Letting Legends Do the Picking


The idea of harnessing the strategies of some of the greatest stock-market gurus to individual investing decisions led John Reese to found Validea. At validea.com, CEO Reese has compiled nine investment strategies from experts as diverse as Benjamin Graham and the Motley Fool. The others cited are Warren Buffett, Peter Lynch, Kenneth Fisher, James O'Shaughnessy, Martin Zweig, David Dreman, and the CANSLIM strategy from William O'Neil of Investor's Business Daily.

Reese explains that Validea applies each of the strategies to the current market and puts together portfolios, each of 10 stocks, that best fit every individual strategy. An interested investor, Reese suggests, could either pick one of the strategies and invest in the 10 stocks it contains, or screen any stock to see if it's represented in any of the portfolios. Reese points out that Validea also compiles a hot list of stocks that have garnered the most interest among the strategies. That list now includes Bank of America (BAC), PetroChina (PTR), D.R. Horton (DHI), Fresh Del Monte (FDP), Foot Locker (FL), Home Depot (HD), Pulte Homes (PHM), and Royal Dutch Petroleum (RD).

These were some the points Reese made in an investing chat presented Feb. 12 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from this chat follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Which guru portfolio did the best last year? And which one is running ahead lately?

A: The Benjamin Graham did the best, with an excess return of 36% vs. the S&P 500 over the same period. Graham is still ahead.

Q: What stocks are in the Graham portfolio?

A: Each portfolio consists of 10 stocks. Graham's portfolio is Building Materials (BMHC), Natuzzi (NTZ), Orthodontic Centers of America (OCA), Wescast Industries (WCST), Fresh Del Monte Produce (FDP), Ameron Intl. (AMN), Industrias Bachoco (IBA), LaFarge Intl. (LAF), Skechers (SKX), and Stage Stores (STGS).

Q: What are some of the significant differences in strategy among the portfolios?

A: Lynch, for example, first classifies a stock into multiple categories, like fast grower, stalwart, or slow grower, and applies different rules to each category of stock. For fast growers, Lynch has a sweet spot for companies growing around 25% per year. He's turned off by companies growing a lot faster, because he believes such growth rates can't be sustained.

Buffett looks for earnings persistence over a 10-year period and takes advantage of the long-term compounding effect of stocks that compound at the rate of 15% or much more year after year, relatively reliably. Zweig looks for very careful signs of quarterly growth and makes sure that it's consistent with sales. Ken Fisher makes very strong use of the price-to-sales ratio, a very good indicator of a stock's popularity.

Q: So how would an investor make use of your guru portfolios in making decisions?

A: If you're looking for one strategy and easy decision-making, you would simply follow the portfolio and have an equal weighting among the 10 stocks. Ten are really needed for diversity. If you're trying to make a decision on an individual stock, look up on our Web site what all the guru strategies are saying about that particular stock, and if no guru finds it of interest at that time, don't invest in that stock.

Q: How long have you been running the portfolios? And how often are the lists updated?

A: We have run our model portfolios since the beginning of this year and our hot list since July of last year. The portfolios are rebalanced monthly. However, we update all information about every stock daily.

Q: What are some of the significant differences in strategy among the portfolios?

A: Take Lynch, for example. He first classifies a stock into multiple categories, like fast grower, stalwart, or slow grower, and applies different rules to each category of stock. For fast growers, Lynch has a sweet spot for companies growing around 25% per year. He's turned off by companies growing a lot faster, because he believes such growth rates cannot be sustained.

Buffett looks for earnings persistence over a 10-year period of time and takes advantage of the long-term compounding effect of stocks that compound at the rate of 15% or much more year after year, relatively reliably. Zweig looks for very careful signs of quarterly growth and makes sure that it's consistent with sales. Dreman looks for stocks that are in the lowest 20% of the market on certain measurements, including price to earnings, price to book, etc. O'Shaughnessy selects both growth and value stocks, and Ken Fisher makes very strong use of the price-to-sales ratio, a very good indicator of a stock's popularity.

Q: What benchmarks do you use to track performance of the gurus?

A: We use the S&P 500 as a very well-known benchmark index. Somebody asked, "why not just invest in an index fund?" Well, the performance of the portfolios is well in excess of an index fund.

Q: What criteria did you apply to selecting the chosen few gurus?

A: One, their strategy must be published so that the public can follow it. Two, the strategies used mostly factors that could be quantified. Three, that the performance was documented and was outstanding.

Q: Would any of the gurus go for stocks in such frontiers as biotech and nanotechnology?

A: Only when they start showing consistent profit, usually for three to five years. To paraphrase another Peter Lynch concept, at that time the stocks are only in the third inning of the ball game, and most will continue to have many years of great earnings if they meet the other criteria.

Most investors get in these concept stocks far too early, when it is like [throwing darts] to pick the real long-term winners. This has happened with all the hot industries of [any] time, going back to railroads and automobiles. There were many startups, but only a handful of long-term survivors.


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