Motley Fool Mechanical Investing Board - Part III

Lesson 1: The Motley Fool Mechanical Investing Board

The main page can be found at Motley Fool Mechanical Investing Board

Lesson 2: Introduction to the Screens.

Lesson 2 can be found at Motley Fool Mechanical Investing Board - Part II

Lesson 3: A Mock Mechanical Guide Portfolio

Introduction

"Most hobbyist traders assume that the name of the game is price prediction. (finding those stock which go up) But it's not. The name of the game is risk management. The first goal is to ensure survival. You need to avoid risks that can put you out of the game. The second goal is to earn a steady rate of return, and the third goal is to earn high returns – but survival comes first." arezi

Fellow Fool arezi sums up something most investors take years understanding, and thousands of hard earned investment dollars learning. While finding stocks that go up is important, you must balance the amount of risk your portfolio is exposed to against the gain you expect to earn.

One way is to diversify your holdings across each of the different types of stocks and screens as we will do in our first portfolio. We'll talk much more about diversity in the next lesson, for now let's buy some stocks.

3.1 “Five Criteria, Four Screens” Consider these four screens: 1) RS26WK 2) CAPLOWEG 3) LOWPB 4) HighYield

There is nothing particularly special about these four. Simply that they fall within one of each of the five criteria. It can be argued the screen Low Price to Book (LOWPB), is more a Contrarian screen than Value, and in a normal portfolio I would add the SIPro screen Net-Net for a Value component, but in these first few lesson I want to be able to show you a full thirteen year backtest.

Nor are these four the screens you will probably settle on when constructing your real MI portfolio. As we continue through the coming lessons, we will look deeper at the screens, and probably make different choices. For now though, such a blend gives us a momentum screen (RS26), a growth screen (CAPPLOWEG), a value/contrarian screen (LOWPB), and an income screen (HighYield), diversifying our portfolio nicely.

We will use the top five picks from each screen, giving ourselves a 20 stock portfolio. We will use a four week (or approximately monthly) holding period, and a beginning portfolio value of $20,000.

Additionally, I'm going to use the Screen Ranking for January 2nd 2004, for our stock first picks. This will give us almost 11 weeks of actual returns to start looking at. We will continue through the Seminar to follow our mock portfolio with weekly updates on the MI Board entitled “IOM-D Guide Portfolio”. This will be the first of several mock portfolios we look at during this seminar.

From “Screen Rankings 02JAN04" http://boards.fool.com/Message.asp?mid=20096027

We see these stock symbols; RS26WK: NOVL, RIMM, TSAI, AIR, NITE CAPLOWEG: WHR, KRB, S, TJX, PKX LOWPB: CWP, AHO, CNA, LTR, VOD HIYIELD: MO, SBC, VZ, BAC, RD

The first thing we can see, none of our screens picked the same stocks. Had they had, you would have two choices:

1. You can buy a double weighing of the stock. This mimics the returns from the backtester, which assume your portfolio is evenly divided between all positions. The downside is in smaller portfolios this can increase the risk you have should that company drop badly.

2. Or you can go deeper in one of the two screens. Suppose that instead of LTR, our LOWPB screen had picked RD, which is also on the HIYEILD screen. You would then look at the number six pick from HIYIELD and use that. But suppose the stock is the last pick on two screens, how to choose which to substitute? You could look at the fields each of your companies are in and pick the stock in another field. Get a little more diversity across the portfolio. It often comes down to a personal choice between two good candidates. Interestingly, backtests have shown no real advantage for either doubling up, or going one deeper.

To start all of the screens we are using have a monthly holding period. As you learn more about MI, and build your own portfolio you will probably chose to hold some of your screens for longer holding periods; quarterly, semi-annually, or even annually. What if LOWPB was a quarterly, and HIYIELD a semi-annual?

We call an overlap between screens of the same holding period a "Horizontal" overlap. The same stock picked in two screens of different holding periods is referred to as a "Vertical" overlap.

(Not to be confused with the "Overlap" screens like RSO, which we discuss in a later lesson.)

Often times, people will double up in this case, because the overlap won't be held for the entire period and your exposure to risk less. Usually you will be fine with doubling up on a stock in portfolios of 15 stocks or more, though we don't recommend tripling up. (A stock on three of your screens.) Ultimately it will come down to a personal decision.

If we look deeper, these are the companies we've picked:

RS26WK Screen: 1) NOVL: Novell, Inc. Sector: Technology Industry: Computer Networks

2) RIMM: Research in Motion Limited Sector: Services Industry: Communications Services

3) TSAI: Transaction Systems Architects, Inc. Sector: Technology Industry: Software and Programming

4) AIR: ARR Corp. Sector: Capital Goods Industry: Aerospace and Defense

5) NITE: Knight Trading Group, Inc. Sector: Financial Industry: Investment Services

CAPLOWEG Screen: 1) WHR: Whirlpool Corp. Sector: Consumer Cyclical Industry: Appliance and Tool

2) KRB: MBNA Corp. Sector: Financial Industry: Regional Banks

3) S: Sears, Roebuck and Co. Sector: Services Industry: Retail (Department and Discount)

4) TJX: TJX Companies Inc. Sector: Services Industry: Retail (Apparel)

5) PKX: Posco Sector: Basic Materials Industry: Iron and Steel

LOWPB Screen: 1) CWP: Cable and Wireless PLC Sector: Services Industry: Communications Services

2) AHO: Koninklijke Ahold NV Sector: Services Industry: Retail (Grocery)

3) CNA: CAN Financial Corp. Sector: Financial Industry: Insurance (Property and Casualty)

4) LTR: Loews Corp. Sector: Financial Industry: Insurance (Property and Casualty)

5) VOD: Vodafone Group PLV. Sector: Services Industry: Communications Services

HIYIELD Screen: 1) MO: Altria Group Inc. (formerly Phillip Morris) Sector: Consumer Non-Cyclical Industry: Tobacco

2) SBC: SBC Communications Inc. Sector: Services Industry: Communications Services

3) VZ: Verizon Communications Sector: Services Industry: Communications Services

4) BAC: Bank of America Corp. Sector: Financial Industry: Money Center Banks

5) RD: Royal Dutch Petroleum Sector: Energy Industry: Oil and Gas - Integrated

Five out of our twenty stocks are in the Services Sector, with Communications Service as their Industry. This may or may not be cause for concern. The Market will often focus attention on certain sectors and industries. We have two choices, accept the concentration as picked, or drop a stock in favor of another further down the rankings.

The first choice, accept the concentration, mimics the way these screens were backtested. Choosing to drop a stock, and pick another will affect our returns. How much? No way to really tell unless we manually perform a simulated backtest. Unfortunately, our database at Backtest.org is not set up to do this. Limited research shows the difference is not great.

For now we will go with the picks as chosen, but you could make the following rule; “No more than 20% of my portfolio in any one Industry”, then go deeper in the screens for a replacement and still be considered mechanical.

3.2 “Socially Responsible Investing” Notice the number one pick in our HIYIELD screen; Altria Group Inc. (MO). This company was formerly Phillip Morris, and its business is Tobacco products.

Many people would hesitate to invest in such a company. They feel it is unethical given the effects tobacco has had on society. Again, you as an investor must decide for yourself whether you would invest in this company. For now we will purchase such stocks.

3.3 “Buying your first MI stocks” As a beginning MI investor you will probably make your trades on Monday. Unless you go ahead and purchase a subscription to Value Line, Inc. you will have to depend on the Weekly Screen Rankings for your stock picks. They are usually posted Saturday or Sunday. Those who do purchase a subscription have the data by mid-day Friday, and as such can make their purchases that day.

I can hear you ask:

FAQ: “Do those that purchase on Friday gain an advantage by buying as soon as they can? Am I hurting my chance for profit by waiting?”

(Author's Note: Whenever I come to a question that we see a lot in MI, I will highlight it with FAQ, or Frequently Asked Question.)

Actually, past research on the MI Board has shown it is better to wait a few days, but any advantage is small. Will it matter in the long run. Probably not. Pick a day and buy, but be consistent. If you decide to buy on the first Friday of the month, then do that. Just be consistent. Not the first Friday one month, the first Monday then next. Consistency will do more for your portfolio than chasing a few percent points of return here and there.

Anecdotally, we have seen price spikes in some of the smaller MI stocks on Friday right after Value Line, Inc. posts its weekly update. Then over the course of the next few days, the price will drop back down. Remember, we aren't the only ones using Value Line, Inc.'s data. Many big institutional investors also use it, and those who use quantitative methods of investing use criteria also found in our screens to identify the stocks they purchase.

(Check the posts in “Further Reading” for the specific data.)

We also have had questions about how fresh the data we receive from Value Line, Inc. and Investor's Business Daily. Value Line, Inc. does not update their RS 52 week rankings but once a month. For RSW screens which use this ranking, the second third and fourth weeks use progressively staler data. This may also be the case for IBD data. We have seen instances where the RS percentile rankings (re:RS99, RS98 etc.) have grown out of wack. There have been weeks where there were no 99 rankings. For these reasons, most of us do our stock buys on the first Friday of the month.

You should also know that Value Line, Inc.'s Friday morning download data is based on Wednesday's closing prices, and will not reflect any sudden drop or sudden increase on Thursday or Friday. Investor's Business Daily download does take into account Thursday's data.

By being consistent with your buys, you are building a habit of confidence in the screens. This will help when you have a down month and lose 20 or 30% of your portfolio. If it is not the day to rebalance, then no matter what your portfolio is doing you don't rebalance.

FAQ: "What if I buy a stock that later turns out to have been on the Rankings by mistake?"

Some people are tempted to just hold that mistake until next rebalance. I am not. You save yourself the $10 or $12 commission on an uncertain product. IMO if you discover you've bought a stock you shouldn't have, sell it and replace it with the one you should have as soon as you can.

FAQ: "What if something comes up, and I can't do my scheduled rebalance?"

If for some reason you can't do your rebalance on the day you plan, do it as soon as possible afterwards. If it is Wednesday or Thursday, you may want to wait for the new rankings on Friday. Then at next rebalance, follow your original plan. One holding period with a few less days, or even one less week, will not mess up your returns. Remember, you are investing I hope, with a multi-year plan.

Now the SCARY part!

3.5 “Your First MI Stock Purchase.” You may have purchased stocks before, but never so many at one time. Making your first MI purchase can seem like quite the scary thing. It's not. All you'll need is a regular hand calculator, a pencil and pad of paper. Begin by logging onto your broker and get quotes for the stocks you plan on buying.

(The backtester uses Monday closing prices, as will we. We will use yahoo.com for our historical data. And we will assume $10 for brokerage commission on each trade.)

The prices for our stocks for January 5th 2004 then are: RS26WK:NOVL: 10.70RIMM: 72.70TSAI: 22.95AIR: 16.16NITE 14.81.CAPLOWEG:WHR: 71.78KRB: 25.19S: 45.56TJX: 21.94PKX: 35.95.LOWPB:CWP: 7.40AHO: 7.45CNA: 24.87 LTR: 49.97VOD: 26.31.HIYIELD:MO: 53.61SBC: 26.74VZ: 35.89BAC: 78.55RD: 52.75

Relist all of them with the highest priced stock at the top, in this case Bank of America (BAC) at $78.55. You will purchase your stocks in descending order, with the lowest price stock last. Why? Doing your purchases this way will minimize the amount of cash left over sitting in your brokerage account.

We'll be funding each of our 20 stock selections with 1/20th of the portfolio, or $990 each when you subtract our $10 for commission. Divide that by the price of BAC, $78.55 gives you 12.60 stocks. Since it isn't a round number, you'll have to round it. I usually round up anytime it is 0.75ths of a stock or greater and round down for anytime it is less. So, we would place a market order for 12 stocks.

Wait while it executes. Most brokers will execute you order within minutes. Once the order goes through, check your final price including the commission. It will probably vary, but in this case let's assume we get our 13 stocks for the quoted price of $78.55 each. Commissions on the trade cost us $10, so the stocks cost us $952.60, leaving us with $19057.40.

The next highest stock is Research in Motion Limited (RIMM) at $72.70. We can either stick with $990 a share or check our balance and then purchase it with 1/19th (or in this case $1003.02)

For simplicity, you could stick with $990 a stock, and worry about it with our last purchase. Doing so would leave you with $1376.82, less $12 for a limit order commission which we will use this time, to purchase 184 shares of Cable Wireless PLC (CWP).

That does give CWP $300 more than other stocks, but that only increases it to 7% of portfolio, instead of the 5% the others have. This amount would have certainly been less, depending on the spread we had paid on each trade. Depending on how math challenged you are, will influence your choice.

For now let's stick with our original plan and use $990 for all but our last stock. $990 divided by $72.70 for RIMM is 13.62, rounded down to 13 shares. Place our market order, wait for it to execute, check your final price plus commission.

So we get to our last stock, Cable Wireless PLC at $7.40 and can purchase 184 shares. Since we don't want to spend more than we have in our brokerage account we will place a Limit Order.

FAQ: "Why a limit order only on the last buy?" We don't recommend using limit orders for your normal screen buys. Just market orders. Probably one of the best posts on the pros and cons of both market and limit orders was posted by Ganymede.

"The difference between market, limit and stop orders (not to mention Fill or Kill Orders, Day Orders, Good till Canceled Orders, All or None Orders, Do not Reduce Orders, etc.) should be outlined in your materials from your discount broker -- YOU ARE USING A DISCOUNT BROKER. The short answer is that Market orders allow the broker to fill your orders at (presumably) the best price it can get, period (you must take his word on what that price was). Although rare, I have read posts from investors indicating their belief that they were taken advantage of by their broker (or the market maker) when placing such orders.

I have only experienced one horror story, but it was enough. It went something like this: (1) stock closes at 40; (2) I place order overnight; (3) stock opens at 42, but shoots immediately up to 51 before drifting back and closing day at 37. My order -- filled at 50 1/2. Since that day, I place all market orders when the market is open while I'm looking at the real time bid and ask price on my screen. Perhaps, it's not necessary, but it sure makes me feel more secure.

In any event, Limit orders seek the purchase (or sale) of a security at a specific price or better. If the stock does not hit that price, you don't buy it. However, you need to realize that, on occasion, a security may trade through a specific limit price without the broker executing your trade. This is more likely in a thinly traded stock or one that experienced explosive volatility during the session.

You should also be aware that if you use limit buy orders in an attempt to get a specific stock at a slightly lower price than the one it is currently trading at -- you may end up chasing the stock up (if it never hits or trades through your limit price). This is particularly true of the screen stocks (utilizing RS) that are making so many of us so much money lately.

Finally, stop orders are used to protect a gain or limit a loss. In other words, you would place a sell stop order below the current bid price – in order to guard against an extraordinary loss. However, once again, there is no guarantee that your stop order will be executed at that price. If the security drops precipitously, the broker will sell the first chance it gets (which may not be at your stop, but when the security hits the bottom – and before any bounce back).

You can guard against such an occurrence with a stop limit order. This order will be executed only if the broker can sell the stock at the price you indicated. Once again, if the stock moves fast (and doesn't bounce back) you'll be stuck with it and may end up chasing it down. Which, in my opinion, hurts even more than chasing it up. I know, I've done both."

We all have our war stories of placing a limit order trying to get those last few dollars of profit and then watching the stock we want take off. You end up chasing it with limit orders and in the end paying hundreds if not thousands of dollars more. Ray Van Tassle has an infamous "Alligator Story" where in the attempt to save $12.50 he missed purchasing a stock which would have made him over $8000 in two days. The illusion of "saving money" will almost certainly cost you big over the long run in missed profits.

(Don't know the difference between market and limit orders? Check this out for more information: http://www.fool.com/FoolFAQ/FoolFAQ0028.htm)

FAQ: "When in the day is the best time to buy?" We also recommended that you not trade at the open. This happens when you place your orders the night before, or over the weekend for Monday purchase. We have seen too many examples of the prices fluctuating widely in the first hour of trading. Common opinion here is to try and make your trades later in the day. Noon or mid afternoon usually sees the smallest spread.

This from Mike McNamee at Business Week online: "Most important, don't use MOOs. That's Street slang for 'market order on opening'--an order to buy or sell at the hard-to-predict price where a stock's trading opens in the morning. Not coincidentally, it's also the noise cattle make on their way to the slaughter. Use overnight limit orders, or stay away from the opening altogether: You'll have a better shot at avoiding a flaying in today's turbulent markets."

("Commentary" for the article "Trading Online: It's A Jungle Out There". http://www.businessweek.com/2000/00_21/b3682001.htm)

What if you can't get to a computer during the day? Try for Tuesday morning by placing limit orders Monday night. Or consider phoning in your order. A few dollars difference in price may save you 30-50 dollars in extra spread. Then again, just like limit orders, if you try and save those last few dollars it may well cost you thousands in missed profits. Over the long run, even paying a few extra dollars at the open will even out.

Author's Note: Daniel Stuart (dan2) did a study of almost 1000 transactions to see if it really made a difference between trading at the open and at 11 a.m. He also tracked about 200 actual transactions with sizes between $1500 and $3000, placing market orders for execution at market open. In both cases he found on average the difference was insignificant.

His post can be found here: http://boards.fool.com/Message.asp?mid=12527712 The thread has some interesting counter points, worth the read.

3.6 Portfolio Tracking Confession time. When I first started investing, I kept track of my trades on a clipboard hanging behind my computer. And figured up the number of shares I needed to buy with a hand calculator. Now I'm a little more advanced.

Most brokers have decent software on their site for tracking the performance of your stocks. Some though only track the stocks you have with them. What if you have two brokers? The Internet has given investors some wonderful sites for tracing your portfolio. MSN Investor has high marks with some people. Yahoo as well. Many run Quicken, which has the advantage of being based on your computer. Quicken allows you to import your portfolio performance to tax software, an advantage at tax time. Since most services are free, set up several and experiment to see which you like. However you do it, you'll need to track the performance of your portfolio.

You can also take a look at this thread on the Workshop board for some more tracking suggestions. http://boards.fool.com/Message.asp?id=1030063003013000

Many people set up Excel spreadsheets. TMF has a message board for spreadsheet advice if you need help with Excel here: http://boards.fool.com/Messages.asp?id=1010005000000000

In addition to my broker's system, I also use the Motley Fool's Portfolio Tracker. While it will not keep track of closed out positions (a flaw I wish they would correct), it does let me check my stocks when first logging onto TMF, as well as providing me with a link to each stock's message board. I find it helpful to read what other fools are saying about the companies I hold.

If you've not used TMF's Tracker, begin here and read through the introduction: http://quote.fool.com/portfolios/portfolios.asp

We will continue through the Seminar to follow our mock portfolio with weekly updates on the MI Board entitled “IOM-D Guide Portfolio”.

3.6 Guide Portfolio – Beginning Stocks So here are the final values and number of shares we begin our mock MI Guide Portfolio with:

Stock Price # shares ValueRS26WK:NOVL 10.70 92 984.40RIMM 72.70 13 945.10TSAI 22.95 43 986.85AIR 16.16 61 985.76NITE 14.81 67 992.27.CAPLOWEG:WHR 71.78 14 1004.92KRB 25.19 39 982.41S 45.56 21 956.76TJX 21.94 45 987.30PKX 35.95 27 970.65.LOWPB:CWP 7.40 184 1361.60AHO 7.45 133 990.85CAN 24.87 40 994.80LTR 49.97 20 999.40VOD 26.31 37 973.47.HIYIELD:MO 53.61 18 964.98SBC 26.74 37 989.38VZ 35.89 27 969.03BAC 78.55 12 942.60RD 52.75 19 1002.25.Cash remaining: $3.22

3.7 Lesson Three Quiz

FURTHER READING: Trading on Monday versus Friday. Aka Lag: 01-14-02 “Trading Date Lag Results” by chrisjames. http://boards.fool.com/Message.asp?mid=16461376

09-03-02 “Re: Trading Day Variations for Misc Screens” by BGauer http://boards.fool.com/Message.asp?mid=17777989 See additional posts under that screen name around that time for further screens. One of note, since it applies to a screen we will use is: 09-01-02 “Trading Day Data for RS26WK” by BGauer http://boards.fool.com/Message.asp?mid=17770429

xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx