September 2002
Round Three
| "Above all, try something." |
| -- Franklin Delano Roosevelt |
WO YEARS AGO WE LAUNCHED OUR first two quantitative portfolios (P3 and P4). At about the same time, value stocks moved back to the forefront. Even more importantly, that was approximately the beginning of the first bear market in over a decade.
We hoped to test our portfolios' performance over a market cycle so our intent was (and still is) to let them run for a full three years before making any changes to their underlying formulas. This past July we moved into the test's third and final year.
So far, neither portfolio lived up to expectations. Both were designed to track the S&P 500 and so far, both have failed. Nevertheless, it's still too early to declare them failures since they've only been tested in one part of the market cycle -- the downside. As the nearby chart attests, they clearly don't perform well under this condition, but the overall evaluation needs to include their performance in an up market as well.
| Down in a Down Market |
It's been a tough two years for the market as a whole and even tougher for our first two quantitative portfolios, P3 and P4. |
What Were We Thinking?
Like Portfolio 3, P4 was the result of regressing fundamental factors against past performance. For both we used seven different factors, measuring both value and growth characteristics. We then used the resulting equations and current fundamental values of the S&P 500 to pick the highest rated stocks for each portfolio.The main difference between the two is how we ran the regressions. Portfolio 3 is run against the entire index and simply looks for the 30 highest rated stocks regardless of weighting or sector. In its early formulations, it was heavily weighted towards tech, but as that sector faltered, it's become more diversified (see Historical Performance).
Portfolio 4 is a little more sophisticated. Rather than applying to all stocks, it runs the regression separately in each sector, making it more sensitive to the differing factors affecting each sector. This is a reasonable approach since you wouldn't expect the same fundamental factors to affect differing sectors equally. While Price-to-Book may be meaningful when comparing Financial stocks, it's pretty meaningless when you're looking at Tech companies. Similarly, Debt-to-Equity means different things for Basic Materials firms and Healthcare concerns.
To accommodate these differences, P4 has a different regression for each sector, based again on past performance. Also, unlike P3, P4 was initially weighted like the S&P 500. To accomplish this, we started with the highest rated stock in each sector and kept moving down the list until the market value of each sector roughly coincided with the sector weight in the S&P 500. We did this again when we reformulated it.
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P4 Version 3.0
From a turnover standpoint, the change from version 2 to version 3 was slightly less dramatic than from version 1 to version 2. The current P4 contains 55 stocks, four more than the previous version and three more than the original. Thirty-eight are new, putting turnover at 67%, just down from the 73% for version 2.This shouldn't be attributable to market conditions since they didn't change as radically from 2001 to 2002. When P4 was originally created in mid-2000, growth stocks had just completed a decade of outperformance. The original formulation was naturally heavily skewed towards growth. Growth fell out of favor just about the time P4 was launched, so the second version moved more towards value. That's why turnover was so high last year.
Over the past year, however, the market hasn't shown a definite preference for one style over the other. Value did well in mid-2001 and early 2002 while growth outperformed in the final quarter of 2001 and second quarter 2002. As a result, this year's changes in the portfolio stemmed mainly from individual stock performance rather than specific style. It's not surprising turnover fell, albeit only slightly.
As of June 30th, the top ten holdings represented 36.12% of the portfolio. Included were four Financial stocks, three Healthcare, and two Consumer Staples, and one Consumer Discretionary. The cyclical nature of this mix anticipates a market turn. Conversely, it wouldn't be too surprising if it underperformed should the bear market drag on.
Make no mistake; this is still a growth portfolio. Although the forward P/E is 32.8, down from last year's 39.1, it's still well above the S&P's 20.5.
Other fundamentals reflect the market's fall. For example, the portfolio's average market capitalization is $18,820 million vs. the prior version's $37,544 million. The current ratio of long-term debt to capital is 23% vs. 28% for the predecessor version. Return on equity is now a modest 2.6% vs. last year's 10.2%.
For the first time in this portfolio's history, the beta is actually below that of the market (.94 vs. 1.00). It will interesting to see if this translates into better tracking of the index.
Watch for This
Despite an abysmal first year and a half, P4 has been the best performer so far in 2002. That, of course, isn't saying too much in the sense that it's down well over 20% through August 30th. Over the first eight months of the year, it trails the S&P 500 by just under 2.5%.As demonstrated in 2001, this portfolio clearly is not designed to best the index in a bear market. What we've seen so far this year is that it can hold its own when stocks move sideways. What hasn't been tested is how it does in an up market.
Over the next twelve months we should get an opportunity to test this. We suspect it can close the gap with the index when stocks begin to regularly post gains. Unless there's a rocket-like recovery (highly unlikely) it's probably far too late to make up all the losses of the prior two years. Nevertheless, it would be nice to see P4 recover some of its lost ground.
Growth stocks tend to do best in up markets. Should stocks find their footing, this could work to P4's advantage. Keep an eye on it.
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