Academic research largely concludes that stock markets are efficiently priced. All knowledge is thought to be in the public domain and is therefore filtered in real time down the each individual stock. Therefore no portfolio manager has an edge. This "efficient market theory" could explain why +85% of stock portfolio managers underperform their relevant benchmark stock index.
But what if instead markets are absolutely inefficient? The reason that managers underperform, is that most stock price movements are random. Analysts get the earnings, margins and revenue estimates correct and then disappointingly the stock goes in the opposite direction of the firm's prediction. Perhaps not all is lost, there might be a method to take advantage of the unpredictability.
Foundational Question
Are there U.S.-listed stocks that appear to move randomly in price, while possessing superior historical economic success? Additionally, do they have an equally positive long-term financial outlook?
Screening 9,571 small to medium-capitalization U.S. stocks reveals a multitude of stocks with these attributes. So the desired stock candidates are reasonably plentiful. All analysts have access to these screens, so there is no advantage in solely populating the portfolio based on historic fundamentals and future outlook. Something is missing in achieving strategy success.
Perhaps the missing ingredient is a comprehensive risk control overlay. We all tend to show stubbornness when, after deciding on a course of action, the outcome goes against us. Ego is involved and decisions are delayed.
How to Overcome Emotional Limitations
Design a rigid set of rules that dictate when stocks must be sold and what stocks can be added.
Guiding Principles
Diversity of the portfolio. Avoid sector concentration. Allocate the portfolio by equal weight to 20 differentiated businesses.
Be disciplined. Establish a set of rules for what stocks qualify for the portfolio (math-based, but subjective in final selection).
Pre-established profit-taking targets so that no stock dominates the portfolio.
Focus the strategy on companies with strong earnings and fortress balance sheets, rather than purely future growth expectations.
Remain fully invested at all times as long as there are stocks that qualify under the fundamental screening criteria. No overall Bull / Bear market timing calls.
MIR20 Investment Goals
To outperform SPDR S&P Midcap 400 ETF by 400 bps, with two-thirds of the volatility
The Benchmark: SPDR S&P MIDCAP 400 ETF (MDY) ETF
Portfolio Metrics
Data Source: 1 September 1995 - 30 November 2022 (~27 years)
Source: lazyportfolioetf.com
MDY Drawdowns - This passive index is the MIR20 benchmark
Stocks having the following attributes.
Profitability. To be consistently profitable. No over-reliance on new products, forecasting commodity prices or short-term consumer fads. Companies with concentrated customer exposure are excluded.
Fundamentals. A strong balance sheet, with consistently positive cash flow. The strategy is not composed of startups, poorly financed or speculative companies.
Valuation. Trade at a price/earnings multiple that is generally at the midpoint of its historical range (i.e., if the home builder Toll Brothers has historically traded in a P/E range of 5x to 20X earnings, look to purchase at less than 10X earnings). Purchasing shares at the lower end of their historic valuation should increase the odds of not overpaying.
Market capitalization. Select companies valued between $1b -$20b, (while targeting an average of $10b across the portfolio- a similar capitalization to stocks in the S&P 400 Index). This will allow comparisons of the strategy performance to the S&P 400 Index.
Volume. Ensure ample trading volume for each selected stock, so that liquidity is never an issue.
Coverage. Confirm that there are multiple Wall Street analysts covering each stock. No need to find hidden jewels or stocks that might never see investor interest.
Return on equity. Companies should have a track record of generating a 20% return on their equity. Indicating that historically shareholders have been rewarded, that the company is well managed and exists in a profitable industry.
Earnings stability. The rating service, IBD, has a measure of earnings stability (are corporate profits consistent or irregular). IBD ranks #1 as being most stable, and #99 as being least stable). The preference is to hold stocks with a stability rating of 20 or less. This could decrease the risk of a disappointing earnings release that causes shares to drop unexpectedly.
Due diligence. External stock research that is positive in regard to company valuation and outlook. Perhaps this research is not of great importance, but it might prevent the purchase of a stock where there is non-obvious risk.
Reaction to Earnings. Frequently the best companies announce excellent earnings growth and the share price drops in response. Often times this allows for an attractive entry price.
Stock & Portfolio Risk Controls
Pre-established 20% Stop Loss sell prices for stocks based on their cost base (for stocks that drop immediately from the purchase price) or when a stock drops from the highest recent trading price (important as you want to avoid, if possible, giving back all your profits)
Equal weight. The strategy initially holds 20 stocks with an equal weight of 5%.
Profit taking. Take profits on any position that exceeds 7% of the portfolio value, due to relative price appreciation. Rebalance this position to a 5% portfolio weight. Re-allocate capital to the other 19 holdings to rebalance.
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
Selling. Let the winners run. Stocks will typically only be sold on a 20% decline from their cost base or recent high price. Portfolio holdings that in the future fail to possess the required fundamentals (from stock screening methodology), will be sold (i.e., reduced ROE, earnings or revenue growth).
Portfolio Option Overlay
Purchasing Put options on the S&P 500. Annual allocation of 5% - 7% of the portfolio value for the purchase of put options. There is excellent liquidity in S&P options and the correlation to MDY is high (see appendix note #2).
Overlay portfolio with S&P 500 put options, 10% out of the money. (out of the money lessens the cost of portfolio insurance). The Put exercise price, being 10% below the current value of the S&P, means the portfolio has little "insurance" coverage in the first 10% drop in S&P 500 value (similar to a deductible on your home/property insurance policy). This option position is intended to serve two purposes.
Reduce portfolio volatility in S&P corrections of less than 10%
Protect portfolio value in market corrections greater than 10%
Why Mid Capitalization U.S. Listed Stocks?
Potential for corporate growth rates to exceed those of large caps stocks due to "size" effect
Mid Cap avoids the issue of potentially poor liquidity in small caps.
Relative to large cap, a greater opportunity to experience positive earnings surprises (less institutional research coverage)
Arguably less expensive valuations and therefore increased potential for takeover by large capitalization companies.
Tim Morton, CFA
Appendix
Note #1 Morton experience with stock selection (46 years).
Exponential Disruptor Strategy was funded with $500,000 of Tim Morton capital. The portfolio ran from September 2016 to March 2020. Morton's strategy produced an annual rate of return of 21.25% versus the global technology index ETF IXN benchmark return of 18.66%. This strategy was less diversified than MIR20. Additionally, it held no Index puts for portfolio protection. I closed the strategy at the onset of COVID as this strategy was not designed to have a Put option overlay, was singularly technology-focused and lacked diversification of capital.
Positions sold below the 0% horizontal line were sold at losses as high as 30%. Shopify, positioned at the far right of the graph, was the most profitable trade returning 180%
Note #2
Put options on SPY serve as a reasonable proxy for protecting mid-cap stocks from drawdowns.
Looking at the past 5 years of MDY drawdowns vs SPY drawdowns there has been a significant correlation of 0.91.
Note #3
Strategy Financial criteria versus Actual MIR20
Characteristics at the Live Portfolio Level
Return on Equity target of +>20%. Actual portfolio 28% ROE
Price/ Earnings Multiple of <20X. Actual median 9X
Earnings Stability < 20 (1 being best, 100 worst). Actual 19
Positive Thomson / Reuters Research Coverage (10 best, 1 worst). Actual 9
Strong Thomson analyzed balance sheets (10 best, 1 worst). Actual 7
Capitalization between $1 billion -$20 billion. Actual: average capitalization rate of $9.2 billion(companies ranging in size from $1b to $19b)
Multiple institutional research coverage. Yes, with average coverage per security of 14 analysts
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