Consumer Staples Strategy – July 2016 Signals

The current stock signals for the consumer staples strategy introduced here are below. They are also published here. I used Portfolio123 to generate this screen.

HLF, Herbalife Ltd
NPD, China Nepstar Chain Drugstore Ltd
SENEA, Seneca Foods Corp.
CCE, Coca-Cola European Partners Plc
MED, Medifast Inc.
ADM, Archer-Daniels-Midland Co
GMCR^16, Keurig Green Mountain Inc
IMKTA, Ingles Markets Inc
MHG, Marine Harvest ASA
UVV, Universal Corp
USNA, USANA Health Sciences Inc
PM, Philip Morris International Inc
KMB, Kimberly-Clark Corp
AVP, Avon Products Inc.
NUS, Nu Skin Enterprises Inc.
ABEV, Ambev SA
GIS, General Mills Inc.
VGR, Vector Group Ltd
EPC, Edgewell Personal Care Co
PEP, PepsiCo Inc
CHD, Church & Dwight Co. Inc.
BTI, British American Tobacco PLC
WFM, Whole Foods Market Inc
FDP, Fresh Del Monte Produce Inc.
BG, Bunge Ltd

What Wilt Chamberlain Can Teach Us About Investing (The Irrational Investor Part 2)

On March 2, 1962 Wilt Chamberlain set an NBA record by scoring 100 points in a game. He scored 28 points in free throws alone, another NBA record, going 28 for 32 (87.5%) from the line. While 100 points in a game is no small task, Wilt averaged 50.4 points per game and had already scored 78 points in a game that season.

What was more impressive in that game was his free throw percentage. Why? Wilt Chamberlain’s career average from the free throw line was 50.4%. So how did he shoot 87.5% that night? By shooting his free throws underhanded. So why didn’t he permanently adopt the underhanded free throw permanently? Because, in his words, it made him “feel silly, like a sissy.” 

Malcolm Gladwell explored this and Wilt’s inexplicable aversion to shooting underhanded in a recent podcast. (A Q&A with Gladwell that touches on the same issue with other NBA players is here). Ira Glass explores this topic, including other examples of people “choosing wrong”, despite evidence suggesting a better outcome if they choose otherwise, in a recent episode of This American Life.

Gladwell ties Wilt’s choice to rebuff the underhanded free throw to Mark Granovetter’s threshold theory. In short, people with low thresholds are much more likely to follow the crowd, despite the advantages of not doing so. People with high thresholds are much more likely to ignore the social context of a behavior.

So how can this help you be a better investor? By being aware of our innate irrationality, we can avoid the herd mentality that led to the dotcom bubble. Awareness of this phenomenon can help you resist the latest trendy stock or strategy and to not lose sight of the underlying fundamentals of an asset. 

Knowing that your brain is working against you will hopefully prevent you from selling low and buying high, like so many millions of investors still seem to do.

Minimizing Downside Risk: Quantitative Strategies for Conservative Investors

In What Works on Wall Street, James O’Shaughnessy looked at how different factors fared within individual sectors of the stock market. He found the best performing factor for the utilities sector was a composite of several factors, called “value composite 2” (VC2), and the best performing factor for the consumer staples sector was shareholder yield (SHY). Both VC2 and SHY were introduced here.

To replicate the utilities value strategy, simply purchase the top 25 stocks in the all stocks universe (market cap >$200M in 2008 $) sorted by highest VC2 score. For the consumer staples strategy, purchase the top 25 stocks in the all stocks universe sorted by highest SHY. Both strategies rebalance annually, as with all the strategies in the book.

What’s amazing about these strategies is not only do they outperform the market, they do it at a lower risk.

Strategy Performance (1968 – 2009)

Both strategies outperformed the market with lower standard deviation (see out-of-sample, 2010-2016 performance here).  A limitation of just looking at standard deviation is that it accounts for upside risk and downside risk, but since upside risk is a good thing, a more useful measure is downside deviation, which only measures downside risk.

The lower the downside deviation, the less likely the return will be lower than expected. In other words, the lower the downside deviation, the less risk the strategy has when stock prices are falling.

That’s all there is to it. If you have any questions, post them in the comments below.

The Irrational Investor (Why Isn’t Everyone Doing It?)

If you read my last post, one of your first reactions might have been, “If these strategies are so effective, why isn’t everyone doing it?” Or, why aren’t you in charge of a big hedge fund, why isn’t every pension/trust fund using it, etc. (these are actual responses I’ve heard from people).

And while O’Shaughnessy covers this very question brilliantly in the first three chapters of What Works on Wall Street, I will make a feeble attempt in this post to begin to answer the skeptics. (He also has commentary on these topics, including “The Myth of the Most Efficient Market” and many others, on his asset management firm‘s website).

To begin, let’s review the obvious: everyone isn’t doing it, especially not managers of equity funds.

% of actively managed funds underperforming the S&P 500 on a 10-year return

On average between 1991 and 2009, 70% of actively managed funds had 10-year returns worse than the S&P 500. Vanguard has more recent (and more complete) data in its case for index-fund investing, shown below.

% of actively managed funds underperforming their benchmark on a 5-year return
(click to enlarge)

For the data and time period Vanguard looked at, actively managed funds underperformed their benchmarks two-thirds of the time on a 5-year return (a pretty strong case to not invest in actively managed funds).

So why, if strategies like trending value and the other 222 strategies that outperformed the S&P 500 between 1964 and 2009 are so lucrative, aren’t these equity fund managers able to beat the market?

Identifying the factors that outperform the market is easy. It’s a well documented fact that value investing over long periods of time will outperform the market (even Warren Buffet knows the value of value investing!). This is the basis for the trending value strategy I previously discussed. If the underlying indicators are obvious, who is left to blame? The investor’s brain is a good place to start.

Indexing the S&P works because it’s a strategy that never varies. Day in and day out, it the S&P 500 is an index of large cap stocks. It doesn’t decide one year, “Oh small stocks are doing well recently, maybe I’ll become a small cap index!” No, it stays the course.

As an individual investor (or as the manager of an equity fund, where it’s literally your job to not lose your clients’ money), would you have stayed the course through the 7 years between 1964 and 2009 that the trending value strategy underperformed the S&P 500?

Difference in CAGR, Trending Value Strategy minus All Stocks

When the strategy lags 20%+ behind the rest of the market (like it did in 1999 and 2009, shown above), are you really going to stick with it? Not likely — fear/risk avoidance is wired into the deepest parts of your brain, an extremely useful feature for species survival, but not so useful for being disciplined in your investment strategy. (And if you stuck with it as a professional asset manager, you’d be fired).

A 2005 study found that brain-damaged people make better investment decisions than able-brained people, by being more willing to take risks and less likely to react emotionally to losses. The brain-damaged people ended up with 13% more money on average at the end of 20 mock investment rounds.

This is a brilliant market-timing game that shows you just how difficult it is to try to beat the market on a short-term basis. If you don’t do well on that game, don’t feel bad, not even Isaac Newton could to outsmart the market in the short-term. Or millions of other investors, as evidenced by recent history.

At the bottom of the Great Recession in Feb/March 2009, there was a net outflux of equity of over $50B (in just those 2 months; $9B net outflow over the year), as the influx into the bond market that year was $375B. Those who sold at the bottom not only realized their 50% losses, but missed out on the 159% rebound since then. They did it despite decades of past data and experience suggesting that the market would rebound.

So what’s the takeaway? Discipline is the key to the individual investor hoping to implement a strategy proven to outperform the market over the long term.

“Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disclination to do so.”
          Douglas Adams

Why I Dumped My Index Funds (An Introduction to Quantitative Investing)

In my last post, I outlined why increasing your portfolio return is the most worthwhile investment of your time and energy. Now I’m going to introduce the investment strategies that have consistently beaten the market for decades.

The first time I heard the term “quantitative investing”, I imagined mazes of cubicles with math/finance graduates working 100 hours a week at big investment banks on Wall St. But once you peel back the scary facade, you find that the reality is not very intimidating.

Instead of picking investments based on a gut feeling, what you hear on the news, what a company’s logo looks like, or other qualitative indicators, quantitative investing uses cold hard numbers. That’s all there is to it. 

In 1991, a strategy called Dogs of the Dow was popularized by Michael B. O’Higgins. Basically, every year you would invest in the ten stocks listed on the Dow Jones Industrial Average index that have the highest dividend to price ratio (also known as dividend yield). As you can see, this strategy beats the market most years. The Dogs of the Dow strategy has faced criticism for not being sophisticated enough. But it isn’t the only quantitative strategy out there — far from it.

Originally published in 1996 and now on its 4th edition (updated in 2011 at the 2009 recession), What Works on Wall Street takes a deep dive into dozens of quantitative strategies and is a must-read if you decide to start experimenting with any of them. This is the book that led me down the path to completely dump the contents my 401(k) and implement a quantitative strategy.

To give you a teaser to the content of this book and a preview for my next post, here is an excerpt that lists all of the strategies sorted by worst year. They were backtested from 1965 to 2009. The highlighted row is a strategy called trending value, which will be the first strategy that we explore in detail.

For the trending value strategy, the average annual return was 21.08%, more than double the S&P 500’s performance. $10,000 invested in 1965 grew to more than $48M by 2009, compared to just over $500k if you’d invested in an S&P 500 index fund (so 2x the return over 40 years gets you 96x the resultcompound interest is amazing). And to implement these strategies, all you need to do is crunch some numbers once a year (with stock data and Excel), buy the stocks that the data is pointing to, hold them until next year, and repeat.

If this intrigues you as much as it did me, buy the book and stay tuned for my next post.