Motley Fool Mechanical Investing Board

Overview

"Mechanical investing", as practiced on the Motley Fool Mechanical Investing board, involves completely mechanical ("rule-based") investment decisions, which (it is hoped) outperfom the most widely-known indices.

The board began shortly after a series of columns in the Motley Fool authored by Robert Sheard. He explored a variety of techniques, often involving the Dow 30 stocks. As an English professor, he often performed research in his university library, where he discovered the weekly stock newsletter, "Value Line." He began exploring various subgroups in Value Line's statistically ranked system and published some of his observations in a book in the late 1990's, called "The Unemotional Investor." Members of the nascent Mechanical Investing board assembled a collection of Value Line data (mostly in discs) for exploration.

Subsequently, other commercially-available data were included, including Investor Business Daily's Weekend Review Feature, and AAII's SIPro software. These historical data are collected and arranged in "backtesters" that can be accessed on the internet (some open to the public, some only by invitation).

Members of the Mechanical Investing board attempt to determine what trends, if any, are "real," and which may be spurious. Topics on the board will frequently involve the likelihood that a "screen" of stocks will work in the future, whether its volatility (sometimes taken as GSD) is unreasonable for the individual investor, whether the odds of a screen failing in a catastrophic fashion make it unfeasible to invest in, and what combination of stock selection critera for one or more screens gives the best reward versus risk ratio.

Since establishment of these backtesters, individuals have run tens of thousands of screens. Some screens have become widely employed by members of the board, and others have fallen into disuse. Whether any of these "screens" are demonstrably better in the long-run than the Foolish Four is an open question.

The following lessons have been exerpted from posts by LAPropDoc:

Table of contents

1) Overview 2) Lesson 1 - What is Mechanical Investing 2.1) Styles of Investing 2.1.1) "The Little Old Lady" style. 2.1.2) Fundamental Analysis (or F/A) 2.1.3) Technical Analysis (or T/A) 2.2) Mechanical Investing Defined 2.2.1) Repeatable 2.2.2) Explicit 2.2.3) Backtested 2.3) What are the Five Types of Criterion 2.3.1) Momentum or Relative Strength 2.3.2) Growth 2.3.3) Value 2.3.4) Contrarian 2.3.5) Income 3) Lesson 2 - Introduction to the Screens 4) Lesson 3 - A Mock Mechanical Guide Portfolio 5) Lesson 4 - Mechanical Investing Boot Camp 6) JimZipCode’s FAQ - MI part1: Intro, Math, Problems 7) JimZipCode’s FAQ - MI part2: Lingo, Screens, Switching, Options, Timing 8) JimZipCode’s FAQ - MI part3: Basics, Thinking, Further

Lesson 1 - What is Mechanical Investing

To understand what "Mechanical Investing" is, it helps to first review the various styles of investing.

Why do you invest? If you are like 95% of the public, you invest to make money. You buy a stock, with the anticipation it will appreciate in price and be worth more when you sell it. How you go about identifying the stocks you buy is dictated by both your personal preference and the style of investing you use.

Investment styles can be broken into two general categories of analysis; Qualitative and Quantitative.

Qualitative Analysis uses subjective judgment in evaluating stocks based on non-financial information such as good management, future outlooks, and market dominance.

Quantitative Analysis uses financial information derived from company annual reports and income statements to evaluate an investment decision such as revenues, earnings, expenses, and cash flow.

Basically, Quantitative Analysis looks at the numbers, Qualitative looks at subjective factors. Within these two are many different styles.

Styles of Investing

"The Little Old Lady" style.

The most basic style of investing is one which I tend to call "The Little Old Lady" style. You could also call it the "Water Cooler" style of investing. When asked why they bought a stock, users of this style will often say, "I liked that company." (Kind of like my Grandmother would say.) Or "I got a tip from a friend." You can include in this style, those who through a savings plan like a 401K, simply invest in their own company's stocks.

This style is entirely Qualitative, and based on completely subjective criteria. Whether it succeeds is usually a matter of luck. As an investor gains more experience, they often begin using more qualitative methods to find companies to invest in.

Few styles are entirely qualitative or quantitative. Most use a bit of both. Among the most popular styles are;

Fundamental Analysis (or F/A)

While many equate this style with Quantitative Analysis, F/A often includes several more subjective criteria in deciding which stocks to buy. A good example of this style is The Motley Fool's "Rule Maker" Strategy. If you look at the ten characteristics you'll see the first three would be very hard to quantify with a number.

This style is often the first one learned by new investors, on the basis of recommendation from more experienced friends or from popular investment books.

Within F/A are several sub-styles; A) Value Investing is a type of F/A where the investor looks for stocks in quality companies which are currently undervalued, due to recent poor performance or market movement. Quantitative factors like P/E Ratios and Book Value are analyzed.

B) Growth Investing is buying companies which are growing faster than others. The main factor considered is Earnings Per Share (or EPS). Some subjective decisions must be made as to a company's or sector's possibility of continued growth. Related to this is:

C) Momentum Investing buys stocks with accelerating numbers such as a rising share price, earnings or revenues. At the first sign of a dip they usually sell. A momentum investor normally buys a stock after its price rise has begun and tries to sell out just after it begins to falter. While the numbers can be quantified, just when a stock has faltered and not "taken a breather in preparation for more rise" is very hard to judge.

D) Day Trading is a type of Momentum Investing which focuses on very short time periods, usually intra-day, and quick entry and exit to make a small profit.

Additionally there are several styles of Fundamental Analysis based on books by famous investors. CANSLIM, Gorilla Game, and GARP are but a few. They all have in common a combination of qualitative and quantifiable criteria which their authors have found work for them.

Technical Analysis (or T/A)

Technical Analysis analyzes the statistics generated by a stock's market activity, past prices, and volume. Technical analysts do not attempt to measure a stock's intrinsic value, instead they look for patterns and indicators on a stock's chart that will help them predict its future performance.

Indicators like Moving Averages and Bollinger Bands can be quantified, but many T/A patterns are very subjective. Two investors will often disagree on whether a chart does or doesn't match the pattern. Technical Analysis is benefiting from the increased use of computers which may help remove some of that subjectivity.

Mechanical Investing Defined

Mechanical Investing (or MI) is perhaps the purest of the quantitative investing styles. Criteria used to pick stocks are numerical in nature and are derived from either a company's financial statements or institutional rating services.

In general any mechanical investment strategy will have two basic characteristics:

1. Repeatable: The rules for selecting stocks are defined so that any two investors, when choosing the same strategy, would end up choosing the same exact stocks.
2. Explicit: The rules for what and when to buy, and when to sell, are defined in advance and strictly adhered to.

Mechanical Investing, as practiced here in the MI Community, has a third characteristic:

3. Backtested: Only rules whose past performance can be verified by a backtest are considered valid candidates for investing strategies.

Let's look at these three characteristics in more detail.

Repeatable

Our first characteristic said; "The rules for selecting stocks are defined so that any two investors, when choosing the same strategy, would end up choosing the same exact stocks.

Consider the definition of the strategy Relative Strength 26-Week (or RS 26): 1) Select stocks with Value Line "Timeliness Rank" = 1. 2) Sort those stocks descending (highest first) by Value Line "Total Return 26-Week". (Such a set of criteria is called a "screen".)

Most but not all of the base data we use to select stocks comes from Value Line, Inc., specifically from their weekly "Value Line Investment Survey". Among the things Value Line, Inc. does is rank the stocks they cover by their proprietary ranking called Timeliness Rank. Stocks are given a number from 1 to 5, with 1 the best. In a few cases a stock may receive no Timeliness Rank.

So as a first step for this screen, we would select all stocks having Value Line's Timeliness Rank of 1, and getting rid of any that don't. (More about Value Line, Inc. in Lesson 2.)

Next we would sort this group by Value Line's Total Return 26-Week. Total Return is simply how the stock's price has improved. A stock whose price was ten dollars 26 weeks ago, and was now priced at twenty dollars would have a Total Return 26-Week of 100%. If the price were now forty dollars, it would be 300%. So the stock that had the highest price appreciation would be our number one pick, followed by the stock with the second highest price appreciation, and so on.

As you see the RS 26-Week screen is 100 percent quantifiable. There is no subjectivity in this description. Either a stock has a Timeliness Rank of 1 or it doesn't. Either it is the highest appreciated stock or it isn't. Given stock data which lists these two values, Timeliness Rank and Total Return 26-Week, two different investors will always arrive at the same set of ranked stocks. All screens used a similar repeatable method, if with other criteria.

Explicit

Our second characteristic states; "The rules for what and when to buy, and when to sell, are defined in advance and strictly adhered to."

Let's say an investor decides to invest in Relative Strength 26-Week. They decide they will purchase the top five stocks, and hold them for a month. At the end of the month, they will re-rank the universe of stocks and any RS-26 stocks they own which are no longer in the top 5 will be sold. The proceeds will then be used to purchase those stocks which now make the ranking. Any stock still in the top 5 will be held for another month.

Again, any two investors who used the strategy as described would at the end of a year have purchased the exact same stocks. Their return will of course differ. Stock prices fluctuate during the trading day, and those differences will of course change the total return each investor ultimately receives.

Holding periods for screens in the MI Community are currently time based, in increments of a month, from 1 month to 1 year. The reason has more to do with data collection than investing. While Value Line, Inc. updates their "Value Line Investment Survey" weekly, currently our historical database is limited to once-a-month data. Any strategy using shorter periods has only a limited backtest, and as such is considered more experimental. Currently a volunteer effort is working at expanding our database, but it will take time.

We teach that an investor should decide on a plan and stick to it for at least a year. No matter what plan is made, to stay "mechanical" an investor will stick to that plan. Deviation based on anything but a discovery that the original screen backtest was in error, removes the investor for being mechanical.

We'll discuss why you should be “mechanical” in a later chapter on Fear, Greed and Investor Psychology.

Backtested

As I mentioned earlier, the MI Community adds a third criterion to what "mechanical" means as an investing style, the Backtest.

Just what the heck is a "backtest"?

Imagine you were the great, great, great grandson of HG Wells. In clearing out the old mansion, you find HG's time machine. What do you do but hop in and take it for a spin. Now the old machine doesn't have the range it did when it was new, so you only get back to January 1986. Out you climb and head to the nearest stock broker with the $1000 in your pocket. But! You forgot to stock up on old newspapers. Which stocks do you buy?

Remember the screen Relative Strength 26-Week? Just give your new broker those simple instructions. He'll check each week's edition of Value Line (which was published then), buy the top 5, and hold them for a year. Then the following year do it again.

"Now, I'm going on a long safari in deepest Africa for missionary work, feeding starving children and don't expect to be back for 16 years," you tell him. "Just keep investing that way, and I'll be back." So after some minor instructions like buy Microsoft at $1, it's back to the time machine.

Fast forward to the future. When you get here, your bank account would be worth $35,933! Not bad for just a $1000 initial investment. But maybe you think you could better that if instead of your 1986 broker trading yearly, he traded semi-annually. Well hop back into the time machine.

Now Jamie Gritton is not HG Well's grandson (unless there's something he's not mentioned). For investors though, he's the next best thing. That's what the backtesters are, time machines. It tells you what would have happened if you'd gone back and invested then. They can't tell you what will happen in the future, but they can help you see the way our screens did in the past.

Jamie Gritton's site provides a variety of regular back tests of the basic strategies, "overlap" strategies, screen-of-screens strategies, and blends of screens. One section, the "Screen Builder", allows the investor to see how different criteria would have done, and put them together in custom screens.

He's always changing something; see what's different this week. http://www.backtest.org (We will devote several future chapters to the Backtester.)

An important question then becomes, "How far back should a backtest go in order for us to have confidence in the screen?"

Many of the core screens derived from Value Line, Inc. data have been backtested for a sixteen year period (1986-2003). This allows us to view the screen performance through a wild variety of market conditions. This gives us confidence that the performance we see in the past will continue in the future.

Beginning in 2000 some members of the MI Community began working with the universe of stocks covered by Stock Investor Pro, sold by the American Association of Individual Investors. SIPro covers some 9000+ companies, with hundreds of criteria fields. SIPro covers many small market cap companies not covered by Value Line, Inc.

More importantly, those members were able to gather backtest data back to 1996. While this is a shorter period than for screens derived from Value Line, Inc. many of us feel that backtests over that shorter period are valid because it included a wide range of market conditions. We've also seen that screen criteria performance common to both Value Line, Inc. and SIPro backtest relatively close in historical returns.

Its worth pointing out that for a screen to be mechanical it should be "able" to be backtested. Not necessarily that it "has" been backtested. The MI Community is always looking for new ideas. Most of the screens you see today, started out as a simple post of an idea.

A word of warning, though; we don't recommend you put your hard earned money into an untested screen, especially when there are many good ones with historical backtests.

What are the Five Types of Criterion

The criteria we use for screening can be broken down into five general quantitative categories.

Momentum or Relative Strength

Relative Strength screens look for a positive momentum in price. Screens of this type ride the wave of upward movement of market sentiment. As a company gets noticed, more and more people buy it, and in accord with classic supply and demand theory, this causes further appreciation. Momentum screens exhibit high volatility, with large day-to-day price swings. They show rapid run-ups, oftentimes followed by equally rapid drops.

Growth

Closely related to Momentum screens, criteria of this type look for growth in one of the many fundamentals other than Price; like Return on Common Equity, Sales Growth and Relative PE. The most common growth criterion is Earnings per Share (or EPS).

Value

These look at fundamental criteria like Price to Book, Net-Net or NCA (Non-Current Assets), trying to identify companies whose current market value is less than the intrinsic worth of the company's assets; the idea being that eventually the Market will recognize that undervaluation and the price will grow. Ideally, we'd like to buy a dollar's worth of a company for less than a dollar.
A problem with value criteria is that the assets used to project company worth may be illusory. (Can we say WorldCom.) And many stocks whose current market value is less than their apparent liquidation value either continue to go nowhere and thus produce no return on capital or, worse, continue to get cheaper. They are cheap for a reason.

Contrarian

Like Value, Contrarian criteria look for stocks which are undervalued by the Market, and we wait for the Market to turn towards them. Unlike Value, the criterion may identify companies whose worth is simply less than other similar companies. If the entire sector is overvalued, then it is entirely possible we're still buying overpriced stocks.
The distinction between Value and Contrarian criterion is minute, but one we should be aware of.

Income

There are two ways to make money with a stock. The largest is price appreciation, which the previous four criteria identify. The second way to make money on stocks is when a company either puts money into your pocket outright, as with dividends, or increases the value of the outstanding stocks, with stock buy back programs. Many screens of this type use Yield.

Some screens will be purely one type, but most screens will be a mix of several criterion. We will look closer at these five criterion and these various screens in the next Lesson.

Lesson 2 - Introduction to the Screens

Lesson 2 is continued here: Motley Fool Mechanical Investing Board - Part II

Lesson 3 - A Mock Mechanical Guide Portfolio

Lesson 3 is continued here: - Motley Fool Mechanical Investing Board - Part III

Lesson 4 - Mechanical Investing Boot Camp

Lesson 4 is continued here - Motley Fool Mechanical Investing Board - Part IV

JimZipCode’s FAQ - MI part1: Intro, Math, Problems

Continued here - Motley Fool Mechanical Investing Board - MI part1: Intro, Math, Problems

JimZipCode’s FAQ - MI part2: Lingo, Screens, Switching, Options, Timing

Continued here - Motley Fool Mechanical Investing Board - MI part2: Lingo, Screens, Switching, Options, Timing

JimZipCode’s FAQ - MI part3: Basics, Thinking, Further

Continued here - Motley Fool Mechanical Investing Board - MI part3: Basics, Thinking, Further