Value Investing Strategies with Lower Risk and Turnover

The purpose of this article is a final follow up to my value investing screen/backtest based on reader comments and suggestions. To review my previous articles,  I backtested a value strategy based on the following criteria starting in 1/1/2002 which rebalanced every 4 weeks and assumed .5% slippage.

Price to Book < 1
Return on Equity Last 12 Months > 0
Return on Assets Last 12 Months > 0
Total Debt to Equity < 40%
Current Ratio > 3
Price to Free Cash Flow Trailing 12 Months <15
Projected Earnings Next Fiscal Year > 0
No OTC Stocks

I backtested the same value investing strategy but which purchased passing companies only if the S&P 500 Index was also above its 200 day moving average.  The goal was to reduce risk by staying in cash when the overall market is in a downtrend.  This potentially reduces overall returns but can reduce drawdowns and general investor angst.  Regular readers know I am generally a fan of this type of investing as a means to increase risk-adjusted returns. The primary inspiration for this type of strategy is Mebane Faber, author of The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets and creator of AlphaClone.

$100 invested in this strategy on 1/1/2002 turned to $574.70 assuming .5% slippage, no commission, rebalanced every 4 weeks, and no return on cash balances. For returns which ignored the underlying indices moving average please see my previous articles here and here.  A visual represenation is below:

Secondly, I decided to run the screen on a longer timeframe in order to reduce turnover.  The portfolio was rebalanced every 3 months.  This screen was not run using the 200 day moving average requirement and all qualifying stocks were held (in other words, I did not limit the number of stocks as in some examples from my previous two articles).  The results are not as impressive as a 4 week rebalance but still beat the benchmark. $100 turned to $321.30 :

However, when limiting the number of positions to no more then 5, ranked by the lowest return over the past 26 weeks, the returns are better on a 3 month rebalance.  $100 turned to $749.50 (see below) and when ranked by the lowest returns over the past 13 weeks $100 turned to $424.

Finally, a reader suggested comparing my results to a different benchmark.  Using the same timeframe, $100 invested in the Russel 200 Index turned to $129.60.  This excludes dividends.  When we compare this to an investment in IWM, the IShares Russell 2000 Index ETF, on 1/1/2002, the return with dividends would have been $142.38.  These results are better then the S&P 500 Index benchmark but still far below any of the results posted in this article or my previous two articles.

As I noted previously, the screening/backtesting tool was StockScreen123, which is currently in Beta.  Thus, please do your own due diligence before making an judgments, assumptions, or investment decisions based on data provided here.  I have no position in the stocks mentioned. Below are the current results of the original value screen:

12/30/09
Free Trend Analysis
Ticker Name Here
ACET Aceto Corporation Here
ALG Alamo Group, Inc. Here
CRDN Ceradyne, Inc. Here
DWSN Dawson Geophysical Company Here
LAKE Lakeland Industries, Inc. Here
NWPX Northwest Pipe Company Here
QLTI QLT Inc. (USA) Here
AOB American Oriental Bioengineer Here
INET Internet Brands, Inc. Here



Last Day to Win a Free Book From Me

If you are interested in winning a copy of Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living, visit Scott’s Investments and do the following:

1) Enter you email to subscribe to the blog on the left-hand side of the page (current subscribers can skip this step). 2) When you receive one of the blog’s email updates between now and December 29th just reply to any one of the emails with your guess on where the S&P 500 will open on January 4th (be specific!).  3) The closest guess will win a free copy of the book and I will email the winner for your shipping address (sorry, US addresses only).  Entries must be received before the market opens on December 30th. 



UPDATE: I’ll extend the deadline to noon CST on the 30th to give people a chance to send their emails over lunch. 

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Value Investing – Strategies for Improvement

Yesterday I wrote an article which backtested a basic value strategy. To  summarize, I backtested a value strategy based on the following criteria starting in 1/1/2002 which rebalanced every 4 weeks and assumed .5% slippage (a note about slippage using StockScreen123 – stocks that pass the screen are equally weighted at each rebalance. Slippage is only calculated when selling out of a stocks that no longer passes and for new stocks. The slippage to bring stocks that remain from one period to the other are not taken into account):

Price to Book < 1
Return on Equity Last 12 Months > 0
Return on Assets Last 12 Months > 0
Total Debt to Equity < 40%
Current Ratio > 3
Price to Free Cash Flow Trailing 12 Months < 15
Projected Earnings Next Fiscal Year > 0
No OTC Stocks

As I noted yesterday one significant drawback of the screen is that while the average number of positions is 10 stocks, during 2008 there were periods where the number of qualifying companies was as high as 77. In addition, turnover can create additional tax burdens and trading costs could significantly reduce returns. 

One strategy to reduce the potential number of trades/commissions is to limit the number of potential stocks one holds.  When running the screen every 4 weeks, one could pick the top 5 stocks based a predefined set of criteria.  I ran the identical screen as the one above but ranked 5 stocks based on the stock’s returns over the preceding 26 weeks.  If one ran the above screen and purchased the 5 stocks with the lowest performance over the preceding 26 weeks, the results with .5% slippage are below:

  • $100 invested in the strategy turned to $1182.70, versus $98.20 in the S&P 500 (excluding dividends)
  • Average turnover was still high at 45%
The strategy suffered signifcant drawdowns in 2008.  However, had the strategy been implemented at the beginning of 2008 it would have still be well ahead of the market as of today’s close:

I also ran the identical screen as the one above but ranked 5 stocks based on the stock’s returns over the preceding 26 weeks.  If one ran the above screen and purchased the 5 stocks with the highest performance over the preceding 26 weeks, the results with .5% slippage are below:

  • $100 invested in the strategy turned to $421.1, versus $98.20 in the S&P 500 (excluding dividends)
  • Average turnover was still high at 41%
Still good returns, but not as impressive as the ‘contrarian’ strategy of purchasing the worst performers based on 26 week returns. Admittedly, I expected the opposite – that the highest momentum stocks would outperform the lowest.
An investment at the start of 2008, near the beginning of the worst performance period for the strategy, would be up 3.8% today:

I acknowledge the backtest is not a thorough academic study and is not a large enough sampling period to draw major conclusions.  However, it is a thought-provoking  exercise for value-oriented investors.  The screen criteria provides a small list of stocks which, if invested in, has provided excess returns over the past 7 years when one ignores tax implications, any additional slippage beyond the .5% assumption, and commissions.

For those interested in the current stocks passing my value criteria, please see below (no stock disclosures):

12/28/2009












Ticker Name Free Trend Analysis Start End Ret (%) MktCap
SPAR Spartan Motors, Inc. Here 5.12 5.34 4.3 167.69
SIGM Sigma Designs, Inc. Here 10.87 11.08 1.93 290.69
NWPX Northwest Pipe Company Here 25.21 28.66 13.69 232.85
HOTT Hot Topic, Inc. Here 5.66 6.41 13.25 254.7
ACET Aceto Corporation Here 5.07 5.27 3.94 125.63
AOB American Oriental Bioengineer Here 4.28 4.37 2.1 333.65
MATK Martek Biosciences Corp. Here 18.42 19.09 3.64 606.28
DIVX DivX, Inc. Here 5.24 5.23 -0.19 171.42
CRDN Ceradyne, Inc. Here 18.38 18.6 1.2 470.98
LAKE Lakeland Industries, Inc. Here 7.95 8 0.63 43.5
INET Internet Brands, Inc. Here 7.69 7.8 1.43 345.94
OPTV OpenTV Corp. Here 1.42 1.38 -2.82 196.1
ALG Alamo Group, Inc. Here 16.08 15.87 -1.28 183.13
QLTI QLT Inc. (USA) Here 4.74 5.09 7.38 259.5

Win a Free Book – Just Send Me an Email

If you are interested in winning a copy of Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living, visit Scott’s Investments and do the following:

1) Enter you email to subscribe to the blog on the left-hand side of the page (current subscribers can skip this step). 2) When you receive one of the blog’s email updates between now and December 29th just reply to any one of the emails with your guess on where the S&P 500 will open on January 4th (be specific!).  3) The closest guess will win a free copy of the book and I will email the winner for your shipping address (sorry, US addresses only).  Entries must be received before the market opens on December 30th.

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Backtesting a Value Strategy

I’ve recently featured some value screens for stocks. I decided to see how the criteria held up over the past few years by running a backtest using StockScreen123.  The criteria I backtested were:

Price to Book < 1
Return on Equity Last 12 Months > 0
Return on Assets Last 12 Months > 0
Total Debt to Equity < 40%
Current Ratio > 3
Price to Free Cash Flow Trailing 12 Months < 15
Projected Earnings Next Fiscal Year > 0
No OTC Stocks

I assumed .5% slippage and rebalanced every 4 weeks. The summary of the first results are below, with $100 starting on 1/1/2002 using the strategy turned into $675.99 while $100 in the S&P 500 lost value, ending in $98.12 (excluding dividends).  This backtest is not meant to be a comprehensive study, but does give one an idea of the possibilities of well-defined strategies.  I am not implying this is the best value screen available but it does show promise.

The starting timeframe of a study can greatly impact how the results are perceived.  As you can by the first graph below, 2008 was not a good year for the market or for the screen.  However, as you can in the bottom graph (12/28/07-12/28/09) even in the worst period for the screen since 2002, it kept pace with a bearish market. Admittedly, this is not much of a consolation when your drawdown approaches 50%.  I will offer two possible strategies in tomorrow’s article for how to avoid such a significant drawdown.
 
One significant drawback of the screen is that while the average number of positions is 10 stocks, during 2008 there were periods where the number of qualifying companies was as high as 77. In addition, turnover can create additional tax burdens and trading costs will reduce returns.  However, stay tuned for a follow-up article tomorrow on some different strategies to a) limit or rank the number of stocks, and b) some additional filters for risk-averse investors.

The current stocks meeting the criteria are at the bottom of the article (return data based on a rebalance on 12/21/09. No stock position disclosures



#Pos AvgRet% No Slip $SP500 Ret% Excess Ret% $100 Investmt $100 in $SP500 Turnover% Min % no slip Max % no slip StdDev Ret%
Average 10 2.26 0.13 2.14 675.99 98.12 32.81 -11.54 19.95 10.97
Up Markets 63 9 6.49 3.18 3.31 32.58 -7.44 25.77 11.88
Down Markets 42 11.4 -4.07 -4.45 0.38 33.15 -17.68 11.23 9.61

12/28/2009












Ticker Name Free Trend Analysis Start End Ret (%) MktCap
SPAR Spartan Motors, Inc. Here 5.12 5.34 4.3 167.69
SIGM Sigma Designs, Inc. Here 10.87 11.08 1.93 290.69
NWPX Northwest Pipe Company Here 25.21 28.66 13.69 232.85
HOTT Hot Topic, Inc. Here 5.66 6.41 13.25 254.7
ACET Aceto Corporation Here 5.07 5.27 3.94 125.63
AOB American Oriental Bioengineer Here 4.28 4.37 2.1 333.65
MATK Martek Biosciences Corp. Here 18.42 19.09 3.64 606.28
DIVX DivX, Inc. Here 5.24 5.23 -0.19 171.42
CRDN Ceradyne, Inc. Here 18.38 18.6 1.2 470.98
LAKE Lakeland Industries, Inc. Here 7.95 8 0.63 43.5
INET Internet Brands, Inc. Here 7.69 7.8 1.43 345.94
OPTV OpenTV Corp. Here 1.42 1.38 -2.82 196.1
ALG Alamo Group, Inc. Here 16.08 15.87 -1.28 183.13
QLTI QLT Inc. (USA) Here 4.74 5.09 7.38 259.5
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Win a Free Book from Me!

If you are interested in winning a copy of Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living, visit Scott’s Investments and do the following:

1) Enter you email to subscribe to the blog on the right-hand side of the page (current subscribers can skip this step). 2) When you receive one of the blog’s email updates between now and December 29th just reply to any one of the emails with your guess on where the S&P 500 will open on January 4th (be specific!).  3) The closest guess will win a free copy of the book and I will email the winner for your shipping address (sorry, US addresses only).  Entries must be received before the market opens on December 30th.

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Market Readings for a Short Week

John Mauldin: The Age of Deleveraging (pdf)
“Note the still widening spread between US 10-year yields over 2-year yields, otherwise known as the yield curve, on this historical. It is still rising, indicating to me that quantitative easing continues. The time to start thinking about closing long portfolios in anticipation of the next bear market, I suggest, will be when the yield curve next inverts by moving below zero. However, the lead was so early last time (early 2006) that some of us became complacent about it.”
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Trend Trading for a Living: A Book Review (+ Win a Free Copy!)

Regular readers of my blog know that I have an interest in trend and momentum systems so I was excited to begin reading Thomas Carr’s Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living (available from McGraw-Hill).  The book did not disappoint and overall does an excellent job of following through on the title and at the end of the book review I will tell you how to win a free copy

I have read other, more high publicized trend trading books which deliver very little in terms of substantial trading strategies.  These books that are more substance than style, while popularizing the term ‘trend trading’, have failed to articulate specific trade setups.  Carr’s book is quite the opposite – he presents several, highly specific trend screens and trading strategies for trades targeted to last 3-30 days.

It is important to understand that Carr is targeting investors who may not be full-time traders but are considering taking that leap.  It is not a book intended for an investor looking to place an occasional trade in a 401(k) or who do not have the time to screen for trade setups on a daily basis.  Carr’s strategies take time to screen and identify potential trades; thus, anyone considering reading the book should be ready to commit time to implement his ideas.

Part of the appeal of the book is that Carr shows how free services such as Stockcharts.com can be used to screen and chart potential trades. In theory the reader would need nothing more then a brokerage account with trading capital and internet access in order to put his trading strategies to practice.  In addition, Carr tells readers the specific indicators he uses as well as how and when to look for chart divergences to increase odds of a profitable trade. He stresses the importance of identifying the trend before entering a trade (and shows how to identify the trend), and lays out different types of trades for different types of trending markets.

There are a few drawbacks in the book. First, Carr offers several options for stop losses but is not as specific as other parts of the book.  I would have liked to see more details on the percentages he uses in trailing stops and ATR stops.  Second, the chapters on options are unnecessary and better addressed in option specific books.

What sets Carr’s Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living is the attention to detail giving comprehensive trading strategies using free tools available on the internet.

If you are interested in winning a copy of Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living, visit Scott’s Investments and do the following:

1) Enter you email to subscribe to the blog on the right-hand side of the page (current subscribers can skip this step). 2) When you receive one of the blog’s email updates between now and December 29th just reply to any one of the emails with your guess on where the S&P 500 will open on January 4th (be specific!).  3) The closest guess will win a free copy of the book and I will email the winner for your shipping address (sorry, US addresses only).  Entries must be received before the market opens on December 30th.

Value Screen Part 2 – 5 Value Stocks to Consider

I have taken a recent interest in running deep value screens in an attempt to expand my investing horizons beyond the basic trend following and momentum systems I regularly track on Scott’s InvestmentsYesterday’s screen looked for stocks trading below book value with low debt, high relative cash, cash flow, and forward earnings.  Today’s screen is an expansion of that screen with some added criteria:

Forward P/E > 0
Price/Cash < 3
Price/Free Cash Flow < 15
Debt/Equity < .4
Price/Book < 1
Current Ratio > 3
Return on Assets > 0%
Return on Equity > 0%
Annual EPS Growth Next 5 Years > 0

The added criteria of positive ROA and ROE is an attempt to filter out companies that are bleeding assets and equity.  Each individual criteria as an isolated element are not strict but when combined as an aggregate screen the goal is to create a list of potential value candidates.  These screens are not a ‘buy list’ but are intended for further investigation. ACET, QLTI, and DIVX are the three stocks which also appeared on yesterday’s screen.  I debated keeping the Debt/Equity requirement at under .1 but decided to expand it to .4 for more results:

No stock disclosures

Ticker Company Trend P / B P / Cash ROA ROE Debt / Equity
ACET Aceto Corp. Here 0.89 2.5 2.46% 3.55% 0
AOB American Oriental Bioengineering Inc. Here 0.89 2.93 7.07% 11.76% 0.34
CRDN Ceradyne Inc. Here 0.74 2.14 1.83% 2.47% 0.13
DIVX DivX, Inc. Here 0.93 1.22 1.38% 1.56% 0
QLTI QLT Inc. Here 0.88 1.42 1.38% 1.75% 0
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Happy Holidays – 1 Last Minute Idea + a Free Book

Happy Holidays to everyone! Thanks for a great year.

If you are on the prowl for a list minute gift idea for an investor, consider a subscription to Mebane Faber’s (author of The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets) recent project AlphaClone. They had a great year launching their new project and I am truly impressed with the simplicity of the site and most importantly the outstanding returns of the various tracked hedge portfolios.

Also, I will be giving away a free copy of Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living next week to usher in the new year so stay tuned!

All the Best,

Scott

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