New Year NAPS - Top Stocks For 2018 And The Benefits Of Ignorance

by: Stockopedia

2017 has been a good year for stock market investors, but it's been a great one for NAPS investors. Over the course of 2017, this remarkably effortless stock selection system (that I'm now calling the "no-admin-portfolio-system") returned over 45% after dividends, beating the performance of 99.8% of 3,295 professionally managed funds in the UK.

What's more, this was achieved in less than an hour's work at the beginning of the year, with absolutely no research into any of the individual stocks in question.

So, I'm going to start the year with a review of the NAPS performance over the last 12 months before considering the difference between ignorance and stupidity.

Once I've convinced myself (again) that it's absolutely fine to know almost nothing about the individual stocks I'm selecting, I'll then publish the 20 stocks that have made it into the 2018 NAPS Portfolio.

And then, I'll sleep on it for another year.

2017 Performance in Context

I've been running the NAPS portfolio since the end of 2014, and the performance has been, you might say, more than satisfactory. The portfolio has more than doubled (+115% before dividends) in these three years, with an average 29% annualised return.

Over this time period, the FTSE All Share has returned about 18.8% before dividends - at an average annualised return of 5.9%. So the NAPS has devoured the performance of FTSE index tracker funds by more than 20% per year since inception, and it's done this at considerably lower volatility.

2017 has been the best year of the three years so far with 42.5% growth before dividends. The chart above contains three lines which are clearly labelled:

  • The dark green line is the 20 stock NAPS Portfolio (top two stocks by StockRank from each sector rebalanced annually).

  • The light green line is the performance of the top 20 stocks by StockRank (no diversification, rebalanced annually).

  • The orange line is the FTSE All Share.

Although it's a small sample, I do believe the above charts provide validation of the core ideas behind the NAPS - namely:

  1. Factor investing can beat the market. (The green lines, based upon the StockRanks, dominate the market index).

  2. Diversification across sectors can further improve returns, and reduce risk. (The dark green line beats the light green line).

The NAPS Portfolio's growth in 2017 was driven in particular by the performance of 2 stocks: IQE and Games Workshop. Both stocks returned more than 260% over the year… which means they have both almost quadrupled. I was very pleased to see that more subscribers named these two stocks as their biggest winners in our 2017 Subscriber Performance Survey than any other.

What I love about the stock market is that you can invest in companies that most people think are just absolutely plain draft, and still make blinding profits. Games Workshop customers spend their evenings painting miniature figurines of trolls and orcs - and that curious activity has helped us quadruple our money. Niche markets can indeed make great investments.

Here's the complete breakdown of 2017's NAPS winners and losers:

This year, we had 14 winners and 6 losers - a 70% hit rate. Other notable performers included Wizz Air (OTCPK:WZZAF) and Morgan Sindall which both roughly doubled. Amongst the losers were: Petrofac (OTCPK:POFCF) (probably pronounced Petro-faaaaac on the day of its profit warning), Quarto (about how much money you have left after investing in it) and Drax (which the dictionary defines as "an expression used when you are slightly annoyed").

It's a game of odds…

It's important to reiterate that just as no batsman is going to hit every ball for six, no stock selection system will ever reach 100% accuracy. It's the batting average that matters.

Stock picking can be such a torturous game as there's an implicit assumption that if you put the effort in to pick an individual stock - you have to be right. But we live in a world of shape-shifting markets and imperfect information… certainty is impossible.

The NAPS theory is that an equal weighted, diversified portfolio of 20 good (quality), cheap (value), improving (momentum) stocks should beat the market - on average.

Dealing in averages relieves me of the burden of being right. I couldn't care two hoots how the individual names react over the year, as long as they perform well in aggregate.

And this approach has been working. After 3 years, there have been an average 72% winners picked annually (returning an average 49% each), and 28% losers (losing an average 20% each).

A note of caution: I have absolute certainty that these numbers will not remain this high over the long term. Markets will not always be as kind as the last three years. I've invested through 2 of the worst bear markets in history (2000-2002 and 2007-2009) and while I hope they won't be repeated, I know hard times will come again.

Diversification pays off again

In previous years, the small caps (2015) and large caps (2016) have dominated returns, but in 2017, it was the turn of the mid caps to drive the NAPS outperformance. This size diversification is by design.

Most private investors focus on small caps as they believe 'elephants don't gallop' - but I'm not so confident of this. Different market segments come into vogue at different times, and often when we least expect. If you have a look at US markets, it's been the mega-cap FAANG stocks (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOG) (NASDAQ:GOOGL)) that have driven most returns rather than small caps.

I want the NAPS to be an all-weather portfolio, and not to have to worry about timing exposures. I want to diversify and be done with it, so spreading the portfolio across small, mid and large caps is prudent and is proving effective.

From a sector perspective, perhaps unsurprisingly, the strong performance has been driven by the sensitive/cyclical sectors rather than the defensives. I would expect the defensive, lower volatility part of the portfolio to come to the fore in a more bearish market environment.

Below are the size and sector diversification charts for 2017.

Ignorance vs. Stupidity

"All you need in this life is ignorance and confidence, and success is sure." Mark Twain

Some private investors have told me that investing in shares without doing individual stock analysis is a rather dumb idea. I happen to think the opposite. I believe it's much more dumb to do huge amounts of analysis on individual shares when you own a large number of shares.

Yes, it makes a lot of sense to do forensic research on individual companies if you own only a few of them. If you run a highly concentrated portfolio, or if you run your own company you absolutely have to do masses of research to invest with conviction.

But in a diversified portfolio of 15+ stocks, the idiosyncrasies of each individual stock pick end up cancelling each other out. One zigs when another zags, and each has less and less overall impact. What ends up mattering is the overall exposure of the portfolio to certain driving factors.

Carhart in his 1997 research paper "On Persistence in Mutual Fund Performance" showed that the fund managers that most outperformed over the long term were those whose portfolios were most consistently exposed to a set of factors which included value and momentum. The individual stock picks mattered far less.

And this means the vast majority of the Active Fund Management industry may indeed be working incredibly hard in a whole host of pointless, expensive activities. James Montier called many of these activities the "Seven Sins of Fund Management" - including such time-wasters as information gathering, meeting the management, forecasting, thinking you can outsmart everyone else, groupthink and believing too much in fairy tales.

This is not to say that some active fund managers can't add value. It's just that the majority of them, and the majority of their activities don't. There is much evidence that in uncertain markets, knowing more than about 5 pieces of information on a stock doesn't lead to better decision making. It just leads to overconfidence. Picking the right 5 pieces of information to use is the key.

I agree with Montier that the fund management industry will end up restructuring itself to be more like the distribution of beasts on the plains of Africa - with 80% herbivores (passive/systematic funds) and 20% carnivores (active funds). As more than 70% of funds under management are currently actively managed, the industry has a long road of disruption ahead of it!

So, the NAPS Portfolio is an approach that is purposefully ignorant of its individual stock selections while retaining a confident focus on what the science shows really matters - a few key pieces of information … exposure to quality, value, momentum plus a dose of diversification. It therefore stands very much against almost all conventional wisdom on 'what it takes' to succeed in portfolio management…. which may ironically be why it's been succeeding.

Of course, there's no guarantee that the NAPS will continue to succeed. Past performance is not a guarantee of future results… and factor investing has been more and more in fashion. And when things come into fashion, they do go out of fashion - which means (in stock markets) that you lose money… or underperform. Everyone be warned.

If ignorance is bliss, Father said, shouldn't you be looking blissful? You should check to see if you have the right kind of ignorance. If you're not getting the benefits that most people get from acting stupid, then you should go back to what you always were - being too smart for your own good. Hal Sirowitz

The 2018 NAPS Portfolio

The rules to compile the NAPS portfolio have been changing over time. Originally, I just selected the top 2 stocks from each sector by StockRank, excluding the small and hard to trade. But in 2016, I introduced some size group diversification to ensure it wasn't just full of small caps. And in 2017, we launched the RiskRatings which analyse the volatility of each share on a scale from conservative to highly speculative. In 2018, I'm relaxing the sector rules to incorporate more diversification across Risk Ratings.

I've always said that these methods are a jazz sheet to riff on, not a prescription. Some readers use different rankings (QM Rank/High Flyers), some filter additionally for Quality or Yield, others use Stop Losses. It's the principles that matter, rather than the specifics. Ultimately, we are all DIY investors, and we all live and die by our own decisions.

So, my rules for 2018 are as follows:

Sort by

  • The StockRank - our overall measure of Quality, Value and Momentum.

Sector Diversification

  • At least 1 from each sector, no more than 3.

  • No more than 1 from each industry group.

Size Diversification

  • A third in each size group - small, mid, and large.

  • A minimum of £25m Market Cap.

  • Less than a 5% bid-ask spread.

Risk Diversification

  • 50% Conservative/Balanced and 50% Adventurous/Speculative.

  • No Highly Speculative shares.

Running these rules systematically across the UK universe of stocks creates the list of shares published below. Here's the diversity breakdown:

The one thing I'm uncomfortable with this year is the lower weighting of "Defensives" (Utilities, Healthcare and Consumer Defensives), but I'm going to trust in the higher weighting of Conservative and Balanced shares doing their job of providing a bit of spine in a downswing.

And to protect my ignorance, I've passed the list over to Ben Hobson's pen and Alex Naaamani's research to compile the write-ups. Thanks to them for the resulting briefs which are set out below.

Safe Investing in 2018 - and remember DYOR!