that right? 50 stocks, equal weight, dividends reinvested, rebalanced annually!

That is what his research shows!

I know some of you can't get to the 50 stock level yet or may never wish to either. He did say you can enjoy some success with a 16 stock portfolio as long as you diversify by sector and/or industry.

There was one strategy ... just one ... that was successful 100% of the time over 5 and 10 year rolling periods, but I'm not going to tell you what it is. ... Ha!

I'm just kidding. I'll tell you in a moment. Before I do, this next comment is very important, and some of you may balk at it, but the results can not be disputed.

Of the scores of strategies that O'Shaughnessy tested over a 40 plus year time frame, the Top 10 Most Successful Strategies all had just one component in common, just one. It was a component that most of you probably don't use, may surprise you, but was no surprise to me. That one component is Relative Strength.

Relative Strength calculates which investments are the strongest performers, compared to the overall market, and recommends those investments for purchase. In its simplest form, it means price appreciation.

Relative Strength is the engine that drives Momentum Investing. Now think about that! Investor's Business Daily promotes Relative Strength. Trend Investing promotes Relative Strength. Traders promote Relative Strength. Value Line uses Relative Strength as a main feature in their stock selection and portfolio management process. They call it their Timeliness Indicator. VL provides a Safety Rating and a Timeliness Rating.

As you Value investors sit there and cringe at the thought of relative strength, O'Shaughnessy showed where it's also a basis for long term success in Value investing. This is what caught my attention and helped shape some of my views about combining value investing and momentum investing.

If we stop and think about it, it does make sense. How many of us require a specific yield before we will consider investing in a company? Why is that? Why do we require a 3 to 4 percent yield and shun a 1 or 2 percent yield? The 1 percent yielding company may increase their dividend 3 or 4 times as much as the company with the 3 or 4 percent yield, and over time, the low yielding company will outperform the higher yielding company in dividend income. We know this is possible and we've seen it happen, yet we ignore it and still require the higher yield. Why?

We require it because the higher yielding company gets us off to a much quicker start with regard to income. We are secure in knowing that it may take quite a few years for the low yield, high dividend growth company to catch up, provided they can. A bird in the hand is worth two in the bush. As the King of Siam said, "Excetera, Excetera, Excetera!"

Guess what! ... That's exactly what relative strength (price momentum) does. It gets you off to a fast start. It's always nice to see that your new positions are at least profitable.

The importance of profitable positions is to help steady you during market drawdowns. The last thing you want to do is undermine your strategy. Human nature, being what it is, makes it very difficult for us to stick with something that is showing a loss prior to a bear move, and now that loss is compounding to the downside as the market pulls back. It will test the emotional endurance of the best of us. Drawdowns are easier to handle when you have a profit as a moat. Relative strength helps to insure that profit a lot of the time. That total return (there, I said it), will help to keep you steady with regard to your strategy, as opposed to abandoning it at the time when you should be utilizing it even more.

In a future blog, I will share some techniques of how and when to apply relative strength, not only to help you buy, but to show you when you need to stay put and let your winners run. Additionally, relative strength will aide you in knowing when to sell. We'll get to that later. This blog is about the Rules Of The Game. The things that work and the things that don't.

The reason that Relative Strength works is because the market is about supply vs demand. Since so many strategies have Relative Strength as a criteria, when the indicator says go, you have a lot of various investors, using various strategies, bidding price higher due to the amount of demand coming to market.

Okay, the strategy that was 100% successful over a 40 plus year time frame when using rolling 5 and 10 year periods had these 3 criteria in common when applied to "all stocks," dividend and non dividend paying companies.

1. Price-to-Sales Ratio (NYSEARCA:PSR) under 1.

2. High 12 month Relative Strength (RSI) number (over 60).

3. Price-to-Earnings Ratio (NYSE:PE) under 20.

Easy, eh? ... Not quite. It's difficult finding Large Cap companies with a PSR under 1. In that case, I will use PSR as a filter to help me choose between one company or the other. The lower the PSR the better according to O'Shaughnessy's research.

Why does price performance work while other measures don't?

According to O'Shaughnessy, price momentum conveys different information about the prospects of a stock and is a much better indicator than factors such as earnings growth rates. Many look at the disappointing results of buying stocks with the highest earnings gains and wonder why they differ from buying the best 1 year performers with regard to share price. Price performance is simply the market putting its money where its mouth is.

This is why you may have seen me comment from time to time that I'm not afraid to pay a premium for quality. Key word being "quality."

It was Runyon who said, winners continue to win and losers continue to lose.

The advice is simple. Buy quality stocks with the best 1 year relative strength, but understand that their volatility will continue to test your emotional endurance. To help keep your emotions in check, know that Large Caps usually works best. It's easier to ride the storm with them. Focus on the financial safety of the company. Stick with companies that are rated high quality, that being an S&P rating of BBB+ or better.

An asset is only as valuable as the income it creates. Covering the dividend isn't enough, covering the dividend growth is even better. That's where the financial strength, or credit rating if you will, comes into play. The larger well-known companies, with strong balance sheets, are in better position to pay and increase the dividend.

In closing, we can learn much from the Taoist concept of Wu Wei. Taoism is one of three schools of Chinese philosophy that have guided thinkers for centuries. Literally, Wu Wei means "to act without action," but in spirit it means to let things occur as they are meant to occur. Don't try to put round pegs in square holes. Don't be more clever than you need to be. Don't look for meaning: Look for use!

For investors, this means letting good strategies work. Don't second guess them. Don't try to outsmart them. Don't abandon them because they're experiencing a rough patch. Understand the nature of what you are using and let it work.