- S&P 500: $11.3 billion
- S&P MidCap 400: $2.6 billion
- S&P SmallCap 600: $806 million
- Low, but not necessarily the lowest, multiples (price-earnings ratio, price-to-book ratio, etc.);
- Emphasis on consistency of growth in earnings, sales, or dividends;
- Strong financials;
- Price momentum;
- Upward earnings revisions.
From Peak to Valley: The Stock Strategy Landscape in 2005
by Wayne A. Thorp
After a rocky start, the market spent most of 2005 hiking up and down, until undertaking a fourth-quarter rally (which was rapidly losing steam as the year drew to a close) similar to that of 2004. The S&P 500 seemingly found its footing in mid-October and gained 7.7% between October 13 and November 25, 2005. The S&P 500 gained 3.0% for all of 2005, while the S&P SmallCap 600 index was up 6.7% and the S&P MidCap 400 index was up 11.3%. Of the 54 strategies tracked on AAII.com, 41 had positive returns for 2005, as compared to only 23 at the time of our mid-year review.
Table 1 on page 16 presents the performance of the stock screens tracked on AAII.com, along with index performance data. The various screening approaches are listed depending on their growth versus value orientation, with additional specialty and sector screens broken out separately. Within each of these groups, the screens are ranked by their 2005 performance.
For the second year in a row, the value-priced technology screen following Michael Murphys philosophy led all strategies during 2005 with a 34.1% gain, while the growth-and-value Zweig approach reasserted its long-term dominance by gaining 27.8% during 2005, resulting in a 1,659.3% cumulative return since 1998.
The year 2005 was yet another good year for mid-cap stocks as the S&P MidCap 400 index gained 11.3% while the large-cap S&P 500 gained only 3.0%. Small- and mid-cap issues outperformed larger companies for the sixth consecutive year as the S&P SmallCap 600 gained 6.7%.
In a reversal over last year, growth-oriented strategies tended to perform better than value approaches for the small- and mid-cap segments during 2005, while large-cap value fared better than large-cap growth.
Gauging Strategy Performance
Table 1 summarizes the performance and variability of the stock screens built into AAIIs Stock Investor Pro fundamental stock screening and research database and presented on AAII.com.
When examining the figures, it is important to be mindful that past performance is not a proxy for future results. Despite being the best-performing strategy two years running, the Murphy Technology screen was the only strategy to show a loss in 2003, and it also had the largest decline in 2002 (79.6%). Furthermore, many of the top-performing methodologies of 2004 are at the bottom of their respective categories this year.
The 2005 Overall Winner
The Murphy low-price-to-growth-flow approach seeks technology stocks with high research and development spending, strong margins, a solid return on equity, and high revenue growth, but selling at an attractive valuation level. It is a growth-and-value strategy that invests in the highly volatile technology sector. The 34.1% gain by the Murphy screen is even more impressive given that exchange-listed technology stocks were down an average of 0.4% in 2005. Just like many approaches heavily invested in technology, the Murphy approach did well during the tech boom of the late 1990s, with a 139.7% gain in 1999. However, the bursting of the tech bubble and the ensuing bear market had a devastating impact on the Murphy methodology. Despite gaining almost 180% over the last two years (the approach was also last years top-performing strategy with a 107.9% gain), the Murphy screen has a cumulative loss of 29.0% since the beginning of 1998.
The Graham—Defensive Investor (Non-Utility) screen led all value strategies in 2005 with its 26.2% gain. Benjamin Graham is considered by most to be the father of value investing and the Defensive Investor screen based on his approach seeks out companies offering a minimum level of quality in terms of past performance and current financial position as well as a minimum level of value in terms of earnings and assets per dollar of share price. The screen tends to isolate larger-cap value stocks.
The long-term category-leading Piotroski screen, which was the top value strategy in 2004, has a cumulative gain of 960.8% since 1998. However, it was one of the worst-performing value strategies in 2005, registering a loss of 8.5%. The screen seeks stocks with low price-to-book values that have strong and improving financial strength, and it tends to turn up smaller-cap value stocks.
Growth & Value Winner
Following up on its spectacular performance in 2004, during which it gained 49.5%, the Martin Zweig methodology gained 27.8% in 2005 to lead all growth & value strategies. Martin Zweig is a former professor turned money manager/newsletter writer. Our interpretation of his strategy is based upon his book Martin Zweigs Winning on Wall Street (Warner Books, 1997), in which he outlines how to identify companies with strong growth in earnings and sales, a reasonable price-earnings ratio given the companys growth rate, insider buying (or at least a lack of heavy insider selling), and relatively strong price action.
In a turnaround from 2004, all but one of the growth screens generated positive returns for 2005. The single losing strategy for the year is the one based on the third edition of William ONeils book on the CAN SLIM approach. Ironically, the original CAN SLIM approach was able to bounce back from its only negative year in 2004 with a 2005 return on 24.1%. Both versions of this approach combine fundamental and technical factors to seek out companies with strong earnings and price momentum, and they tend to isolate smaller-cap growth stocks. The biggest difference between the two is that the third edition drops its focus on stocks that have a small number of shares outstanding. The difference in performance for the two CAN SLIM strategies may be because, in the long run and all else being equal, stocks with a small or reasonable number of shares outstanding usually outperform older, larger-capitalization stocks; the original CAN SLIM approach caps the number of shares outstanding that a company can have.
The original CAN SLIM strategys strong 2005 performance propelled it to a cumulative return of 860.3%.
|View From the Summit: The Investment Characteristics of the 2005 Winners|
Right from the beginning, 2005 gave investors an indication of a less-than-ideal investment environment. The much-ballyhooed January effect turned out to be a New Years hangover as the S&P 500 lost 2.5% in January. Anxiety relating to economic, political, and world issues carried over from the previous year and plagued the market for much of the year. If a weak dollar, rising short-term interest rates, the threat of a bubble in the housing market, and continued uncertainty in the Middle East were not enough to rattle investor nerves, one of the most destructive hurricane seasons on record added more turmoil to the economic and investment landscape. As the year progressed, small- and mid-cap issues outperformed large-cap strategies, and growth- and momentum-oriented approaches typically performed better than strategies that focused on value.
For the second year in a row, the Murphy low-price-to-growth-flow approach outperformed all the other strategies tracked on AAII.com, with a 34.1% return. Over the last two years, the Murphy approach has generated a cumulative gain of 178.8%. This is in stark contrast to the 86.5% cumulative loss the strategy sustained in 2002 and 2003. Exchange-listed technology stocks tracked in Stock Investor Pro lost 0.4% in 2005, so the few stocks passing the Murphy screen handily beat their peer group for the year. Despite the extraordinary gains the Murphy Technology approach has seen over the last two years, it still has the weakest cumulative eight-year return with a loss of 29.0% over the period.
Table 2 presents the current characteristics of the top- and bottom-performing strategies for 2005 and cumulatively since 1998.
As has been the case in years past, many of the bottom-performing strategies are specialty and sector screens. One of the top-performing approaches for 2005 is the Estimate Revisions Up 5% screen. Meanwhile, its counterparts—Estimate Revisions Down and Estimate Revisions Down 5%—made the cumulative list of weakest-performing screens. Note that the strong performance for the upward revisions screen and weak performance for the downward revision screens came in the month after the revision, which indicates the persistent impact of an earnings estimate in the months following the revision.
Among the top-performing strategies of 2005, the Stock Market Winners screen has the lowest price-to-book value ratio (price divided by book value per share). Its ratio of 1.3 is roughly half the median value for all exchange-traded stocks. This screen requires a price-to-book-value of 1.5 or lower. For the most part, the multiples (price-earnings, price-to-book and price-to-sales ratios) of winning strategies tend to be lower for the 2005 winners than for the losing strategies.
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 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 estimated current fiscal year earnings per share) by the estimated earnings per share growth rate. 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 stocks.
In general, the top-performing methodologies had PEG ratios below the typical exchange-traded stock, while the bottom-performing strategies had higher PEG ratios. As a rule, growth strategies tend to have higher PEG ratios. Among the top- and bottom-performing strategies this year, however, the Dogs of the Dow—Low Priced 5 approach has the highest PEG ratio of 3.0, which is a by-product of the relatively low price-earnings ratio of 18.2 for the current portfolio and a paltry 5.4% estimated growth rate in earnings per share over the next three to five years.
The Murphy strategy and the Graham—Defensive Investor (Non-Utility) approach were the only top-performing methodologies in 2005 that selected stocks not currently outperforming the S&P 500. In a break from last year, the rest of the top-performing strategies are made up of stocks with current positive relative price strength.
Turnover & Risk
The Monthly Holdings columns in Table 1 offer data on portfolio holdings over time—the average total number of stocks that were in each portfolio over the last eight years and the average turnover percentage from month to month. On average, 11 companies have passed the Murphy Technology screen since 1998. The screens strong performance in 2005, and 2004, came from holding only a small number of companies in any given month (the screen averaged only two passing companies per month in 2004 and five per month in 2005).
The Percent Turnover column provides an indication of how many stocks leave a given strategy from month to month. Every month, these portfolios are rebalanced and only those companies passing the screen for a given month are held over to the next month. The lower the percentage turnover, the greater the chance that a company will continue to pass a screen month after month. Since 1998, the Murphy Technology screen has experienced a 24.9% monthly turnover. This means that, on average, almost 25% of the companies that pass the screen each month did not pass the month before. The Zweig approach, with the highest cumulative return of 1,659.3%, also has a relatively high monthly turnover of 43.5%.
The Murphy Technology screen outpaced all other approaches in 2005 with a concentrated portfolio of reasonably priced technology stocks—a high-risk approach that has paid off over the last two years. When measuring performance, the risk of the strategy should also be considered: 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 strategy as one indication of the volatility it has experienced over the last eight years.
The Murphy Technology approach had a maximum loss of 44.9% in value during a single month, and has gained as much as 58.5% in one month. By way of comparison, the most the S&P 500 index gained in a single month was 9.7%, and its largest single-month loss was 14.6%.
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 experienced relative to the average for a strategy over the test period. As a rule, the higher the standard deviation, the greater the total risk of the strategy.
The 16.2% monthly standard deviation of the Murphy Technology screen is by far the highest among all the screening strategies and well above the 4.6% figure for the S&P 500. The NASDAQ 100, which includes 100 of the largest domestic and international non-financial companies listed on the NASDAQ Stock Market (based on market capitalization) has a monthly standard deviation of 10.5%.
|Scaling the Heights: The Stocks That Won the Strategy|
For the second year in a row, the Murphy Technology screen was the top performer, with a gain of 34.1% in 2005, which follows 2004s 107.9% gain.
Its interesting to look beyond the performance data at the individual stocks that contributed to the overall return—an exercise that should be carried out whenever any stock approach is considered. In the case of the Murphy screen, we find a relatively concentrated portfolio made up of highly volatile, small-cap technology stocks.
The Murphy screen attempts to isolate technology stocks with high research and development (R&D) expenditures as a percentage of sales, high pretax margins and return on equity, and strong top-line sales growth, but that are also selling at attractive values as measured by growth flow. Murphy does not believe in buying growth at any price. Instead, he prefers to follow companies and purchase them only when valuations reach attractive levels.
However, traditional valuation techniques are misleading for technology companies. R&D spending cuts into a companys bottom line; as a firm spends more on R&D, its current reported earnings fall proportionately. As a result, a company that spends more on R&D will have a relatively higher price-earnings ratio. To counter this, Murphy adds per-share R&D spending (R&D spending divided by the number of shares outstanding) to earnings per share to determine what he terms a companys growth flow. Dividing the current price of a stock by the growth flow per share provides the price-to-growth-flow ratio. Murphy uses this ratio to measure the underlying investment value of a technology stock. Murphy views technology stocks as fairly priced when price-to-growth-flow ratios are around 10 to 14; anything under eight is cheap and below five is a real bargain; 16 and over is too expensive.
Table 3 presents all of the stocks that passed the screen during this year, along with their performance while they were held, the number of months the stock was held, and current financial data. What all these stocks have in common is that they had a low price-to-growth-flow ratio when they passed the Murphy screen.
PalmSource, Inc. was the best-performing stock that passed the Murphy screen during 2005. PalmSource makes the Palm Operating System (OS) used in over 40 million hand-held and mobile devices around the world. Its 133.8% gain came while the stock was held during three months—September, October, and November. The portfolio was fortunate to hold the stock during this period, as Japanese software developer Access Inc. made an offer for the company in September and the price of the stock rocketed that month 81.4% from $9.95 to $18.05. The deal closed in November.
NovAtel Inc. gained 70.9% in the one month it was held in the Murphy portfolio—May. The designer and marketer of global positioning devices saw its stock price jump after the company reported strong first-quarter results. When it passed the Murphy screen at the end of April, its price-to-growth-flow ratio was 6.3. After its 70.9% rise in May, the ratio rose to 9.2 (it is currently 9.3) and the stock no longer passed the screen, which caps the price-to-growth-flow ratio at 8.0.
Sigmatel, Inc., which was in the Murphy portfolio for seven months, was not able to overcome its poor showing the first month in the portfolio. The maker of semiconductors for MP3 media players, including the Apple iPod, had its rating lowered by CIBC World Markets on June 27, 2005, over concern with Sigmatels excess inventories. Following the downgrade, the share price fell 21.4% by the close of June trading. For the month, the stock price was down 24.2%. After recouping much of its losses over the succeeding months, Sigmatel was struck again in October, when it lost 32.8%. On October 10, 2005, the company cut its third-quarter revenues and earnings outlook, citing equipment issues at test and assembly facilities. The company also warned of a decline in gross margins. Further negatively influencing share performance was the discovery that Sigmatel was not providing flash chips for the new iPod nano media player. Instead, fellow portfolio member PortalPlayer, Inc. was tapped by Apple to supply the audio processing chips. Overall, Sigmatel generated a 42.2% loss while it was in the Murphy portfolio.
The Murphy screen has produced a hypothetical portfolio that has generated dizzying returns the last two years. However, this was achieved with a relatively small collection of highly volatile, small-cap technology stocks. Sophisticated investors willing to stomach wild oscillations may use this approach to find promising technology stock ideas. Investors looking for a more diversified, and potentially safer, portfolio will probably want to look elsewhere.
The Long-Term Winner
The Total Price Change column in Table 1 indicates the percentage amount each test portfolio has appreciated or declined from January 1, 1998, through December 30, 2005. This return does not include dividends. Large-cap value strategies that tend to produce high dividends, such as the Dogs of the Dow, would be negatively impacted by this type of dividend reinvestment exclusion.
The current average dividend yield of the Dogs of the Dow screen is 4.8%; shareholders of these stocks would actually have a return that is higher by approximately this amount annually.
The strongest gain over the last eight years comes from the screen based on the Martin Zweig approach, which is up 1,659.3% cumulatively after gaining a respectable 27.8% for 2005. By way of comparison, the S&P 500 is up a total of 28.6% over the entire period. Zweigs growth-and-value approach examines trends in both quarterly and annual sales and earnings growth, with an emphasis on consistent and strong results.
Despite his desire for high-growth companies, Zweig also believes that a price-earnings ratio can be too high or even too low. He feels that there are two types of companies with low price-earnings ratios—those that are experiencing financial difficulties and neglected companies.
The risks of investing in financially troubled firms, in Zweigs opinion, are too great to justify the investment in them, since the risk of these firms going under overshadows any potential value or upside in these stocks.
Neglected stocks, on the other hand, are ignored by the market and often exhibit extraordinary performance once discovered. Value investors strive for these stocks.
The price-earnings ratio constraints used for the Zweig growth-and-value screen consist of a minimum level of 5.0 to avoid potentially troubled firms and a maximum level of 1.5 times the median price-earnings ratio of the entire Stock Investor database (to avoid overpriced firms).
The final element of the Zweig screen looks for companies exhibiting price momentum by requiring that any passing company outperform the S&P 500 over the last six months.
The first step of stock screening is to establish a set of practical and disciplined rules to follow. The AAII Stock Screen strategies are based on relatively simple screens that are interpretations of the investment approaches advocated by prominent investment professionals. Examining the investment 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 screens is to simply select the strategy with the highest performance and immediately buy all the passing stocks. Instead, it is important to gain an understanding of the forces that influenced their performance and how these strategies might perform during current and expected economic and market environments.
Most importantly, remember that screening is only the first step. The result of any screen is not a buy or recommended list. There are qualitative elements to consider that cannot be captured effectively by a quantitative screening process. Performing due diligence is necessary to verify the financial strength of the passing companies and to identify stocks that match your investing tolerances and constraints before committing your investment dollars.
For further information on these approaches, consult the Stock Screens area of AAII.com.
|The AAII Stock Screens|
AAII has been developing, testing, and refining a wide range of screening strategies over the last eight years. Many of the screens follow the approaches of popular investment professionals, while others are tied to basic principles of investing. These approaches run the full spectrum, from those that are value-based to those that focus primarily on growth, while most fall somewhere in the middle. There are even a number of specialty screens that attempt to gauge the stock selection impact of a single variable—such as the short ratio.
Screens following the approach of an investment professional do not represent their actual stock picks. The rules of each screen are defined by our interpretations of their respective investment approaches. The results of the screening strategies, as well as the criteria for each screen, are programmed into the Stock Investor Pro program and are also posted in the Stock Screens area of AAII.com.
Each month over 50 separate screens are performed using AAIIs Stock Investor Pro and the current companies passing each individual screen are reported. Stock Investor Pro subscribers can perform the screens themselves, while AAII members can access the screening results by clicking on the All Screens link within the Stock Screens area of AAII.com. The results are usually posted to the site in the middle of each month using data from the previous months end.
The performance of the stocks passing each screen is tracked on a monthly basis. The month-to-month closing price is used to calculate the return, with equal investments in each stock at the beginning of each month assumed. The impact of factors such as commissions, bid-ask spreads, cash dividends, time-slippage (time between the initial decision to buy a stock and the actual purchase) and taxes is not considered. This overstates the reported performance, but all approaches are subject to the same conditions and procedures. Higher turnover portfolios would typically benefit more from these simplified rules.
Sell rules are the same as the buy rules: The screens are simply reapplied using each subsequent months data. Thus, a stock is sold (no longer included in the portfolio) if it ceases to meet the initial criteria, and new stocks are added if they qualify.
Stocks that no longer qualify are dropped even if the strategist behind a particular approach suggests different sell rules versus buy rules.
Wayne A. Thorp, CFA, is financial analyst at AAII and associate editor of Computerized Investing.