A Roller-Coaster Ride to a Strong Finish in 2006

    by Wayne A. Thorp

    After experiencing a lackluster start one year earlier, investors were no doubt pleased with the onset of 2006 as they rode the S&P 500 up to a quick 3.7% gain over the first six trading days of the new year.

    However, reality poured cold water on the market rally toward the end of January in the name of earnings season. For the next few months, the market and investors were on a roller-coaster ride driven by corporate earnings; the deflating housing market; a weakening dollar; rising inflation, wages, and commodity prices; and Federal Reserve actions.

    Just as the market seemed to break out of its funk and various indexes—including the S&P 500—were climbing to five-year highs, the Federal Reserve stalled the ride by failing to quell Wall Street’s fears of continued rising interest rates. Between May 5, when the S&P 500 closed at its year-to-date high, and June 13, the S&P 500 dropped nearly 8%.

    Interestingly, just as many investors were wishing they had followed the old adage “sell in May and go away,” comments made by Fed Chairman Bernanke regarding easing inflationary pressure calmed investors’ nerves and formed the foundation of the second-half rally of 2006. Within a few days many of the broad indexes—including the S&P 500 and NASDAQ composite—found their bottoms for the year. Since then, the market has enjoyed an almost uninterrupted upward march since the middle of July. After closing at 1234.49 on July 17, the S&P 500 gained over 14% through the close of December 8. Year-to-date, the S&P 500 has risen 12.9%.

    Of the 58 strategies now tracked on AAII.com, only four failed to generate positive returns for the year through December 8, 2006. In comparison, 39 of 54 methodologies had positive returns through June 9, the time of our mid-year review (four new screens have been added since that time). Table 1 on page 19 presents the year-to-date and annual performance since 1998 of the stocks tracked on AAII.com, along with index performance data. The 58 screening approaches are grouped based on their “style” orientation—growth versus value, etc.—with additional specialty and sector methodologies broken out separately.

    Within each of these groups in Table 1, the screens are ranked in descending order on their 2006 year-to-date performance (through December 8, 2006).


    The Top Screens

    This year, the leading strategy in terms of one-year performance is the value-oriented “Enterprising Investor” methodology of Benjamin Graham with a year-to-date return of 56.1%, the largest single-year gain of any approach since 2004.

    Also this year, a newcomer has supplanted Martin Zweig at the top of the list for long-term performance: James O’Shaughnessy’s Tiny Titans growth and value strategy has gained 2,730.6% since the start of 1998 after gaining 27.8% this year.

    Small-cap stocks reigned supreme in 2006, as the S&P SmallCap 600 index gained 15.2% through December 8 while the S&P MidCap 400 underperformed both the small-cap and large-cap indexes for the first time since 1998 with a 10.6% return.

    In addition, value-oriented strategies re-exerted their dominance over growth approaches as large-, mid-, and small-cap value indexes outperformed their respective growth counterparts.

    Evaluating Strategy Performance

    Table 1 summarizes the performance and variability of the stock screens created and tracked using AAII’s Stock Investor Pro fundamental stock screening and research database and presented on AAII.com.

    When examining performance data, it is important to remember that past performance is not a proxy for future results. Several examples effectively illustrate this point:

    • The top-performing strategy in 2005, the Murphy Technology screen, struggled to stay in positive territory in 2006, eking out a 0.8% gain through December 8.
    • The non-sector/non-specialty screen with the largest loss in 2005—the Dogs of the Dow Low Priced 5 approach—was the top-performer for much of 2006 and has a year-to-date gain of 29.7%.
    • The Piotroski screen, which is one of the top long-term performers, has turned in negative returns the last two years (a total loss of 24%); one of only two non-sector/non-specialty methodologies with losses each of the past two years.

       What It Takes: The Investment Characteristics of the 2006 Winners

    Table 2 presents the current characteristics of the top- and bottom-performing strategies for 2006, as well as cumulatively since the start of 1998.

    For the first time in several years, none of this year’s worst-performing strategies are specialty or sector screens. In addition, only four of the 58 approaches tracked on AAII.com were down for the year.

    Note that there is no characteristic data for the Piotroski strategy, the poorest-performing approach for 2006. For the last several months, no companies have passed this screen, so we are unable to generate statistics for the companies that make up the portfolio.

    Market Capitalization

    The median market capitalization (share price times number of shares outstanding) of the stocks that make up the major S&P indexes is:

    • S&P 500: $13.2 billion
    • S&P MidCap 400: $2.7 billion
    • S&P SmallCap 600: $890 million

    Among the top 2006 performers, the Graham Enterprising Investor companies have a median market capitalization of $118 million, which falls into the realm of micro-caps.

    Despite small-cap stocks, on average, being the top segment for the year, the only other small-cap screen to make our top-five listing is the Foolish Small Cap 8 Revised strategy with a median market capitalization of $594 million.

    The ADR approach is the only large-cap methodology among the 2006 top-performers with a median market capitalization of just under $7 billion.


    The price-earnings ratio (price divided by trailing 12-month earnings per share) of the Graham Enterprising Investor screen is 7.0, roughly a third of the median value, 19.8, for all the exchange-listed stocks currently in the Stock Investor Pro database. The screen looks for companies with price-earnings ratios that are in the bottom 10% of the stock universe.

    The value elements found in three of the five top-performing methodologies for 2006 reflect the overall dominance of value-oriented investing this year. We also see that the current portfolios of three of the five top-performing methodologies have price-earnings ratios below the typical exchange-listed stock, as do three of the worst-performing strategies.

    The Graham Enterprising Investor screen also has the lowest price-to-book-value ratio (price divided by book value per share). Its ratio of 1.2 is almost half the median value for all exchange-traded stocks and is at the top end of the screen’s other value filter, which requires the companies have a price-to-book-value ratio of 1.2 or lower.

    Interestingly, the multiples—price-earnings, price-to-book, and price-to-sales ratios—of losing strategies tend to be lower than those of the winning strategies for 2006.

    The price-earnings to earnings-per-share-growth ratio is called the PEG ratio and attempts to balance the trade-off between price-earnings ratios and earnings per share growth rates. Investors are willing to pay more for current earnings when there are reasonable expectations of growth and higher earnings in the future.

    The PEG ratio is computed by dividing the normalized price-earnings ratio (price divided by the consensus earnings per share estimate for the current fiscal year) by the estimated earnings per share growth rate for the next three to five years. Normally, companies with PEG ratios near 1.0 are considered fairly valued. Ratios above 1.5 may indicate overvalued stocks, and ratios below 0.5 potentially indicate attractively priced (undervalued) stocks.

    In general, both the top- and bottom-performing methodologies had PEG ratios below the typical exchange-listed stock. As a rule, growth strategies tend to have higher PEG ratios. Among the top- and bottom-performing strategies this year, however, the Graham Enterprising Investor approach has the highest PEG ratio of 3.1. This is a result of the anemic 2.7% estimated growth rate in earnings per share for the next three to five years.

    Relative Strength

    The relative strength index in the table is calculated against the performance of the S&P 500. Stocks with performance equal to that of the S&P 500 over the last 52 weeks have a relative strength index value of zero. A relative strength value of 26 indicates that the stock outperformed the S&P 500 by 26%. Negative numbers indicate underperformance relative to the index.

    The stocks currently comprising the Graham Enterprising Investor screen have a median relative strength value of 9%, indicating that the individual stocks currently passing the screen have outperformed the S&P 500 by 9% over the last year.

    All of the top-performing methodologies in 2006 are currently selecting stocks that have outperformed the S&P 500 over the last year. The T. Rowe Price strategy is the only 2006 bottom-performing approach currently made up of stocks with current negative relative price strength.

    Winning Characteristics

    When looking at those strategies that have achieved long-term success, several common factors are apparent:

    • Low multiples (price-earnings, price-to-book value, etc.), more on a relative rather than an absolute basis;
    • An emphasis on consistency of growth in earnings, sales, or dividends;
    • Strong financials;
    • Price momentum;
    • Upward earnings revisions.


    The 2006 Overall Winner

    The Graham Enterprising Investor approach looks for unpopular dividend-paying companies with low price-earnings and price-to-book ratios that are exhibiting positive earnings and have a reasonable amount of long-term debt relative to net working capital (current assets less current liabilities). The screen’s 56.1% year-to-date return is its largest since 1998, propelling it to a long-term gain of 591.3% since the start of 1998.

    This is also the second year in a row where a strategy of Benjamin Graham, considered by many to be the father of value investing, led all value-oriented methodologies. Last year, it was Graham’s Defensive Investor screen that was on top of the value-oriented strategy list.

    Value Winner

    The top long-term category leader among the value approaches is the John Neff screen, which has a cumulative gain of 902.5% since the start of 1998.

    Neff, former manager of the Vanguard Windsor fund, used a strict contrarian philosophy when searching for stocks with low price-earnings ratios relative to growth, and solid forecasted earnings and historical sales growth.

    On average, this screen tends to isolate large-cap value stocks in sectors such as basic materials, capital goods, and financials.

    Growth & Value Winner

    The revised version of the Motley Fool’s Foolish Small Cap 8 approach turned in the second-highest return in 2006 and led all growth and value strategies with a 43.8% return.

    This screen builds on the original Foolish 8 strategy, which uses eight criteria to look for profitable and rapidly growing small companies with strong price momentum.

    Revisions made by the Motley Fool add elements of valuation and management effectiveness, and also relax the small-cap criteria. Despite this, the companies that currently pass the screen tend to be small-cap companies in the financial and healthcare sectors.

    The top long-term performer in the growth and value segment is the O’Shaughnessy Tiny Titans screen, which has risen 2,730.6% since 1998. It has also generated the top overall long-term return, and we will discuss it in greater detail later in this article.

    Growth Winner

    The top performer among the growth strategies this year is that of Chicago-based money manager Richard Driehaus.

    This momentum approach, which has gained 42.8% year-to-date, focuses on small- to mid-cap companies with strong, sustained earnings growth that have had significant earnings surprises. Given its high-growth nature, it is probably not surprising that many of the companies currently passing the Driehaus screen are mid-cap companies in the technology and biotech industries. The original CAN SLIM strategy’s 22.1% gain this year propelled its segment-leading cumulative return to 1,072.4%. This approach combines fundamental and technical factors to seek companies with strong earnings and price momentum, and tends to isolate smaller-cap growth stocks.

    2006 Winner: A Closer Look

    The Monthly Holdings columns in Table 1 offer data on portfolio holdings over time—the average number of stocks that were held in each hypothetical portfolio over the last nine years and the average turnover percentage from month to month.

    On average, five companies have passed the Graham Enterprising Investor screen since 1998. For 2006, the screen, on average, generated less than three companies per month, with the most stocks being four in August and September.

    When investing based solely on quantitative screening results, one way to insulate yourself from hidden landmines in the portfolio is by investing in several companies. As the number of companies passing a given methodology declines, it raises the importance of individual company analysis since you have greater exposure to individual stock price movements.

    The Turnover Percent column provides an indication of how many stocks exit a given strategy month-to-month. Every month, the screens tracked by AAII.com are rebalanced and only those companies passing the screen for a given month are held over to the next. The lower the percentage turnover, the greater the likelihood a company will continue to pass a screen month after month.

    In addition, since our performance figures do not take into account transactions costs such as commissions, you can use the turnover figure to gain a better understanding of how these costs would cut into the reported hypothetical performance.

    Since 1998, the Graham Enterprising Screen has seen 34.2% monthly turnover. This means that, on average, just over 34% of the companies that pass the screen one month did not pass the next month. The O’Shaughnessy Tiny Titans methodology, with the highest cumulative return of 2,730.6%, also has a relatively high monthly turnover of 42.5% (the median monthly turnover for all the approaches tracked on AAII.com is 31.9%).

    The Graham Enterprising Investor screen outperformed all other strategies in 2006 with a highly concentrated portfolio of low price-earnings and price-to-book stocks of dividend-paying companies with positive earnings and strong balance sheets. The strategy has generated positive returns in all years over the analysis period, except in 1998 and 1999. It was during that period that the tech-fueled bull market was in full swing—a time when value approaches typically underperform. When evaluating performance, one must also take into consideration the risk associated with generating that performance: Are you prepared to stomach the volatility that typically accompanies high performance?

    The Monthly Variability columns report the greatest monthly percentage gains and losses of each approach as one indication of the volatility it has experienced over the last nine years. The Graham Enterprising Investor approach has experienced a maximum loss of 18.7% during a single month since the start of 1998 and gained as much as 33.1% in one month. By way of comparison, the worst month the S&P 500 had over the period was a 14.6% loss and its largest single-month gain was 9.7%. For 2006, the Graham Enterprising Investor portfolio had two months with double-digit growth (16.5% in January and 15.4% in October) and saw its biggest single-month loss in July when it lost 10.5%.

    The Monthly Variability columns also report the monthly standard deviation over the full study period. Standard deviation is a measure of total risk, expressed as a monthly change, which indicates the degree of variation in return relative to the average monthly return over the test period. As a rule, the higher the standard deviation, the greater the volatility of returns and, thus, the greater overall risk of the strategy.

    The 7.9% monthly standard deviation of the Graham Enterprising Investor approach is the second-highest among all value strategies and is higher than most of the strategies tracked on AAII.com and, by means of comparison, is almost twice the 4.4% monthly standard deviation of the S&P 500.

    In contrast, the NASDAQ 100, which consists of the largest (by market capitalization) domestic and international non-financial companies listed on the NASDAQ Stock Market, has a monthly standard deviation of 9.9%.

       The Stocks That Propelled the Top 2006 Strategy

    The Graham Enterprising Investor approach and its 2006 gain of 56.1% through December 8, 2006, ended the Murphy Technology screen’s two-year run as the top-performing strategy tracked on AAII.com. It is useful to look beyond the performance data and examine the individual stocks that contributed to the overall return.

    The Graham Enterprising Investor approach was able to produce solid, consistent returns this year and over the long-term by isolating large, unpopular dividend-paying companies with low price-earnings and price-to-book ratios that are exhibiting improving earnings and have a reasonable amount of long-term debt relative to net working capital (current assets less current liabilities).

    The Graham Enterprising Investor methodology also has the smallest average portfolio size among all the strategies tracked by AAII.com. This year the portfolio, on average, held less than three stocks in a given month. Investing in such a small number of companies makes the portfolio more susceptible to individual stock price movements (on both the upside and downside). This is why the volatility of the Graham Enterprising Investor strategy, as measured by monthly standard deviation, is as high as it is relative to the other strategies tracked by AAII, where it ranks in the top quarter (see Table 1 on page 19).

    Table 3 presents the nine stocks that passed the Graham Enterprising Investor screen in 2006, as well as their performance while they were held in the hypothetical portfolio, the number of months the stock was held this year, and select current financial data.

    POSCO was the best-performing stock that passed the Graham Enterprising Investor screen during 2006. POSCO is an integrated steel producer in Korea, manufacturing a variety of steel products sold primarily in Korea and throughout Asia, its major export market, including China and Japan. It was held for the duration of 2006, generating a 59.2% return. POSCO’s strong performance in the first and last quarter of 2006 allowed it to weather a 16.2% decline over the three-month period from May through July.

    The largest one-month return came from Building Materials Holding Corporation when it jumped 21.9% in August. The residential building products and construction services company entered August trading at its low for the year, having lost over 38% since the close of 2005. On August 11, the company’s shares jumped 13.7% following a healthy increase in July retail sales. The company did not pass the screen at the end of August because its price-to-book-value ratio had risen above the screen’s 1.2 maximum, from 1.14 to 1.4.

    Blair Corporation was the only company held in the Graham Enterprising Investor portfolio in 2006 to have a total negative return. The company sells fashion apparel for men and women, as well as home products, mainly by direct mail. The company first passed the screen at the end of April and was held for the next seven months, losing 20.7% over that time.

    Blair serves as an excellent example of why one should not mechanically invest in any screening system. Blair shares fell over 13% the last trading day of March, forcing down the company’s price-to-book value ratio below the 1.2 threshold to 1.19 from 1.27. The day before, the company announced a 1,638% decline in same-quarter earnings. The company also suffers from low trading volume—trading roughly 10,000 to 14,000 shares each day. Combine this with a general lack of analyst or editorial coverage of the company, and many investors may have chosen to bypass it altogether. The Graham Enterprising Investor screen’s 2006 performance is not a flash in the pan. Although the strategy greatly underperformed at the tail-end of the bull market in 1998 and 1999, the screen has been able to generate above-average long-term returns. But one drawback is the small number of companies passing the screen month to month, which places a greater onus on investors to do their due diligence to protect themselves from potential problems at the company level.


    The Long-Term Winner

    The Total Price Change column in Table 1 indicates the percentage amount each hypothetical test portfolio has appreciated, or declined, between January 1, 1998, and December 8, 2006. Note that this return does not include dividend payments. Large-cap value strategies that tend to generate high dividends, such as the Dogs of the Dow, would be negatively impacted by this.

    Figure 1.
    Winning Performance:
    Graham Enterprising
    and O'Shaughnessy Tiny Titans

    The current average dividend yield of the Dogs of the Dow screen is 3.7%; shareholders of these stocks would actually have a return that is higher by approximately this amount, annually. The top-gaining strategy over the last nine years is the O’Shaughnessy Tiny Titans screen, which is up 2,730.6% cumulatively after gaining 27.8% year-to-date as of December 8, 2006. Meanwhile, the S&P 500 index is up a total of 45.3% over the entire period.

    O’Shaughnessy believes there are many advantages to investing in micro-cap stocks. Few analysts cover these small stocks and this lack of coverage leaves much room for upside potential when good stocks are largely unnoticed. Additionally, micro-cap stocks have a low correlation with other market capitalization strategies.

    The Tiny Titans screen is very simple in its construction—it looks for exchange-listed stocks of U.S.-based companies with market caps between $25 million and $250 million, price-to-sales ratios less than one and strong upward price movement over the last 12 months.


    The first step of stock screening is to establish a set of practical rules to identify a collection of potential investment opportunities.

    The next step is to have the discipline to follow these rules instead of allowing your emotions to dictate your buy and sell decisions.

    The AAII Stock Screen strategies are based on relatively simple screens that are our interpretations of the investment approaches advocated by prominent investment professionals or are based on basic investment principles backed by academic research and real-world results. Examining the characteristics of an investment methodology reveals many of the practical problems you may run into when trying to develop your own disciplined approach to investing.

    One pitfall to avoid when looking at the performance of these strategies is to simply select the methodology with the highest return and blindly buy the stocks that pass the screen each month. Instead, it is important to gain an understanding of the forces that influence the portfolio’s performance and how these strategies might perform during current and expected future economic and market environments.

    Most importantly, however, remember that screening is only a first step. The results of any screen are not a “buy” or “recommended” list. There are qualitative elements to consider that cannot be quantified in a mechanical screening process. Due diligence is needed to evaluate a stock to decide if it has the necessary financial strength and the risk and time horizon qualities required to earn a place in your investment portfolio.

    For further information on these approaches, consult the Stock Screens area of AAII.com.

→ Wayne A. Thorp