Belt and Suspenders - Should it be Mandatory for a Stock Picking Strategy?

Why would investors need safety nets when it seems straightforward to just buy good quality stocks and hold on for the long term? In fact, it is not so easy, as even the largest companies in America are removed from the S&P 500 for declining valuations.

As reported by Innosight, "by 1990, average tenure in the S&P 500 had narrowed to 20 years and is now forecast to shrink to 14 years by 2026. At the current churn rate, about half of today’s S&P 500 firms will be replaced over the next 10 years"

What seems like an excellent holding today, can be tomorrow's troublesome child. There is any number of current examples from Tesla to Shopify. General Electric was a terrific company until it wasn't.

A belt and suspenders may prove overprotective in the new stock strategy. Time will tell as the results come in.

10 Rules of Engagement - The Importance of the number 20. As I was working on risk management rules I noticed the number 20 coming up again and again. In fact, it comes up so frequently that I am going to call the stock pickers' strategy, MIR20 (Morton Investment Research 20).

1 . Equal weight. The strategy will hold 20 stocks with an equal weight of 5% in each position.

2. Profit taking. Take profits on any position that exceeds 7% of the portfolio value, due to relative price appreciation. Re-allocate capital to the other 19 holdings to rebalance.

The rebalance rule will reduce exposure to stocks that perform really well. Unlike most research analysts or portfolio managers, the MIR20 strategy has no selling target price for each security. The basis of the strategy is that the upside on each position is unknown (so give each stock ample room to make money and take profits along the way).

3. Valuation. Select securities that trade at less than 20X earnings (there may be a few outliers at +20x, but the portfolio P/E multiple will be below 20x.

4. Belt #1 - Stop loss / Protect capital / Minimize losses. Each stock will be sold if it drops 20% from its purchase price or falls 20% from a new high. Every time a stock makes a new high, the software ratchets up the minimum price level at which the stock will be sold.

The downside risk can be roughly calculated, although it is not always possible to sell a security at the stop loss price. In some instances (such as a very poor earnings report) the stock may reopen well below your expected selling price. Limiting each security to a 5% to 7% portfolio weight decreases the risk that the overall portfolio will be dramatically affected by a disappointing sale price. This rule works particularly well for dynamic stocks that appreciate rapidly. The risk to stop loss protection is that one might sell after a 20% correction and then see the stock rebound smartly...in my view a risk worth taking.

5. Suspender #1 - Price momentum. Each stock, when purchased, must be trading above its 50-day and 200-day average price level. I am not seeking to catch a "falling knife". No need to buy the down-and-out securities, instead purchase those stocks that are acting in a positive manner.

6. Suspender #2 - Relative Strength. The selected shares will have a recent history of performing better than the IBD index (an index of 1,700 stocks) in good markets and falling less in poor markets. Similar to the moving average price rule, the Relative Strength rule seeks to capture stocks doing well (relative strength as defined by IBD). My minimum cutoff is an IBD rating of 70 ( #1 being a stock disaster...#99 being the strongest rank).

7. Diversification. No more than 2 of the 20 stocks are to be in the same industry group. This will limit the risk of being overweight in a sector..... such as computer chips or energy.

8. Growth markets. Focus on industries that are identified as having a growing underlying market, where higher stock returns are possible.

9. Selling. Let the winners run. Stocks will typically only be sold on a 20% decline.

10. Minimize the frequency of the sale of any security due to its languishing in price, disappointing earnings, or excessive valuation etc., Be patient. This reduces the subjective and emotional risk of acting on impulse.

It will be interesting to see if either the stock picking or the risk controls add value relative to the S&P 400 index. Perhaps one or both components will positively impact both risk and return.

My initial stock research is identifying numerous candidates that meet the criteria. Opportunities abound in multiple sectors. Coming soon, the MIR20 portfolio and going live.

best regards, Tim

Thoughts, agreement/disagreement? email me at tim@mortonir.com

Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your registered advisor for investment advice.