Every month, we construct a theoretical long/short portfolio of stocks that demonstrates solid relative value with potential for ongoing cash flow growth and ROIC expansion.
In September 2017, our theoretical Core Long Model was up +4.42% versus +1.92% for the S&P 500. The theoretical Core Long/Short model was up +0.88%.
YTD, the Core Long Model is up +14.82%, beating the S&P 500 by +2.84%. The Core Long/Short Model is up +14.86%, significantly ahead of the Barclay Long/Short Index by +8.83%.
We have two strong long candidates this month: Micron Technology, Inc. and Agilent Technologies, Inc. Both are attractive from a relative valuation and operating momentum standpoint.
Our favorite pair trade this month is Long Micron Technology and Short Cree, Inc. Cree is probably not a good standalone short sale idea because we do not expect an accelerated deterioration in its fundamentals, however, we think it is a good hedge against Micron.
In this report, we highlight stocks that demonstrate solid growth prospects at a reasonable price (GARP) and provide an update of last month's report and our October 5 rebalancing note. For older reports, you can visit this link.
Our criteria for selecting stocks in these model portfolio strategies, which heavily weight proxies for cash flow growth and ROIC, include the following:
- Relative Value
- Operating Momentum
- Consensus Estimate Revision Momentum
- Fundamental Quality
As a simple quantitative model based on fundamental rankings, these portfolio models do not take into account rumors or pending M&A transactions. For easier comparisons of one period to another, we track theoretical portfolio returns on a simple cumulative basis (no compounding).
Long Rebalancing Actions
As noted in our abbreviated report, we assume that just prior to the October 5, 2017 close 12 stocks have left the long-only model, 16 have been added, and 19 have been rebalanced. This 35-stock theoretical long model assumes a 2.86% weight for each stock. The long model portfolios are composed of high-quality stocks.
Close Long Positions
Yum! Brands, Inc. (YUM)
LVMH Moët Hennessy Louis Vuitton S.E. (OTCPK:LVMUY)
Peabody Energy Corporation (BTU)
First Horizon National Corporation (FHN)
Cathay General Bancorp (CATY)
Celgene Corporation (CELG)
Cirrus Logic, Inc. (CRUS)
CDW Corporation (CDW)
Alphabet Inc. (GOOG)
Ansys, Inc. (ANSS)
Louisiana-Pacific Corporation (LPX)
Cabot Corporation (CBT)
Hold/Rebalance Long Positions
Burlington Stores, Inc. (BURL)
Kohl's Corporation (KSS)
Evercore Inc. (EVR)
Raymond James Financial, Inc. (RJF)
SVB Financial Group (SIVB)
Agilent Technologies, Inc. (A)
Masimo Corporation (MASI)
MasTec, Inc. (MTZ)
EMCOR Group, Inc. (EME)
Allison Transmission Holdings, Inc. (ALSN)
Valmont Industries, Inc. (VMI)
Advanced Energy Industries, Inc. (AEIS)
Vishay Intertechnology, Inc. (VSH)
YY Inc. (YY)
Facebook, Inc. (FB)
Arista Networks, Inc. (ANET)
Teck Resources Limited (TECK)
Norbord Inc. (OTC:OSB)
United States Steel Corporation (X)
Open Long Positions
Thor Industries, Inc. (THO)
Compañía Cervecerías Unidas S.A. (CCU)
TC PipeLines, LP (TCP)
East West Bancorp, Inc. (EWBC)
American Equity Investment Life Holding Company (AEL)
Exelixis, Inc. (EXEL)
Trex Company, Inc. (TREX)
ManpowerGroup Inc. (MAN)
Graco Inc. (GGG)
Donaldson Company, Inc. (DCI)
Applied Industrial Technologies, Inc. (AIT)
InterDigital, Inc. (IDCC)
Micron Technology, Inc. (MU)
Intuit Inc. (INTU)
Kronos Worldwide, Inc. (KRO)
Trinseo S.A. (TSE)
Short Sale Rebalancing Actions
Just prior to October 5, 2017 close, we assume that 4 stocks have left the short-sale model portfolios, 9 have been added, and 16 have been rebalanced. This 25-stock theoretical model portfolio assumes a 4.00% weight for each stock.
This short sale model is composed of low-quality stocks and only tends to work well during periods of high uncertainty or volatility in the market. Low-quality stocks do tend to outperform high-quality stocks during market rallies as the market prices in expectations for a sharp recovery in fundamentals.
Hold/Rebalance Short Sale Positions
Adient plc (ADNT)
Under Armour, Inc. (UAA)
MetLife, Inc. (MET)
Voya Financial, Inc. (VOYA)
Agios Pharmaceuticals, Inc. (AGIO)
Penumbra, Inc. (PEN)
Jacobs Engineering Group Inc. (JEC)
ZTO Express (Cayman) Inc. (ZTO)
Univar Inc. (UNVR)
Fluor Corporation (FLR)
Flowserve Corporation (FLS)
MACOM Technology Solutions Holdings, Inc. (MTSI)
Integrated Device Technology, Inc. (IDTI)
ViaSat, Inc. (VSAT)
PTC Inc. (PTC)
The Mosaic Company (MOS)
Open Short Sale Positions
Penske Automotive Group, Inc. (PAG)
National Oilwell Varco, Inc. (NOV)
Alnylam Pharmaceuticals, Inc. (ALNY)
Puma Biotechnology, Inc. (PBYI)
Textron Inc. (TXT)
Colfax Corporation (CFX)
KBR, Inc. (KBR)
Cree, Inc. (CREE)
The Sherwin-Williams Company (SHW)
Favorite Long Ideas for October
We have two strong long candidates this month: Micron Technology, Inc. and Agilent Technologies. Both are attractive from a relative valuation and operating momentum standpoint.
Our high relative value ranking for Micron Technology is likely signaling the market’s belief that the company has reached a peak in its operating cycle. Supporting this theory is a consensus forecast that implies ROIC will likely peak in February 2018 quarter. The philosophy of this model, which has tended to work well over time, is to hold stocks displaying the best fundamental momentum and relative value until proven otherwise. Consensus tends to be poor at calling peaks and troughs, so we support the “contrarian” stance that there is a good chance that estimates for Micron continue to be revised higher.
Agilent Technologies was in our model portfolio last month, but its rankings recently changed to a configuration that on occasions in the past have subsequently performed very well. In addition, economic profit is poised to turn positive for the first time since July 2013, and ROIC is set to reach double digits for the first time since October 2012. When certain key stock metrics reach certain thresholds, such as turning to positive from negative or from the single digits to the double digits, it seems to attract additional interest from investors.
Our favorite pair trade idea for October is Long Micron Technologies and Short Cree, Inc.
In the semiconductor space, Cree, Inc. looks as unattractive as does Micron Technologies appears attractive. Cree is probably not a good standalone short sale idea because we do not expect a significantly increased deterioration in its fundamentals. However, CREE's ROIC is low and the trend is stagnant, and relative value is unattractive. It's a good hedge for a long position in MU, in our opinion.
September 2017 Returns
High-quality stocks lagged low-quality stocks for the first 3 weeks of September but finished the month relatively higher.
The theoretical Core Long Model portfolio finished September 2017 up +4.42%, versus the S&P 500 up +1.92% and the SPDR S&P 500 ETF (SPY) up +2.01%.
Stocks in the theoretical Core Short Model portfolio finished up +3.54% for the assumed inverse short sale loss of -3.54%.
The theoretical Core Long/Short Model portfolio finished up +0.88% (+4.42% - 3.54% = +0.88%), ahead of the preliminary Barclay Equity Long/Short Index average of 0.71% (representing return data from 153 funds, compared to 400+ funds that would represent the full average).
For the year through September 29, on a simple cumulative return basis, the Core Long Model portfolio strategy is beating the S&P 500 by 2.84% (up +14.82% versus the S&P 500 up +11.99%) and the Core Long/Short Model portfolio strategy is significantly beating the Barclay Long/Short Index by 8.83% (up +14.86% versus +6.03%).
The theoretical Opportunistic Model portfolios use the same basket of stocks as the Core Model but additionally use a cash allocation strategy in an attempt to minimize losses during periods of extreme market volatility. While this strategy significantly improved returns in the 2009-2011 period, moving to cash has consistently hurt the portfolio returns in every instance since the beginning of 2012.
The theoretical Opportunistic Long Model maintained a minimum 30% cash allocation for the month, with cash levels only changing when a stock position was closed and replaced with cash. This model will remain with at least a 30% minimum cash allocation through just prior to the close of October 12, when it will assume a 0% cash allocation (excluding stock positions that were closed and replaced with cash). The Opportunistic Long/Short Model finished September 2017 down -1.42%.
Theoretical long stock returns September 2017
Our favorite long idea as of September 8 was Yum! Brands, Inc.. The stock finished the September 8-29 period down -3.75%.
The best performing stock in the long model since the September 8 rebalancing was MasTec, Inc., which reached a price target on September 26 and was assumed closed the next day for a 16.81% return. MTZ was the worst performing stock in August, down -11.69% that month.
The worst performing long idea since the September 8 rebalancing was Teck Resources Limited, down -9.25% for the period. Interestingly, TECK led the model portfolio for the first four trading days of October with a +9.10% return and remains in the model portfolios for October.
Theoretical short sale stock returns for September 2017
The best short sale idea for September was Sage Therapeutics, Inc., which reached a price target on September 13 and was assumed closed the next day for an assumed short sale gain of +25.46%.
The worst short sale idea was Integrated Device Technology Inc., which hit a stop loss target on September 13 and was assumed closed the next day for a short sale loss of -10.81%.
Long-running advice regarding the use of our model portfolio report
Wayne Gretzky said it best: “Skate to where the puck is going to be, not where it has been.” Quantitative screens like the one in this report show where a stock has been and assume the trajectory is fixed. Of course, this is not always the case. The best investors will use this model portfolio as guidance, and not the end all. At the same time, the model does well enough on its own, often beating the indices with ease. With a little effort, we hope that active fundamental portfolio managers will do even better.
We favor reporting theoretical model portfolio returns data on a simple cumulative basis. Cumulatively adding daily returns allows for the easy comparison of returns from one period to another. Simple cumulative returns are significantly lower than compound returns over time. For the theoretical Core Long Model portfolio, simple cumulative returns since March 31, 2009, inception have been 190.94% and compounded returns have been 451.11%. S&P 500 returns over that same period have been 125.24% on a simple cumulative return basis and 215.76% on a compounded basis.
A pdf of this report is available here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As a simple quantitative model based on fundamental rankings, the portfolio models do not take into account rumors or pending M&A transactions. Theoretical return data reflect simple cumulative returns (not compound returns) and do not assume the impact of costs such as execution fees, margin fees, slippage, the availability of stocks for short selling, or any other kind of cost. There are limitations inherent in our theoretical model results, particularly with the fact that such results do not represent actual trading and they may not reflect the impact material economic and market factors might have had on our decision making if we were actually managing client money. We do our best to provide accurate information in this report, but do not guarantee its accuracy.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.