Active value investing works in all markets

What You’ll Learn

• How my hand picked model 2017 Action Score portfolio fared
• Mistakes I made and lessons learned
• What I’ll be doing differently

What a dud

After I claimed the 2017 model portfolio was going to beat the market, it did the opposite.

Talk about embarrassment after making such a claim.

To get to the point, the model portfolio ended the year with a disappointing 6.53% when the S&P did 21.8% and the Russell2000 index did 14.65%.

In this post, I will be going over the portfolio, review of the thought process as I was picking the stocks, lessons learned, what I’d do differently as well as other notes on how I used particular strategies for my own portfolio.

The Handpicked 2017 Portfolio Review

The original rules when creating this portfolio was as such:

• No changes until end of the year, UNLESS a company is bought out and needs to be replaced.
• 20 stocks @ $5k each for a $100k portfolio
• A grade stocks (but can include B if not enough A’s)
• No OTC stocks due to many people not wanting or being able to buy them (nothing wrong with OTC stocks though)

The idea of the Action Scores and the way we set up the variables were designed so that the strategy and the stocks will do great when the market doesn’t. But it’s still a shame to see it underperform or at least not to better in a strong market.

Here’s how the portfolio ended the year.

2017 Top 20 Handpicked Action Score Portfolio – Enlarge

Because this is an equal weighted portfolio, the bottom 4 stocks took a lot of wind out of the final performance. Equally affecting the performance was that out of the 20 stocks, only 6 managed to do better than the market at the end of the year. In terms of total hit rate, 13 were winners and 7 were losers for a 65% hit rate.

Maybe looking at the ratings at the beginning and at the end will give more insight.

By the end of the year all the stocks lost their A grade. This happens because unlike other stock grading or scoring systems out there, we constantly rank every stock against each other.

We’ve thought about ranking every stock independently, and that would make the stock grades stay the same much longer, but because the objective of any investor is to try and find the best stock to buy, we’ve made all stocks compete and rank against each other.

At the end of the day, if you have to choose between 2 stocks, you want to know which one is better. That’s what we do across every stock to make the best float to the top.

It doesn’t make sense to have 10 #1 stocks.

This also means that stock grades change more often as the scores are re-calculated every day. Not quarterly.

When I run backtests and test weightings to optimize the system, 1 year backtests are run. But if you can, it is better to replace stale or declining stocks with a fresh pick. More on this later.

Handpicked vs Original Portfolio

I keep referencing this portfolio as handpicked.

That’s important and funny because because I’ve written before that humans do more damage to themselves by getting in the way. We tend to have big heads. I know I have a hard time with it.

Here’s why. This is the original portfolio, had I chosen to go with the top 20 as it was.

Compared to this portfolio, my “picks” ended up costing the portfolio a 9.5% return.

• There were 9 stocks vs 6 that beat the market for the hand picked ones
• The winners were bigger with ISDR returning 106%
• There were fewer negative stocks
• Total hit rate was 75%.

So why did I choose my own stocks?

A hurdle that I’m still trying to get over is the idea that picking stocks with no research is a disgrace. It comes from believing what Buffett said about diversification.

Diversification is protection against ignorance. It makes little sense if you know what you are doing. – Warren Buffett

It also has to do with my pride and ego.

Having come from the fundamental side of investing, and having read book after book on how to analyze companies, crunch numbers and learn about management, it’s hard for me to take a backseat. I want to be in the drivers seat. I want to prove that I can be there with the best.

No need to name people, papers and research, but it’s been shown again and again that a systematic approach works. It doesn’t have to be complicated.

Ok, I will name a few.

Walter Schloss used a basic checklist and template when working for Ben Graham to find net nets. Even on his own, he managed to amass huge returns by following a simple process. Evan from Net Net Hunter has achieved amazing returns using similar methods with net nets.

Finding low EV/EBIT or EV/EBITDA stocks have also proven to work.

Now who doesn’t want to be like Buffett, Schloss or even Mohnish Pabrai with his huge win in Fiat (FCAU). I think that’s where we all get stuck. We want our name to be considered among these investors.

If you hold a max of 10 stocks, it’s a good idea to know what you are holding, but when you own more than that and are open to replacement based on metrics and scores, it’s not a good idea to dig into them too much.

The handpicked portfolio wasn’t 100% automated and it also wasn’t 100% researched. It was something in between and results were mediocre.

Winners and Losers

The beauty with using a system like Old School Value to find stocks is that you’ll come across stocks you’ve never heard of. Rather than focus on the stocks you hear about all the time (AMZN, FB, NFLX, BABA, TWTR, GOOGL etc etc) you have the opportunity to be surprised by no name stocks.

Who would have thought that a company like Issuer Direct Corporation (ISDR) would do so well.

I didn’t include KORS in my list because I don’t like fashion and retail, but it did 46%.

Other no name stocks like Wabash National (WNC), Fonar Corp (FONR), Teradata (TDC) and Aaron’s (AAN) all did well.

On the losing side, Smith and Wesson (AOBC) was the worst performer. The starting value of $10K eroded to $6k. Limiting such losses is an obvious move to improving performance.

The overall performance would have also increased by several points if you sold or took profits in TSR Inc (TSRI) during the year because in June, it reached a peak of $10 after a massive short run.

I was able to lock in profits for my own portfolio at a gain of 80% before it crashed back down. Because the portfolio is a buy and hold for 1 year rule, managing your portfolio and checking up on it once in a while will increase your own returns too.

Remember, when something is too good to be true, it likely is. Nobody went broke taking profits.

Active Value Investing

During 2017, Lester started the INVEST1000 project and it gave me the opportunity to spend time going back and forth with somebody from a different background.

Lester is new to value investing, but I think I got the most out of it.

His mid year update is coming up soon but I’ll show you what his portfolio was doing at the end of the year. If you don’t want to wait, you should check the original series to learn how Lester picks and sells stocks using technical analysis.

I bring this up because Lester decided from the beginning to use an active approach. Rather than buy and hold for one year, he occasionally checks on his portfolio, sees which stocks are doing well or have dropped in rank and replaces them with new picks.

With his portfolio mostly made up on small caps, he is beating the R2K by 5% and the S&P by 3%. Not bad for a professed newbie.

So I made my own and I’m taking the same active approach.

Transferred the money over, and I bought about $600 worth of stocks and had $400 in cash figuring I would get back to it later.

I ended up buying more stocks about 2 months later and still had cash left over. It certainly wasn’t the best execution of building a portfolio. If the amount had been larger, I would have been motivated to get it up and running quicker.

Either way, a 7% gain with only 60% of the portfolio invested for most of the time is a huge win (so far). Sadly, the market has more to do with it than anything else. We’ll see the results after a year.

2018 Portfolio?

I haven’t released the 2018 portfolio yet. With a truck load of things needing to be done at the end and start of the year, trying to get a portfolio out in Jan is too much of a struggle.

What I haven’t shared before is that my wife is also an entrepreneur and the venture she started a few years back from our small apartment has grown like a weed, requiring significant investments, employees and operations. As I play the role of a COO of that business, running 2 full time businesses in one household makes for interesting workloads and challenges.

Because of this, the 2018 portfolio will be coming soon.

I think it will be easier to show a sample portfolio of what it would have looked like if it was started on Jan 2, and have the real one created to start on Feb.

Closing Thoughts After Closely Watching the 2017 Portfolio

After monitoring the portfolio throughout 2017, here are some observations that I’ve started to employ and improve on where I can.

• Being active with selling and replacing losing stocks is a better strategy than the simple buy and hold for 1 year.
• Limit losses by having selling rules for quant portfolios. Don’t let a stock like AOBC damage your portfolio.
• Sell when ratings falls to a C or D. Replace with an A or B stock depending on strategy.
• Take profits if a stock rises to quickly. Momentum chasers and fear of missing out investors and traders will cause temporary insane prices. Lock in profits.
• Quant investing is not evil. It’s requires the same discipline as being open to selling a stock if a better idea comes along. No rule that you must sit still.
• Value stocks may be out of favor throughout periods of time, but active value investing works in all markets.
• It’s not so much about the single stock pick, but making sure you avoid sectors that kill your performance.
• Has great benefits of being detached with stocks to make objective decisions based on facts. Focus goes towards the process and the end results. Not the messy emotions in-between.

Resources Mentioned

• OSV Action Score Independent Validation Report
• Robinhood App for free trades
• Old School Value All-in-One Stock Tool
• Net Net Hunter
• Mohnish Pabrai holdings

Article by Jae Jun, Old School Value