DYNAMIC VALUE INVESTING USES SCIENTIFICALLY PROVEN INVESTMENT TECHNIQUES FOR SUCCESS:

A REFINED PORTFOLIO APPROACH

We've spent hundreds of man-hours "in the lab" so to speak, looking for refinement to our "Dynamic Value Investing" approach that will produce excellent returns in the current, challenging marketing environment.

We've come up with a new timing system that we call "Intelligent Timing." Here what we've found:

1) Buy and Hold Investing should be labeled with the acronym 'DNW,' i.e., 'Does Not Work.' Investing in the current environment requires a more active approach using market timing. Investing in the two decades from the early 1980's to the late 1990's was a piece of cake compared to the most recent decade:

Many investors long for the easy days of 'Buy and Hold' investing that dominated the two decades prior to the last one. Chart courtesy of StockCharts.com.

We can't invest in the market we wish for. It will likely take another 6-8 years before the market resumes a bull trend where Buy-and-Hold works again. In the meantime, we're going to use a new, revised approach to market timing. Chart courtesy of StockCharts.com.

2) Classic Value Investing Approaches Are Struggling. Extensive studies done by IntelligentValue show that commonly accepted Value Criteria such as Price-to-Earnings (P/E) no longer work well to identify undervalued companies. The chart below shows the results of a Price-to-Earnings ranking system run on stocks over the past year. The top ranked stocks by P/E over the last year are on the far right. The top 1% of stocks shows a return of -17% based on this factor:

Classic value criteria such as Price-to-Earnings and PEG are not working. The far right bar indicates the top ranked stocks by P/E over the last year. The rest of the chart is all over the board. Chart courtesy of Portfolio123.com.

3) Criteria Using Price/Sales, Price/Free Cash Flow Are Performing Best. In the current environment, investors are skeptical of reported earnings and earnings growth. The fundamental criteria of Price/Sales and Price/Free Cash Flow are working best. These two criteria provide investors with confidence that the companies are truly undervalued relative to top-line performance and are also generating strong cash flow from their sales. This differs from payroll cuts that can result in strong bottom-line earnings, but are temporary. Investors are placing a higher value on organically grown top-line revenues, rather than savings derived by cutting staff.

The chart below shows the top ranking system we have uncovered through extensive research and number crunching to assure robustness. This ranking system emphasizes five basic, fundamental-value criteria that emphasize cash flow and cash on the balance sheet:

This simple 6-factor ranking system emphasizing fundamental value factors of Price to Free Cash Flow, Sales, and Book Value shows an astonishing return of 360% in the top 1% of stocks. Chart courtesy of Portfolio123.com.

4) A Portfolio Based on This System is Extraordinary. Running this ranking system with criteria that eliminates stocks that are too small or with poor liquidity results in a performance chart that is amazing. The chart below shows the performance of this system over the last year:

A portfolio based on the DVR 6-Factor System is amazing. Chart courtesy of Portfolio123.com.

In backtesting, the portfolio produces an annual return of 302% with a maximum drawdown of 24%. Overall winners were 75% of the portfolio and the Sharpe Ratio is an astonishing 6.54%. The average stock was held 47.27 days with the biggest winner gaining 119.35% and the biggest loser at -26.90%.

5) Too Much Drawdown. However, as amazing as this 302%-annual-return portfolio is, it's not good enough. Many investors would gladly trade the risk of a 24% maximum drawdown for a return of 406%. But our experience, after many years of publishing IntelligentValue, is that subscribers will NOT tolerate a drawdown this high. Previously, when there was anything over a -15% drawdown, subscribers leave in high numbers.

There seems to be a pain threshold among individual investors at about the -15% level. Therefore, we have spent a great deal of time revising the market timing system we use in hopes of reducing drawdown without losing much return. That system is now ready to be unveiled.

6) Revised Market-Timing System. We have used multiple market timing indicators over the years to try to satisfy subscriber's drawdown threshold while still providing solid returns. That objective has been met over the years with various levels of success. In the market crash of 2008, we were able to sidestep the big sell-off because we went to cash before the downturn started.

Previously, we used Moving Average lines, trendlines, MACD indicators, Stochastic Oscillators, and other technical approaches to try to get a handle on the direction of the market. None have been good enough to satisfy us or our subscribers. Even with a 400% annual return, subscribers will leave if the drawdown gets even close to 20%.

But now we've developed a new market Entry/Exit system that we've dubbed "Intelligent Timing." This system was built from the ground up based on massive amounts of backtesting on technical indicators. Nothing we have done before comes anywhere close to the results from the timing system we are going to use going forward.

7) Here's How It Works: Recently we came across some new scientific-based tests of various technical indicators and it was an eye opener. The study, conducted by FINVIZ, showed that Wells Wilder's Relative Strength Index (RSI) as well as the Directional Movement Indicator (DMI, also from Wells Wilder) were the only two technical indicators that truly showed significant returns over a buy-and-hold investment approach. That was surprising in and of itself!

Since coming across this information, we have been working hard to find the appropriate settings for the Directional Movement Indicator (DMI) and Relative Strength Index (RSI) so we can consistently use them as Buy/Sell signals. Simply stated, in the chart below, when the green line (+DI) moves above the red line (-DI), and is confirmed by a second day with a price that moves higher than the signal day, it is a 'buy' indication for the market. Vice-versa for a short signal when the red line (-DI) moves below the green line (+DI).

To eliminate whipsaws at inflexion points, the system needs confirmation from a second day of prices in the same direction and surpassing the signal day. You can see this indicator in the middle chart of the graphic below. The thick, vertical red and green lines show the buy and sell signals given by the system.

Our revised market timing system show excellent results over multiple years. Chart courtesy of StockCharts.com.

But it's not enough to have a single signal indicator. To make sure the signal was valid, we needed more than the DMI indicator (with confirming day) to issue a buy or sell signal. With a lot of man-hours, we've put together a confirming indicator that we believe is a breakthrough variation on the Relative Strength Index (RSI).

This indicator, shown in the middle chart of the graphic above, identifies when the RSI is moving up from oversold levels (0.2) and down from overbought levels (0.8). This is different from the standard RSI as it adds an oscillating property showing overbought and oversold as well as Bollinger Bands to help define the signal trend. I have never seen this RSI hybrid used elsewhere, but it certainly shows outstanding results when it is used as a confirming indicator for the DMI signal.

8) The Results Are Astonishing. When these timing inputs are used in the value-based stock-selection system discussed above, the drawdown is halved. That's excellent news!

However, when drawdown (some call this risk) is reduced, the result is usually lower returns. 'No pain, no gain' as they say. So how much are returns lowered? None. Zip. Squat. Nada.

In fact, returns are increased by 300% to a 702% annual return! In more than 35 years, it's one of the few times I've seen risk reduced and reward increased in an investment context. And never at this level, which nearly doubled the original backtested results.

The backtested return of this portfolio over the last year jumps to +702% while the drawdown is reduced to just -11.8%. Overall winners are 80% of the portfolio with the highest gain being 125%. The average hold time is 47 days, and the Sharpe Ratio is a whopping 13.3% - the highest I have ever seen! Here's a chart of one year through the end of April, 2010:

Double the return with half the drawdown when using the 'Intelligent Market Timing' system.
Chart courtesy of Portfolio123.com.

The one facet of the system that subscribers will have to accept, one which is difficult for some, is that we have to be out of the market for what can sometimes seem to be long periods of time. That's understandable: it's human nature to not want to miss an opportunity. Extensive scholarly studies have been done of human responses related to their avoidance of loss and pursuit of opportunity which confirm our experience with subscribers.

But the timing system has shown that we can avoid very serious drawdowns that wreck portfolio returns by staying out of the market at critical points. New subscribers should understand that this is our approach.

8) The System is Robust Over Time. We have examined the system using hundreds of different start and end dates, eliminated the top 10% of winners, started and stopped it in down periods, but the result is always the same: Rocket-to-the-Moon Returns and minimal drawdowns - a maximum drawdown of 14% down in all backtests done.

To see more details of our real-time RESULTS, click here. If you are ready to get started with a service that provides you with clear buy and sell signals, outstanding returns, credibility, and savvy insights into the market, then you are ready for IntelligentValue!

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