Portfolio Planning

From Archive 02 March 2004

By PWM Editor

In this section of PWM we test the performance and volatility of two investment strategies using model portfolios. Each month we look at two distinct approaches – one global and one European.

EUROPEAN PORTFOLIO

Emerging value in beaten up stocks

This concept has been tested systematically and in real time on five different portfolios since September 2001, to obtain results at three months after inception and returns over the whole period. The results are particularly astonishing when considering that most portfolios were built during a bear market.

The five portfolios have beaten their benchmarks eight times out of 10 (two different time frames) and all of them have been extremely profitable since inception in absolute, as well as relative, terms. The testing also reveals that the portfolios don’t need adjusting very often, which decreases the overall maintenance costs. The basic idea is to let the portfolio run as long as it is able to beat the index on a quarterly basis.

Another interesting fact is that the return of the portfolios has literally exploded since March 2003.

We’ll now create a pan-European portfolio that uses this promising strategy. The recent market strength requires relaxation of the original rules. As a lot of value has disappeared from the market, the disciplined value investor should be investing

less at present price levels.

The first selection process tries to locate those stocks which have shown a poor relative performance over one year and which have shown a sudden surge in performance over the last three months. The valuation should also be low.

Usually, an allocation process would be needed to limit the number of stocks to no more than 15. This time the selection process produced only 13 stocks and therefore the second step can be eliminated.

The two value strategies will be reviewed in a future issue of PWM.

Chart 1 –The blue line represents the portfolio of 13 stocks which has emerged powerfully against the Stoxx50 Index (pink).

Chart 2 – The overall valuation of the portfolio is exciting: a gross dividend yield of +4.476 per cent against a very low price to earnings ratio of 13.939 times and a price to sales ratio of below 0.7221.

Chart 3 – Which are the stocks that show this excellent valuation? There are quite a few familiar names all over Europe (see table at left). Financials are heavily under-weighted against the Stoxx50 as well as utilities. Consumer cyclicals, industrials and technology (telecom) are over-weighted.

GLOBAL PORTFOLIO

Searching for cheap and consistent performers

Beating a roaring bull or bear market is a very difficult undertaking, particularly when conservative strategies are applied. This strategy was presented for the first time in the May 2003 issue of PWM and has shown very good results, considering the strong performance of the major stock market indices.

This portfolio has beaten its benchmark in terms of low volatility and high return, comparative and absolute return, as well as trend consistency. It might very well continue to perform well, as it contains quality value stocks despite the recent market rise. Nevertheless, let us create a new portfolio in order to check the sustainability of the approach.

Portfolio optimisation is achieved using two different techniques. The first selection process filters the database in such a way that the 17,000 items available are reduced to 44 stocks that show a low annual draw down and good value characteristics. The second selection step takes those 44 stocks and limits the choice to stocks with a high information ratio and relatively high profit margins. The final result is a portfolio of 15 stocks that will have defensive characteristics in a market decline and good upside price momentum.

The portfolio shows an interesting mix of defensive and cyclical stocks, which is the basis of a consistent performance in good and bad markets. The historical evolution of this portfolio is very similar to the one presented in the May issue of PWM.

Chart 1 – What is remarkable about the performance of this portfolio of cheap stocks (Apache, BCE, Brisa, CLP Holdings, Conooc, Cosmote Mobile, Hong Kong Electric, Malaysia Intl Shipping, Pernod Recard, Singapore Telecom, Telstra Corp, United Technologies) is its very defensive nature during the big decline of 2003 and the excellent change of gear when the market took off.

Chart 2 – The quantitative valuation of the portfolio reveals a high alpha.

Chart 3 – The portfolio shows excellent valuation parameters. The average price to earnings ratio is below 13 times and the dividend yield of the portfolio + 3.557 per cent, which is excellent compared to the present bond yields.