Grading Stocks on Quality

Comments on “Using Alerts to Keep Tabs on Securities,” by AAII Staff, in the April 2024 AAII Journal:

How would you think about the validity of the Quality Grade on a company like Uber Technologies Inc. (UBER), since most of the quality metrics are a ratio to assets? That is, assets for a company that totally relies on third-party contractors for its revenue. Does any Quality Score make sense for this stock, let alone 61? I also can’t tell if the Quality Grade takes into account the fact that over 21% of Uber’s total assets are from goodwill.
—Dave G. from Texas

Wayne Thorp responds:
Uber’s goodwill/intangible assets account for roughly 25% of its total assets (per AAII’s Stock Investor Pro). By comparison, Microsoft Corp.’s (MSFT) ratio is 31.6%, Visa Inc.’s (V) is 49.1%, UnitedHealth Group Inc.’s (UNH) is 43.5% and Johnson & Johnson’s (JNJ) is 42.2%. You are right to consider the source and safety of a company’s revenue stream, just as you would for a pharmaceutical company that relies on patent protection and its product pipeline.

Evidence for Stock Rules

Comments on “Five Key Markers Pointing to Successful Stock Investing,” by Charles Rotblut, CFA, in the April 2024 AAII Journal:

Since 2015, I have been following a quantitative rules-based strategy with part of my total portfolio. I began with a small allocation and gradually expanded. It is now over 20% of my total portfolio. I have found it very helpful. Having precise sell rules has enabled me to sell losers without regret. I strongly concur with the article.
—Mohammed A. from Great Britain

Perhaps small stocks are still overlooked and mispriced, but the recent performance (15 years) of the Model Shadow Stock Portfolio doesn’t support this hypothesis. An alternative hypothesis is that after years of AAII discussing small-cap mispricing, individual investors have bid up the prices. If this hypothesis is correct, small investors have no advantage and should invest in cheap index funds.
—John L. from New Jersey

I disagree with John L.’s post about the current absence of mispriced stocks. I try to follow the guidelines of the Model Shadow Stock Portfolio. Like Mohammed A., I began about 10 years ago with a small portion of my portfolio, and it has grown without any substantive addition to it to about 25% of my invested assets. The majority are in larger stocks, real estate investment trusts (REITs) and managed funds that my broker and I decide on. That is primarily for income, but the smaller portion is capital-appreciation-oriented. The stocks I now hold have been held for an average of 563 days and have generated a return of 17.6% on capital appreciation and 20.6% including dividends.
—James E. from Florida

Alternatives to Five-Index Approach

Comments on “Tempering the Risks of Market-Cap Weighting,” by Craig L. Israelsen, Ph.D., in the April 2024 AAII Journal:

The five-index approach’s average annual return was 0.06% greater than the S&P 500 index’s return. Since each of the suggested options have expenses exceeding 0.06%, I would suggest investing in the top 25, 50 or 100 stocks of the S&P 500 and rebalancing every six months. The stocks can be purchased and traded with zero fees. This should be feasible with a $1 million account. Alert: I have not tested this approach.
—Philip J. from Virginia

It’s not possible to test any of the exact portfolios suggested since most didn’t exist in 2002, but you could compare the Vanguard 500 Index fund (VFINX) to a two-fund approach of 70% in the Vanguard 500 Index fund and 30% in the Wasatch-Hoisington U.S. Treasury fund (WHOSX), a bond fund. This gives similar results to that of the article. The use of the bond fund improves results by a 1% compound average growth rate with the same withdrawals of $50,000 per year, as used in the article. Another way of beating the market-capitalization-weighted S&P 500 over the last 20 years would be to own the Invesco S&P 500 Equal Weight ETF (RSP), the equal-weighted version of the Vanguard S&P 500 ETF (VOO). The results of both tests using Portfolio Visualizer can be seen here: https://shorturl.at/cxPT8.
—Dave G. from Texas

History’s Limit in Forecasting

Comment on “Stocks Not Always Top Dog: A Challenge to Mean Reversion,” by Eunice Kim, in Dispatches in the April 2024 AAII Journal:

Only if you expect the period of 1802–1902 to repeat in 2024–2124 would it make sense to forecast bonds outperforming stocks. That is unlikely due to the creation of the Federal Reserve and the change from gold-backed to fiat currency. Since 1914, the Fed has been creating ongoing inflation and manipulating the bond market to lower interest rates.
—John L. from New Jersey