Politics & Policy

Virtual Gurus

Computer-based stock picking makes sense.

Over the past six months, a portfolio of stocks chosen by Benjamin Graham, perhaps the greatest investment mind in history, has beaten the benchmark Standard & Poor’s 500-stock index by a whopping 38 percentage points. That’s a remarkable accomplishment, especially when you realize that last year’s hottest stocks were fast-moving growth companies, especially of the tech variety, while Graham, the father of modern value investing, likes obscure plodders.

With the exception of Fresh Del Monte Produce (FDP), purveyor of pineapples and bananas, the stocks that Graham chose certainly aren’t household names. His portfolio currently includes Industrie Natuzzi SpA, an Italian furniture company whose shares trade as American Depositary Receipts with the symbol NTZ; Triumph Group (TGI), which makes aircraft components; and Orthodontic Centers of America (OCA), a provider of business services to dental practices.

They’re classic Grahamian value stocks — that is, they appear to be overlooked bargains. Del Monte has a price-to-earnings (P/E) ratio of 6, which means that you can buy $1 of its annual profits for just $6, as compared with $22 for the typical stock in the Dow Jones industrial average. Natuzzi has a P/E of 9; Triumph, 18; and Orthodontic Centers, 8.

Graham’s portfolio includes another six stocks, but at this point I should probably tell you that Graham himself didn’t select them. In fact, Ben Graham long ago passed on to his heavenly reward. He has returned as a stock-picker through the magic of modern science, and therein lies this week’s tale.

Say you are convinced that some gifted people can actually beat the market — and you are also convinced that you aren’t one of them. How can you get one of these gifted souls, or gurus, to manage your portfolio (especially if the guru is dead)?

One way is to buy shares of stock in a mutual fund, or some other sort of investment company, that the guru (living, in this case) manages — for example, Berkshire Hathaway Inc. (BRK), whose chairman, super-investor Warren Buffett, oversees a few dozen companies that his firm owns outright, such as Geico (insurance) and Fruit of the Loom (underwear), and a scattering of others in which it has a large chunk of public stock, such as Gillette (G) and Coca-Cola (KO).

But how would you get Graham, Buffett’s own mentor, to manage your money? Graham, coauthor of the influential 1934 text Security Analysis, was an erudite classicist who loved Proust and Virgil and translated books from the Portuguese. He was also a spectacularly successful practitioner whose own investment of $720,000 in Geico ended up worth $500 million. The big problem in hiring Ben Graham, however, is that he died in 1976 at the age of 82.

A fascinating website called Validea has developed a software program that seeks to imitate the investing style of Graham — plus those of eight living gurus, including Buffett.

The program analyzes a large universe of stocks to see if they meet criteria that the gurus would, according to their own writings and public statements, be expected to set. For example, Graham rejected stocks whose prices were more than 25 times their average earnings per share over the previous seven years or more than 20 times their earnings over the previous 12 months. Graham also required a “margin of safety.” He bought only companies priced at least 50 percent below their real, or intrinsic, value (as he determined it).

Stocks that pass these “screens” and several others qualify for a virtual portfolio that the guru himself might compose. For each guru, Validea uses screens to produce a portfolio composed of the 10 highest-rated stocks. Most of the guru portfolios are dominated by smaller companies (Graham’s has only one large-cap and one mid-cap) — and that makes sense. What the best investors seek are stocks whose merits others haven’t noticed. Since large-caps are closely scrutinized by analysts and big investors, the gems are usually hidden among mid- and small-caps.

Validea established the Graham portfolio on July 15 last year. Since then, it has returned 52 percent, compared with just 14 percent for the S&P 500. Indeed, all eight of the original guru portfolios are far ahead of the S&P since inception. The ninth, based on the precepts of Buffett, was started only on Dec. 2 and has since merely matched the benchmark.

The top portfolio (54 percent return since inception) adheres to the investment principles of Peter Lynch, the former manager of the Fidelity Magellan fund. The Lynch portfolio is geared toward growth companies that have low PEG (or P/E ratio to earnings growth) ratios. For example, one of the stocks, Oxford Health Plans (OHP), a mid-cap, is expected to increase its earnings at an annual rate of 13 percent over the next five years, according to a consensus of analysts. It trades at a P/E of just 12, so its PEG ratio is 12/13 or 0.9. A PEG ratio under 1.0 is typically considered an attractive stock.

Understand that while Lynch, like Buffett, is very much alive, he did not actually select the portfolio displayed on Validea’s site. He is out of that line of work. “What we’ve done,” Justin Carbonneau of Validea told me, “is to look at the methodologies that these gurus have publicly disclosed” and calculated computer screens that mimic their styles. A Validea disclaimer hastens to point out that the gurus have not endorsed the stock selections.

Still, they ought to be proud of their electronic achievements. Validea backtested the strategies over three years and found that all the portfolios beat the S&P by wide margins (between 7 percent and 31 percent annually). But, of course, historical tests aren’t as valuable as the real thing, and the real thing has been going on for only six months.

A similar web-based guru screener is offered by the American Association of Individual Investors. Some of the gurus, however, are more obscure than the Validea cast. Last year’s winning strategy is based on the work of Joseph Piotroski, a young accounting professor at the University of Chicago, who recently studied stocks with low price-to-book-value (P/B) ratios.

Book value is generally determined by subtracting total liabilities from total assets; it’s a company’s net worth on its balance sheet. Divide it by the total number of shares outstanding and then divide that result into the stock price per share and you’ve got P/B — a figure that is much maligned in investing circles these days because many analysts believe that balance sheets can’t capture the true value of modern assets such as human resources and patents.

The AAII’s Stock Investor Pro software, which uses a universe of 9,000 stocks, first found the 20 percent of listed companies that had the lowest P/Bs. Then it applied Piotroski’s nine-point scale to separate financially distressed firms (which richly deserve their low P/Bs) from companies that were sound but neglected.

The list is updated every month, and last year only seven stocks made the cut. Currently, the list comprises just five companies, including Parlux Fragrances (PARL), a Florida-based perfume maker with brands such as Perry Ellis and Jockey, and Champion Industries (CHMP), printing and office products. These are tiny companies; by coincidence, each has a market cap of $45 million.

The Piotroski strategy returned 142 percent in 2003, but its volatility — that is, the extremes of the ups and downs of the portfolio’s value from month to month — was nearly twice as high as that of the 500 S&P stocks. Over the past five years, Piotroski stocks have returned a total of 506 percent, compared with just 27 percent for the S&P.

When I introduced readers to some of the joys of the AAII guru screens a year ago, one of the portfolios I highlighted was composed by a computer imitating Martin Zweig, a popular author and money manager who searches for companies with what he calls “reasonable gains in sales and earnings.”

The Zweig screens are complicated, but they focus on earnings stability and persistence (in others words, he’s not looking for firms that have one or two big quarters) and sales growth. The resulting portfolio is a marvel. It rose 86 percent in 2003 and 806 percent over the past five years.

Validea also has a successful Zweig growth-stock portfolio, which was up just 34 percent over the past six months — more than double the rate of the benchmark. Validea’s virtual Zweig holdings are dominated by financial stocks, including HDFC Bank Ltd. (HDB), headquartered in Mumbai, India, and Countrywide Financial (CFC), a large-cap mortgage banker. HDFC, by the way, seems an excellent vehicle for playing the Indian boom; be aware, though, that its price has more than doubled in the past year.

The 13-stock AAII version of the Zweig portfolio also includes Countrywide, but all the other companies are different from Validea’s. They include Tractor Supply Co. (TSCO), a retail chain whose shares have quadrupled over the past two years and, despite growing like crazy, carry a relatively modest PEG ratio of 1.4, and Coventry Health Care (CVH), a managed-care firm whose earnings are projected to grow at 15 percent annually for the next five years.

What’s remarkable about the virtual Zweig portfolios is how much better they have done than the real thing. Last year, the Zweig Fund (ZF), a closed-end fund that trades on the New York Stock Exchange and is managed by the real Marty Zweig, returned just 9 percent, and it has lost money (rather than rising by a factor of nine) over the past five years. Also, the real Zweig Fund, as opposed to the virtual ones, is loaded with blue chips like Citigroup (C) and Pfizer (PFE).

Another living guru whose strategy is modeled by both Validea and AAII is David Dreman, author of one of my favorite investment books of all time, The Contrarian Investment Strategy (plus two sequels with similar titles). Dreman is a Graham-style value hunter whose real-life Scudder Dreman High-Return Equity (KDHRX) mutual fund has returned an annual average of 14 percent over the past 10 years, easily whipping the S&P. The fund is currently top-heavy in financials, with such companies as mortgage-funders Freddie Mac (FRE) and Fannie Mae (FNM) and regional banker PNC Financial Services (PNC) topping the list.

Last year, the AAII virtual Dreman returned 33 percent, almost precisely the same as the Scudder fund. The Validea fund has returned 42 percent since mid-July. Again, the computer-generated portfolios have little overlap, both with each other and with the real Dreman fund, but the stocks in all cases are similar.

Finally, there’s one of least-known but best-performing gurus of them all, James P. O’Shaughnessy, a financial adviser and quantitative analyst to whose work I first called the attention of readers in a column back in 1996. O’Shaughnessy, the author of What Works on Wall Street, came up with a simple system that turned out to be hugely successful when it was back-tested over a 42-year period. The system, which combines elements of growth and value strategies (for example, it searches for companies whose earnings are rising swiftly and whose price-to-sales ratios are low), is modeled by both Validea and AAII.

O’Shaughnessy launched a fund — later sold to a financial entrepreneur named Neil Hennessy — that applied the system using computer screens, and it has produced amazing results. Over the past five years, Hennessy Cornerstone Growth (HFCGX), as it’s called, has returned an annual average of 20 percent. What I like best about this fund, whose praises I have sung for several years now, is that it has done well in both good markets (last year it was up 45 percent) and bad (in 2002, it lost only 5 percent). Hennessy has also cut the expense ratio to 1.1 percent.

The portfolio is evenly split between mid-caps and small-caps (again, the lesson here is that the large-caps are already picked over for deals) and includes such companies as Nam Tai Electronics (NTE), a Hong Kong manufacturing-services provider; Select Comfort (SCSS), which makes beds you can adjust for firmness; and Flagstar Bancorp (FBC), a thrift based in Troy, Michigan.

Again, the AAII version of O’Shaughnessy has done better than the real thing — perhaps because its computer reconstitutes the portfolio once a month instead of once a year. As a result, the AAII portfolio sells and replaces about 30 stocks out of 50 in the average month, a nightmare for an individual managing a portfolio. But, at least according to five years’ evidence, it seems to work.

By the way, both AAII and Validea charge for their service, and the fees seem pretty reasonable, based on recent history, but you’ll have to decide for yourself. Validea offers a seven-day free trial, after which online access costs $29.95 per month or $74.95 per quarter, renewed automatically until you cancel. With AAII’s portfolio software, Stock Investor Pro, you run the various screens yourself. The program, which contains a 9,000-stock database and screening and filtering capability, comes in the form of CD-ROMs, mailed monthly, for $247 a year, $198 for AAII members. Membership costs $49 a year. The portfolios also appear online, available to members, but are updated less frequently.

Validea’s Carbonneau told me that the most popular service on his company’s site appears to be a service that lets you choose any stock and see how the nine gurus would rate it. You can analyze industries, too.

Consider home builders. A few weeks ago, I examined the sector, about which I am fairly enthusiastic. Validea can crunch the numbers and find the companies in the industry that the gurus like most. D.R. Horton (DHI), admired by five of the nine virtual experts, leads the list. High rankings also go to Centex (CTX), Hovanian (HOV), Lennar (LEN), Pulte (PHM), Standard Pacific (SPF), and Toll Brothers (TOL).

Validea includes Horton in Zweig’s 10-stock portfolio, and AAII includes Pulte and Standard Pacific in its own Zweigian 13-stock portfolio. Across all gurus, the sector is well liked.

You can go completely dizzy following all these virtual goings-on, but for many investors computer-based stock picking makes sense, especially when for some reason — like mortality — you can’t hire the guru you really want.

– James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com . This article originally appeared in the Washington Post.

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