"Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so."
-- Douglas Adams, British author
Whether it's a young child insisting "I can do it myself!" while trying to tie his shoes for the first time, or a hopelessly lost grown man refusing to stop his car to ask for directions, people like to do things on their own. It's natural; there's a sense of pride and accomplishment when you can do something without help.
But there are times when going it alone just doesn't work. Many investors -- including myself -- have learned that the hard way when trying to beat the market. In fact, my research has found that more than 90 percent of money managers -- professional investors, that is -- fail to produce returns that beat the market.
It's no surprise, really. When you look at the amount of stock market data that exists, it's hard for anyone, even very smart people, to know what data is most important to pick stocks that are likely to perform well. What's more important, high sales or high earnings? And what defines "high"? How far back do you need to look into a firm's past when examining its performance? How much corporate debt is too much when you're considering investing in a company?
These are not simple questions, and to come to some sort of reliable conclusion on them you'd have to conduct hours upon hours, or even years' worth, of research. But what many investors don't know (or perhaps simply ignore) is that some of Wall Street's greatest investing strategists have done this research already, and they've been kind enough to share their findings. Peter Lynch, Benjamin Graham, Martin Zweig -- these investment greats and others built their fortunes by developing long-term, mostly quantitative strategies that they stuck with for many years through a variety of market conditions, and they've publicly disclosed those strategies in books or research papers.
Using my best interpretation of these "gurus'" strategies, I've developed computer models that mimic each of their approaches. Doing so has shown me that you don't need to reinvent the wheel to beat the market. I started tracking portfolios of stocks picked using each of these "Guru Strategies" in July 2003, and each of these 11 portfolios has beaten the S&P 500 since its inception. Several have doubled or even tripled the S&P's gains.
Before I begin dissecting each guru-based strategy and explaining how to use it to your benefit, I'd like to take a brief look at each of these investors to show why I chose them, and how they made their mark on the investing world:
Peter Lynch: From the time he took over Fidelity's Magellan Fund in 1977 until the time he retired in 1990, Magellan averaged an incredible 29.2 percent annual return -- almost double the S&P 500 average of 15.8 percent. In the last five years of his tenure, the fund beat 99.5 percent of all other funds, according to Barron's.
David Dreman: Dreman is a contrarian. He focuses on the least popular stocks -- those that have been shunned because they're in a troubled industry, or because of investor apathy, and finds stocks within that group that have strong underlying financials.
Benjamin Graham: Widely considered the father of value investing, Graham averaged a 20 percent annual return from 1936 to 1956.
Martin Zweig: During the 15 years that it was monitored, Zweig's stock recommendation newsletter returned an average of 15.9 percent per year and was ranked number one on the basis of risk-adjusted returns by Hulbert Financial Digest, a publication that tracks the records of investment newsletters. Zweig looks for growth stocks and his methodology is highly selective.
James O'Shaughnessy: O'Shaughnessy's What Works on Wall Street, in which he detailed what he learned from back-testing 44 years worth of the stock market, made a couple of surprising findings, including that P/E ratios aren't the best criteria for selecting stocks. He developed two models, one targeting larger value-oriented stocks and the other targeting growth stocks. His back-tested results averaged 22 percent per year over those 44 years.
Kenneth Fisher: Fisher is the son of Phil Fisher, who is generally considered the father of growth stock investing. The younger Fisher gained fame with his book Super Stocks, in which he popularized the use of the price-to-sales ratio for picking stocks.
John Neff: Neff managed the successful Windsor Fund, using a value oriented strategy, from 1964-1995, averaging a 13.7 percent annual return in that 31-year period, which beat the S&P 500 by more than 3 percent per year.
Warren Buffett: Perhaps the most famous, and greatest, investor of all-time. Buffett's Berkshire Hathaway averaged a 24 percent annual return over a 32 year period. Buffett is known for his patient, highly selective, long-term investment style.
Joseph Piotroski: This little-known University of Chicago professor published a highly regarded research paper on high book/market ratio stocks (i.e. stocks whose prices indicate that they have been unpopular with investors). The paper outlined a brilliant strategy for distinguishing the high book/market stocks that were likely to be successful performers from those that deserved their unpopularity, His strategy would have produced a 23 percent average annual return from 1976 to 1996.
William O'Neil: O'Neil's highly popular book How To Make Money In Stocks involved a massive study in which he identified the characteristics of the 500 best growth stocks over the previous 30 years. His methodology might be characterized as "buy high, sell higher", a momentum strategy that selects stocks holding similar characteristics to those in his study. He also founded Investor's Business Daily, a well-known financial newspaper.
Varied styles, similar success
One key similarity between all of these gurus is that each developed a long-term strategy based on experience or back-testing, and stuck with that proven strategy through a variety of market conditions. At times when the market is volatile, as it has been lately, people have a tendency to let their emotions guide their decisions, which can be dangerous. These greats, however, had the wisdom and discipline to stick with their methods over the long-term, and doing so paid off for them.
Along those lines, it's important to note that every strategy I studied (including Warren Buffet’s) had years in which it did not beat the market, yet those who unwaveringly stuck to the methods still compiled the best long-term track records. Most investors expect that the best strategies always outperform the market every year (and sometimes every quarter!). When their strategy doesn't, they often switch to the latest hot new strategy, which rarely has a track record of more than a couple years (if that). These strategies may succeed in the very short term, but most investors soon find that they would have been better off sticking with their original long-term strategy. If there's any one wisdom that I can share with you that will most help your long term returns, it's that.
While the gurus upon whom I based my models were similar in that each stuck to his long-term methodology, the specifics of their strategies varied. Lynch, for example, considers the most critical stock variable to be the P/E/Growth ratio, which divides the stock's price-to-earnings ratio by its growth rate to find growth stocks that are still selling at a good price. O'Shaughnessy and Fisher, meanwhile, believe the best indicator of future success is the price/sales ratio (although not by itself).
These greats also often have different takes on the same variables. Graham wanted P/E ratios below 15, but Lynch likes them to be less than 40, and Zweig wanted P/Es greater than 5, but less than 3 times the market average -- and never over 43.
Guru philosophies join forces
I raise all this not to confuse you, but to show you that these great investors often found success in very different ways. For a stock to obtain approval from one of my diverse models is hard -- currently just over 10 percent of the 7,500-plus stocks I track do that -- but for it to score high on more than one strategy is even harder, because of the array of different variables that each model uses, and because the models use opposing strategies (such as growth and value).
To get approval from both my Dreman- and Zweig-based models, for example, a company must successfully run the gauntlet of more than 25 different variables; those tests involve earnings history, debt load, cash flows, asset/liability ratios, pre-tax profit margins, and return on equity, to name just a few, and they examine data from as recent as the current quarter and as old as five years ago. Finding companies that look solid from so many different perspectives is a tall order, and those that pass such varied tests must be on extremely solid financial ground.
This concept is a major part of the approach that my company, Validea, uses when picking stocks. I've found that, in many cases, combining these successful individual strategies has yielded even better results. Any individual strategy will go out of favor from time to time; it's the nature of the market. But combining these models ensures that stocks have been analyzed from a myriad time-tested perspectives, increasing the likelihood that a stock will rise in the near-term compared to most stocks.
My "Hot List" portfolio, for example, includes the stocks that score best using a formula weighting all of my guru-based models on the basis of the models' risk-adjusted performance. To date, the Hot List has gained almost 160 percent since its inception, almost four times the S&P 500's gain over that time.
Beginning with my next column, which will appear in two weeks, I'll start looking more closely at each of my individual guru-based models, highlighting stocks that score high using each model, explaining why they pass muster. Deciding to accept the advice that these gurus have publicly offered was perhaps the best -- and most profitable -- investing decision I've ever made. I'll show you how you too can make sense of their strategies, and I hope you'll be as open to learning from their wisdom as I was.
Published by Globes [online], Israel business news - www.globes.co.il - on August 20, 2007