Introducing Our New Service: AAII's Stock Superstars Report
by James B. Cloonan
AAII is about to launch a new stock service—the Stock Superstars Report (SSR). A complete description will be found later in this article. But first, I want to address the question of why AAII would want to provide such a service.
Traditionally, AAII has concentrated on investor education and the providing of data that aids individuals in making their own investment decisions.
Why are we now going a step further and providing specific advice?
There are several reasons.
First, we have found that many of our members have decided it is too difficult or time-consuming to create and maintain a portfolio of individual stocks alone. They want specific advice. The Stock Superstars Report is aimed at those investors. We sincerely hope that the majority of members will continue to make their own decisions. The Stock Superstars Report will be an optional service with a fee high enough to cover all costs so that other AAII members are not indirectly paying for a service they dont want.
Second, we feel that with a 25-year history of research and analysis, AAII can do a better job of providing a stock advisory service oriented toward managing portfolio return and risk than anyone else. If our members want specific advice, we believe we can do more for them at AAII with the Stock Superstars Report than other stock advisory services.
The service will only be available to AAII members. A Web-based subscription will be FREE to all AAII members during a trial period that will last until the end of the year. We expect that members using the service during this period will help us make final adjustments by responding to questions and making suggestions.
The SSR Concept
The first objective of the Stock Superstars Report is to select stocks that will appreciate more than the market, both absolutely and on a risk-adjusted basis. This, of course, should be the objective of any advisory service, and each of the existing services has its own approach to stock selection. Unfortunately, according to research at The Hulbert Financial Digest, only a few stock advisory letters outperform the market over long periods, and it is a different few in each time period.
There are, however, investor superstars whose approaches have beaten the market over very long time periods. It was the work of these investors, such as Benjamin Graham, William ONeil, Peter Lynch, John Neff, Martin Zweig, Warren Buffett, David Dremen, John Templeton, etc., that became our starting point for the creation of the Stock Superstars Report concept.
While the approaches of these superstars have performed well over the long run, each superstars approach has had extensive periods of under-performance. Since they each have a specific approach, portfolios based solely on one of their approaches will have high correlation between the stocks, and thus high risk. It is also true that their approaches often deal only with initial stock selection and not overall portfolio management—which is as important or more important than the individual stocks selected.
The approach of the Stock Superstars Report is to build on the work of these superstars to develop a complete portfolio management system. In addition, we monitor the success of each approach in the current market, and utilize the three to five approaches that are working best. We dont select the best one because market conditions may change rapidly and we dont want an entire portfolio vulnerable to a change. There are other reasons for not using a single approach, which are discussed below.
We constantly monitor the success of each of the utilized approaches, as well as those approaches not being used at present, to judge when a change in the approaches used should be made.
We use very specific sell criteria, the underlying philosophy of which is: * Cut losses; * Let winners ride. As well as being the time-tested winning approach, this sell philosophy is also very tax wise. We are not trying to predict or time the market, but rather to use the feedback of the market itself to develop the best selection approaches for current market conditions.
The SSR Approach
The last few years of market volatility have made us all cognizant of the need for risk control. While the type of stocks we invest in is related to risk, we have seen even blue-chip companies go bankrupt. The best control of risk comes from effective diversification.
There are several levels of diversification:
Level One is completely naïve diversification that counts on achieving effective diversification from having many stocks. While theoretically you reduce risk significantly by having a 20-stock portfolio, the theory assumes that the stocks are randomly selected. In fact, most portfolios are selected based on approaches that tend to end up with highly correlated stocks. For example, the S&P 500 index and mutual funds based on this index are inefficiently diversified and are much riskier than a large portfolio should be. This is due to the fact that the top 10 stocks of the S&P 500 account for 23% of the holdings and those stocks may be concentrated (i.e., tech stocks). AAIIs experimental Beginners Portfolio, with only 18 micro-cap stocks, has less portfolio risk than an S&P 500 index fund. [For a complete description of the Beginners Portfolio, see The AAII Beginners Portfolio: An Annual Performance Review, August 2001 AAII Journal, available on AAII.com.] The Stock Superstars Report approach avoids inefficient Level One diversification.
Level Two tries to obtain diversification by making sure that stocks are divided among categories to reduce correlation. This involves balancing stocks among industries, capitalization sizes, and national or regional boundaries. All of these approaches probably reduce correlations and improve diversification, but they dont measure the actual correlations in a portfolio.
Level Three looks at the actual correlations in a potential portfolio. This approach can be used to check for correlation after selecting stocks and making effective adjustments to the stocks or to the selection techniques. The Stock Superstars Report uses this approach to adjust decision rules.
In the Stock Superstars Report, we go beyond historical research to get at likely future correlations and risk reduction. We do that by always choosing, among the superstar approaches used, several that have low correlations with each other. We check this historically, but basically the approaches used almost assure low future correlations.
Experience to Date
We did do historical research, and we used this research to develop the starting format of the Stock Superstars Report. Historical testing showed that our approach provided higher returns than either the S&P 500 or Nasdaq, and with a considerable reduction in risk.
However, as I pointed out in an earlier Matter of Opinion (Evaluating the Research on Historical Performance, May 2002 AAII Journal), there are severe limitations to historical backtesting. For that reason, at the beginning of the year we began producing recommendations based on a test version of the Stock Superstars Report. We started an actual portfolio that invested as if it were a subscriber to the advice given by the Stock Superstars Report. We had commissions and bid-ask spreads, and we also introduced a one-day delay in our ability to act on the advice. The results for the first six months are provided in Table 1.
|TABLE 1. Rates of Return for Stock Superstar Report Test Period|
|Stock Superstars Report Portfolio||4.5||2.7||3.6||7.1||-4.2||-0.3||**13.8||85|
|S&P 500 Index||-1.5||-1.9||3.8||-6.1||-0.7||-7.1||-13.1||102|
|Nasdaq Composite Index||-0.8||-10.5||6.6||-8.5||-4.3||-9.4||-25.0||163|
|* Based on relative standard deviation, where 100 is the average of all world equities.
** Commission costs were 1.4% during this period. Going forward, the estimated commissions are expected to be 0.4% due to lower turnover, lower per transaction commissions, and larger positions. With the lower commission costs, this figure would have been 14.8%.
*** Based on the Vanguard Total Stock Market Index fund (VTSMX).
During this test period, we added stocks gradually for the first four months and tested for the optimal portfolio size. Coming up with the stocks all at once was not possible within the Stock Superstars Report approach. We also sold and replaced a number of stocks during the six-month testing period in response to our sell rules, and their gains and losses are included in the results in Table 1.
As you can see, the test results are very encouraging on an absolute return basis, but of course, are no guarantee of future results.
Even more importantly, analysis shows that we accomplished the results shown with a risk level 17% below that of the S&P 500 and 48% below that of the Nasdaq. In other words, the Stock Superstars Report approach also produced higher risk-adjusted returns (returns per unit of risk).
This indicates that our belief that the Stock Superstars Report approach to stock selection would reduce future risk may be justified. There is often a tendency to overlook the true importance of portfolio risk beyond the fact that it reduces volatility and lets us sleep better. There is also a dollar value to risk reduction.
When comparing portfolios, the highest risk-adjusted return is the best choice because, by changing asset allocations, the highest risk-adjusted return can be converted to the best absolute return at any given level of risk (see Measures of Portfolio Risk and How You Can Apply Them, July 2002 AAII Journal).
Because the Stock Superstars Report portfolio has 17% less risk than the S&P 500, individuals who are investing in an S&P 500 index fund and are comfortable with that risk level could increase their asset allocation in stocks by 17% if they instead invested in the Stock Superstars Report portfolio. They would have the same level of risk as the S&P, but they would then have the extra return of stocks versus reallocated bond or money market fund investments. Over the long run there would be a huge difference in the portfolio rate of return.
It is essential to point out, however, that each individual should set an appropriate risk level and not trade risk for return beyond that level. And remember it is the risk of your entire portfolio that matters, not the risk of individual securities.
While it is encouraging to see the risk reduction that results from our approach to diversification, there is no guarantee that level of efficiency will continue.
The SSR Service
Our testing period is now over and we are embarking on a free trial period for all AAII members. The format of the service during the trial period will be similar to how we envision the final service next year.
The list of all stocks currently recommended is now available on the Stock Superstars Report Web site (www.stocksuperstars.com). On the Friday following the first Monday of each month, a list of any new stocks to buy will be provided. Each Friday after the close, the Stock Superstars Report Web site will list stocks that should be sold.
In addition, individuals signing up for the free trial service will receive E-mails indicating the weekly sale recommendations and notice of the monthly buys.
The Stock Superstars Report Web site will provide extensive and continually updated information about the recommended portfolio.
One thing you will not find is hype about individual companies. Our decision rules are based on company statistics and not management predictions. Stocks are purchased only once a month because some of the data used in the purchase decision process is only available on a reliable basis monthly. Data necessary for sell decisions is available more frequently.
The principal difference between the trial version and the eventual full service is that there will be no printed version of the Stock Superstars Report letter during the trial period. We will also not provide fax or phone alerts—only Web site and E-mail. This is still a period of adjustment, and those of you who avail yourselves of the service during the free trial period will be asked to respond to questions regarding format, data, communications and Web site clarity.
The Stock Superstars Report will be provided as a separate service with its own Web site. While all AAII members may subscribe free during this period, you will have to register to receive access.
If you would like to receive weekly alerts, you must provide your E-mail address. The Web site will provide specific instructions on how to effectively utilize the service. The next page will explain how to enroll.
James B. Cloonan is chairman of AAII.