John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
"Finding exploitable investment opportunities does not mean it's easy to make money, however. To do so requires the ability to consistently, patiently and slavishly stick with a strategy, even when it's performing poorly relative to other methods."
– James O'Shaughnessy, What Works on Wall Street
In 2014, the "Guru Strategy" I base on the writings of Benjamin Graham – the man known both as the "Father of Value Investing" and the mentor of Warren Buffett – had by far its worst U.S. performance since I started tracking it 12 years ago. While the S&P 500 was up more than 11 per cent, my Graham-based 10-stock portfolio was well in the red. It was accurate (meaning it made money) on less than 40 per cent of its picks.
So, what will I do in 2015? Tweak the strategy? Scrap it altogether? No, and no. I'm sticking with it.
It's not a case of stubbornness – it's just that I understand the realities of investing. As James O'Shaughnessy noted in the quote above, all strategies go through periods of underperformance. It's inevitable.
The Graham strategy is a good one. Based on the "Defensive Investor" approach Graham laid out in his classic book The Intelligent Investor, the model looks for companies with strong balance sheets - they should have a current ratio (current assets divided by current liabilities) of at least 2.0, a sign of ample liquidity. Net current assets should also be greater than long-term debt.
They should also have cheap shares – the price-to-earnings ratio should be lower than 15, and the product of the price-to-book ratio and the P/E should be less than 22. In addition to helping Mr. Graham build his own stellar track record, the strategy has produced excellent returns for me. Since its mid-2003 inception, a 10-stock, monthly rebalanced portfolio picked using this model has beaten the S&P 500 in all but two years. Over that stretch, it has returned 266 per cent, or 11.9 per cent annualized. The S&P has returned 104 per cent, or 6.4 per cent annualized, over that same stretch (all figures are without dividends).
Sticking with good strategies through the ups and downs is hard work. But great strategists such as Mr. O'Shaughnessy succeed because they stay disciplined – very often, a strategy will generate some of its best returns after its worst stretches, as investors warm to the bargains they've been ignoring while the strategy has struggled.
Consider Warren Buffett's performance during and after the tech bubble of the late 1990s. The fundamental-focused Mr. Buffett refused to ditch his approach as speculative tech stocks soared, and Berkshire Hathaway shares fell nearly 20 per cent in 1999 while the S&P 500 was up 21 per cent. But as investors came back to reality, Berkshire bounced back strongly, gaining a total of about 30 per cent over the next three years while the S&P fell more than 37 per cent.
I'm not expecting my Graham portfolio to surge tremendously this year. I don't even know if it will beat the S&P in 2015. I do believe, however, that the strategy will bounce back at some point, and that over the long term I'll be far better off sitting tight than I would be if I tried to guess exactly when the turnaround will come. So I'll continue to buy the undervalued, financially sound stocks that the strategy recommends. Here are a few that are high on its list right now.
National Oilwell Varco: Oil services firms have been hit hard because of oil's plunge, but Varco's fundamentals are stellar: The company, with a market cap of $22-billion (U.S.), has a 2.2 current ratio and $8.8-billion in net current assets versus $3-billion in long-term debt. It also trades for 9.4 times three-year average earnings and 1.06 times book value.
Chart Industries: Chart ($900-million market cap) makes highly engineered equipment used in the production, storage and end-use of hydrocarbon and industrial gases. The firm has a 2.3 current ratio and $372-million in net current assets versus $267-million in long-term debt. It trades for 14 times three-year average earnings and 1.06 times book value.
Guess Inc.: This trendy fashion retailer ($1.6-billion market cap) has a very nice balance sheet – 3.6 current ratio, and just $7-million in long-term debt compared with more than $800-million in net current assets. At its current price, its valuation – 14.6 P/E using trailing 12-month EPS and 1.45 price-to-book – comes in just under the Graham-based model's upper limits.
Disclosure: I'm long GTLS and NOV.