The Bloodhound System Exchange

It’s all about jobs, right? Unfortunately creating jobs is an ephemeral process with many dimensions, so its much easier to make political points out of debt, which only has two parameters, income and expenditure. Anybody can understand that, especially if you have the benefit of the having a Congressional Budget Office to create long term projections. It’s exciting to hear 20 year projections about debt, especially when next year is the tenth year anniversary of the ten year forecast that the US would have NO DEBT at all! Now that we understand all about debt, we can talk knowledgeably about all the other countries who do/may/ have a debt problem, always assuming that those responsible for running them do nothing about it for 10 years (sounds like us!). Jobs ……… maybe they will take care of themselves until we have a vocabulary for discussing them.

It was while pondering the fact that the market keeps cratering, while we keep hearing companies reporting good earnings, that lead us to take a look at our database to see whether there was a divergence between prices and earnings. We looked at the last 12 months of EPS reported up to July 24th., and the gain over reported figures a year ago compared to the initial share price. Then we looked at the change in share price over the same period, to compare them and then, since we had introduced a measurement of earnings change/share price we looked at the typical size of that number (which is really the PE ratio inverted).  To be exact, the first row shows the increase in trailing 12 months EPS before DNE between the latest reported quarter and the same quarter a year earlier; unfortunately you cannot measure this as a percentage because a percentage change from -10cents/share to +10 cents/share does not make sense, so the change is shown as a percentage of the initial share price. The second shows the percentage change in share price over the same period and, since we measured the EPS change relative to share price in the first comparison, we showed the actual EPS/share price at the latest reported date. The data was based on  our database July 24th. and excludes companies with a share price below $2.

What does it tell us? The top line shows that out of around 2900 companies 33% experienced a decline in EPS while only 30% suffered a decline in share price, so prices were not punished more than earnings. When you look at those with positive earnings, however, many saw a higher increase in share price than the increase in earnings, most of which gained less than 10%. The bottom line is the inverse of the PE ratio, which is not meaningful for negative numbers, so if you look at the positive group, it shows that most EPS/price ratios are in the 0-10% range (i.e. PEs greater than 10) with one third in the 10-20% range (PE’s between 5 and 10) and very few with lower PE’s than that.

Every investor has goals for return and risk. Risk is hard to measure; familiar measurements like standard deviation (often referred to in the industry as “risk”) and beta (which is based on standard deviation) are inadequate because standard deviation cannot differentiate between growth, volatility and decline. In the following diagram, all three portfolios A, B, and C have the same mean and standard deviation, but they look very different to the investor! Growing portfolios (like A) are therefore said to have a high standard deviation and to therefore be “risky”!

Downside deviation, upon which the Sortino ratio is based, excludes upwards movement from its measure of volatility. For portfolios with significant gain, it is a more satisfactory measurement.

We wanted to find a more tangible measurement of risk that an investor could relate to more easily. The question we asked is “How likely is it that I could have obtained an average annual return of 20% if I had invested in Model Strategy X for 8 years, and I had started on any day in the last 24 years?” Bloodhound’s ability to invest a specific strategy and follow it for 24 years enabled us to  answer the question which, since we could do the analysis for every Model Strategy, enabled us to add “and which Model Strategy would have given me the highest probability of obtaining 20% over an 8 year period, and what was that probability”.

Here is the result: in order to be able to fit the table to the page we abbreviated the strategy names with their first letter, so SA5_10 is the strategy “SuperAggressive5, with a portfolio of 10 stocks (C, M, G, A refer to the Conservative, Moderate, Growth and Aggressive strategies respectively). The categories are color coded.

In the example that I took, of investing for 8 years and looking for an annual compound return of 20%, the table shows that the strategy most likely to have delivered that return is SuperAggressive5 with a 10 stock portfolio, and (in the lower table) the probability of doing so was 100%!

We also included, for reference, the worst performance. This represents the performance that you would have achieved if you had invested on the worst possible day in the last 24 years and held your investment for the period of interest. For an 8 year investment period, the best performance on the worst possible investment day came from SuperAggressive5 and the worst investment return achieved over that period was 31% a year.

Of course, we have to remember that we invest in the present, for a return in the future, and here we are looking at the events of the last 24 years, not the next. However, when EVERY 8 year period that you could have picked averaged more than 20%, it is encouraging, to say the least! This, in 24 years that included Black Monday, two occasions when the market fell 50%, wars, terrorism, the “Crash of 2.45pm” in May this year, and six Presidential terms.

Why? Why is it that a high growth strategy produces greater certainty of  a return? We cannot answer for certain, but it seems to be that the volatiliy of the strategy enables it to recover faster and more certainly than a “Conservative” strategy that is based on larger companies with lower average returns.

One might, perhaps, expect a Conservative strategy to lose money less often but this, too, is nt necessarily so. If you examine the 24 years of detail that we have for SuperAggressive5, for example, you will see that it took a  hit in 2000, 2002 and 2008, but replied in each case with an outstanding return in the following year (parenthetically, it also lost less often than the SP500 index, which should represent the ultimate in conservatism!) . Notice also that it is the 10 stock portfolio that appears most often; again, the 10 stock portfolio usually outperforms a 20 stock portfolio so the correlation seems, again, to be with return. It seems to us that if you can tolerate higher volatility on a day-to-day basis, the ability of the strategy to produce high gains overwhelms losses.

It is important to take notice of the shorter investment periods.  If the measurement of success is not gain, but to not lose money in individual years (0% and 1 year in our table), then other strategies make their appearance. What this indicates is that when you look at one year performance, results are more variable; but they become more stable, the longer you stay with the strategy. If there is one message that comes out of our research, it is that staying with a strategy produces greater predictability.

Is there something special about SuperAggressive5? As with any mathematical measurement, one cannot tell from the chart whether there were three other strategies that produced almost the same result for each point in the chart, hence our general conclusion that aggressive strategies seem to offer greater confidence of any given return.

To test this we removed any Aggressive or SuperAggressive strategies from consideration, which created the following result.

Notice, again, that out of the Conservative, Moderate and Growth Model Strategies, it is the Growth (the highest returning of those included) strategies that dominate, which seems to corroborate our earlier conclusion that higher returns produce greater likelihood of a return over time.

Many investors are familiar with stock screening as a way to select candidate stocks for their portfolio; Bloodhound takes screening to the next level.

Screening has two disadvantages:

• The number of stocks that pass your screens varies with the state of the market, so if you are looking  for a portfolio of 20 stocks, the only way you can reduce the candidates to 20 is to add screens that you would not otherwise use.
• Until time passes, you do not know whether your screen produced stocks that Wall Street will reward, or not.

Bloodhound solves both of these problems. We use your  screens (or one of ours) to find candidates; you use just the screens you trust, and you can include any of 1400 fundamental, or more than 120 technical algorithms, or create your own. Then we add a ranking method to sort the candidates that pass. Ranking  rates candidates according to a measure of value (like Earnings, for example), divided by the cost of obtaining that value (like the share price).Then we pick the highest ranked candidates to create your portfolio.

Next, we add trading rules; these include the amount of money you want to invest; how often you want to trade stocks, what you want to do with the proceeds, whether you want a stop-loss or not, etc.

Now you have a complete investment strategy, and we do two things with it:

1. We use our 24 year fundamental and technical database and our state-of-the-art simulator to analyze the performance of your strategy, daily, for the last 24 years. This shows you how it performed in all kinds of markets, which stocks it held, how much it gained, what drawdowns it experienced, how often it traded.
2. If you like the results, we find out what stocks it would pick if you were investing today, and if you are, and have an account with one of our linked brokers, you can invest the entire portfolio with a single click.

 But that’s not where investment ends; as Benjamin Graham (the father of modern investing) said:

“……the investors chief problem is himself, temperament is more important than expertise in accounting, finance or stock market lore…”

 So Bloodhound tracks your portfolio for you, every day, rates every stock in the market against your strategy, and tell you if and what you need to trade.

 All you have to do is to follow your strategy. If you know how it has performed for 24 years, it will probably do a better job of managing your portfolio than you can. You can sleep at night, because Bloodhound doesn’t, and if you are too busy to check on things, we are doing it for you; all you have to do is check in, and if you see a red Alert, it will tell you what to do. Strategic investment beats trying to time the market!