Improve Returns With Lower Risk Exposure

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Includes: AGFS, AMC, ASNA, BCOR, CACC, CBI, CNDT, COT, COTY, HMHC, KN, KORS, L, SPY, TEVA, TWTR
by: Mark Bern, CFA

Summary

A picture paints a thousand words and our model portfolio performance chart tells a remarkable story.

Beating our benchmark while still heavily in cash.

Consistently strong free cash flow and efficient capital allocation are great indicators of future potential returns.

Poor free cash flow and terrible capital allocation tend to indicate good short position candidates.

An algorithm that helps us sift through thousands of stocks every month quickly to find great candidates on both ends of the investing spectrum.

A picture paints a thousand words and our model portfolio performance chart tells a remarkable story. Beating our benchmark while still heavily in cash. Consistently strong free cash flow is a great indicator of future potential returns.

The Picture

We are the red line.

Our model growth portfolio has outperformed New York Stock Exchange Composite Index (NYA), our benchmark, handily since its inception on December 8, 2016. What makes this feat remarkable is that the portfolio still retains 30% of assets in cash. The portfolio is up 13.24% vs 9.29% for the benchmark.

The results of the portfolio compared to the S&P 500 (SPY) also shows that a portfolio need not be 100% invested to capture market-beating returns.

Our most conservative model portfolio, our Friedrich Final Four Model Portfolio, has only six holdings, each with just 2% of portfolio assets, and yet it is almost keeping pace with the S&P 500 Index. This portfolio is 88% in cash and still returned 1.02% since its inception on August 7, 2017 through the end of September. That compares to SPY which is up 1.29% over the same period. Had an investor put his/her full portfolio into those six stocks with equal amounts in each, the investor would have a gain of 8.29% in less than two months.

We are not able to find new Final Four stocks in the U.S. every month but when we search globally in all 36 countries we cover we generally uncover more. Unfortunately, some of those countries do not allow foreign investors to buy individual stocks on their listed exchanges. But we have subscribers in some of those countries so we must include them in our research.

More cash means less risk

The point is that investors need not be fully invested to capture market returns. Being fully invested has been considered the only way to compete with returns of the broad indices. The flip side to that story is that investors need to accept the higher risk associated with being fully invested the result of which crushes a portfolio when markets correct or crash. As advisors we understand the backlash that occurs coming from fearful clients when they see markets plummeting and the assets it took them (and us) years to build diminish significantly. We also understand that long-term investing requires discipline and that it is difficult to calm and hold onto unhappy client when markets are in turmoil. But that may no longer need be the case.

By holding a sizable cash position our clients are well positioned to take advantage of the next downturn in equities while, at the same time, still able to fully participate in the continuing bull market advances. When the inevitable next downturn does come we fully expect our model portfolios to hold up much better than the broad market indices. In addition, when the bargains begin to appear again our analytical algorithm will identify the best companies with future growth potential.

Back test results

We completed two back tests of our approach linked here for our 60-year back test ending in 2009. We can also provide results and data from a ten-year back-test beginning in 2008 upon request. So we provide 69 years of evidence on how well a portfolio should perform when using our analytical approach using consistently strong free cash flow as the primary assessment tool. Our approach beat the Index return being tested in all but five of the 60 year back test .

The key is to choose only the highest quality companies when priced at bargains with a reasonable margin of error. That is what our Friedrich algorithm does for us (and could do for you) by performing 2,600 calculations to determine 69 ratios we use in our analysis of over 4,000 U.S. exchange-listed U.S. stocks and a total of 17,000 stocks in 36 countries globally.

Recent Examples

Here is an example of the output for one of our favorite companies, Credit Acceptance Corporation (CACC):

We recently published an article about CACC that can be found here. The company utilizes tools that most analysts do not understand to outperform when Wall Street expects it to fail. Without Friedrich we would have followed the conventional logic. Instead we dug deeper into the company and asked questions of industry experts (one of which is a subscriber) to develop a better understanding of what makes this company unique. The stock is up a mere 1.5% since we added it on August 7th. We added Michael Kors (KORS) on the same day at $36.90. That stock is now trading at $47.56, a gain of over 29% in less than two months! It is not always that easy, but finding those gems do wonders in attaining the results that clients desire. Both of these positions are long-term holdings we intend to keep for their potential growth prospects over the next five to ten years (if not longer).

Below is a legend to better understand what we look for from each ratio:

For an in depth explanation of how we calculate each ratio and how it is used to analyze a company please refer to our Introduction to Friedrich page.

No tool is perfect. Our Marketplace subscription service, Friedrich Global Research, also includes guidance to help subscribers avoid many of the false positives resulting from the algorithm. That is the added value of having two analysts with a combined 75 years of experience in equities analysis working behind the scenes and available for questions on how to interpret the algorithmic output. If you decide to click on the link to our service to check it out make sure to read the powerful reviews from some of our current subscribers.

We run the algorithm each month to keep our analysis updated and to help us spot companies with improving fundamentals relative to price levels. We focus on FCF (free cash flow) and consistency. Our formula for FCF is slightly different from the standard method in that we ignore the periodic changes to balance sheet items and cash flow in the calculation. We analyze those fundamental components separately. Our methodology was used as the basis for investing decisions in the 60-year back test linked earlier and produced an annual average compound return of 21.02% over the full period. Our model portfolio in the back test was reallocated annually with the only requirement that a company must meet our one FCF requirement. That is why we stick with our deviation from the standard methodology.

Other Uses of the Friedrich Algorithm

We continue to test new ways to use the analysis performed by the algorithm. On August 1st we announced a new live test of how we think Friedrich can identify companies that are highly overvalued with stocks that are ready to fall. The last part of that is the tricky piece since there are plenty of stocks that are overvalued in the market these days but as long as Wall Street believes in the "dream," so to speak, the stocks are not likely to fall any time soon.

So, we decided to put together a model portfolio for the test of candidates which met certain criteria that we considered to make the companies extremely toxic. The results were phenomenal for the overall portfolio but mixed within the different individual stocks. Our initial test portfolio included: Teva Pharmaceuticals (TEVA), AMC Entertainment (AMC), COTY (COTY), Chicago Bridge & Iron (CBI), Houghton Mifflin Harcourt (HMHC), Ascena Retail (ASNA), AgroFresh Solutions (AGFS), Twitter (TWTR), Lowes Corp (L) (not to be confused with LOW), Knowles (KN), Blucora (BCOR), Conduent (CNDT), Cott (COT). Of course, we do not advise shorting the group above as this was just a test; many of these stocks have already fallen and others have been removed as we assessed/improved our selection criteria.

We have found that companies that have piled up too much debt in acquiring assets while paying huge premiums above the market value for those assets tend to have a better chance of imploding. But there is more: we also want those companies to have terrible FCF; a price to tangible book value above 100 (meaning that the company has no more assets to use as collateral for additional debt); and to be running out of cash. When a company needs more cash to continue operations but has no feasible method to raise more it is on the proverbial cliff's edge. Friedrich helps us sift through these details quickly to find the best prospects for shorting.

Some went down by 40% or more in the first three weeks (down is good when shorting). So we looked at all those in the group that dropped by double digits in the first three weeks and refined the criteria. This led us to drop a few positions and add some new ones in early September. We will continue to fine tune the methodology we employ and update the portfolio monthly as we update the analysis on all 4,080 U.S. exchange listed stocks we cover each month. We suspect the greatest opportunities will come along at the beginning of each new quarterly reporting season.

We believe that Friedrich could also be used to construct a long/short portfolio for those who want to play the market in both directions at the same time. Most such strategies fail miserably but we believe it is primarily because of the selection processes employed by those managers as well as restrictive allocation requirements. Better selection and more flexibility as to how much of a portfolio can be long or short depending upon the overall market conditions could vastly improve performance, at least this is our expectation.

Maintaining long positions in the highest quality stocks (Friedrich Final Four picks) could allow an investor to outperform the overall market returns with only half or even less of ones portfolio invested in long positions as long as the bull market continues. With the added potential of a carefully selected short portfolio, even if the market continues higher the short positions that fall as predicted by Friedrich simply add more return. But the best part is that when the market does correct again, having short positions in a group of very weak companies means that the short portion of the portfolio should post significant gains to offset any damage done by the long positions. In addition, because of the power of the selectivity process an investor could still hold a good portion of his/her portfolio in cash, still beat the market indices and have plenty of dry powder available to buy bargains when such opportunities present themselves.

This part has not been tested, of course, but it does sound enticing in theory and we intend to build a model portfolio to test its validity in the near future. Higher returns with lower risk is always our primary objective.

Conclusion

Our Friedrich Global Research subscription service is proving to be a valuable tool for both individual investors and a growing number of professional advisors. When the next bear market does come along our subscribers (and their clients) will be well-positioned to avoid much of the damage and to capture market-beating gains in the next recovery.

If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button next to my name at the top of this article. For those who would like to learn more about my investment philosophy, please consider reading " How I Created My Own Portfolio Over a Lifetime."

Disclosure: I am/we are long CACC, KORS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.