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 November 2010 Clean Sweep -- Almost Model Portfolio 2 Gets a Major Overhaul
But don't misunderstand, the fact that P2 was unchanged for so long doesn't mean it had failed. Quite the contrary, as you can see from Chart 1, P2 has not only kept up with its benchmark, the Russell 2000, it has actually slightly outperformed it over the October 31, 2008 - September 30, 2010 period, +26.8% vs. +25.8%, respectively.
Chart 1 also explains why we thought it was time to do a little trading. Clearly P2 did a good job following its benchmark, but we wanted more. An index fund could have done the same -- although ironically, P2's expenses were actually lower because an untraded portfolio doesn't incur any expenses. Instead, we wanted P2 to incrementally exceed the return of the benchmark allowing it to slowly expand its cumulative lead. By September 30, 2010, P2 was above the benchmark, but one percent over two years was a little too incremental. The other thing that was troubling about P2 was the way it traded over shorter time frames. Ever since 2008, its ten constituents always fell into two distinct categories: Sugar or Sh...er, garbage. At the last performance report in early September, five of P2's ten holdings were off more than 10% for the year, while another three were up over ten percent. This was not unusual and even more notable was the fact that those in the sugar category often switched to the garbage (and vice-versa) from one two-month reporting period to the next. No wonder the overall model was unable to establish a growing lead over the benchmark. So yes, it was time for a change. Although one may question the justification of altering a portfolio that was performing acceptably, the goal of active management is to do more. Because the current mix just wasn't moving forward fast enough, it was time to look for alternatives.
The Search P2 is a bottom-up model meaning there is no restriction on the holdings' distribution across sectors. Rather than looking for structure from the index itself, stocks are selected for P2 based on their individual fundamental characteristics. Conceivably, all components could come from just one sector. Unlike quantitative models 3 - 6, the shares' fundamentals are the determining factor for inclusion.
That, however, doesn't mean quantitative screening doesn't play a role. It serves as a starting point to locate stocks with promising value-oriented characteristics. Once the quantitative process narrows the potential universe, each stock receives a qualitative analysis. In essence, the quantitative process reveals stocks that are priced at a discount, while the qualitative process searches for catalysts to begin their ascent back to fair value. The goal is not to find shares that are deep values relative to their book value, but rather shares that have been mispriced or unfairly punished by the market. The key is not only to see they're a value now, but that they have the potential for a near-term recovery. Unlike deep value investing, this is more of a relative value approach seeking growth in the coming six to twelve months. Because of this, some traditional growth factors play a role in the quantitative screening process. Specifically, the screen looked for stocks that were not currently crippled, but instead were showing quarterly earnings growth of 15% or more with a positive prior quarter surprise. They also had to produce value for the shareholders by boasting Return on Equity in excess of 10%. To assure management isn't gaming the numbers, long-term debt to capital had to be less than 30%. Finally, and most importantly, shares had to be fairly priced relative to growth. To assure this, we required a PEG (Price-to-Earnings ratio to Growth) of less than 2 -- the lower the better.
The Results
Nine of the ten stocks are newcomers. With turnover at 90%, this is the most active year for P2 since its inception. Until now the highest annual turnover occurred in 2004 when turnover hit 60%. The lowest annual turnover was recorded in 2009, when there were no transactions. The sole remaining veteran holding is United Stationers, Inc. which initially entered the portfolio six and a half years ago on March 9, 2004. None of the others scored high enough on the quantitative model to reach the qualitative level. When selected based on September 30 data, the average market cap for P2 was roughly $1 billion, well below the $1.5 - $2 billion cutoff for small cap stocks. The average P/E was 15.4x last four- quarters' earnings. That's not super cheap, although it is in line with historical averages. Again it's important to realize that although this is a value model, it isn't intended to be deep value. The goal is to find underpriced stocks with a current catalyst to get them moving back towards fair value. It the first month, the new P2 lived up to its billing. From October 1 through October 29, the model added 6.5% while the Russell 2000 was up 3.7%. On September 30, prior to the rebalancing, P2 trailed the benchmark on a year-to-date basis +4.48% to +8.11, respectively. Thanks to the strong October showing, P2 finished the month ahead of the index for the year, +12.66 vs. +12.47. Of course one month is a very short evaluation period. It will take months, and yes, perhaps even a year before the verdict will be in. Nevertheless, it's encouraging to see the model get off to such a good start. It's highly unlikely it will go for such a prolonged period as before without even minor trades. The fact that it did so well over the past two years is a testament to its stock selection. The short-term performance of the new mix underscores that, too. Search this site! Just enter you key word or words: Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
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ODEL PORTFOLIO 2 HAS remained virtually unchanged for almost two years. The last trade occurred on Halloween 2008 and even it was dictated by the purchase of Long's Drug Store by 
