A REFINED APPROACH TO CLASSIC VALUE INVESTING

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

We have developed a new system that provides amazingly accurate signals for Market Up and Market Down situations. We call it "Intelligent Timing." Here's what we've found:

Buy and Hold Investing worked extremely well in the 1980's and 1990s. However, in the current decade, which is a consolidation of the previous 20 booming years, buy and hold doesn't work. With dramatically increased volatility, investing these days requires a more active approach to choosing value-based stocks that uses the identification of market turns to determine portfolio exposure levels.

The market hasn't always been so volatile. Relatively speaking, investing in the two decades from the early 1980's to the late 1990's was very easy. Buy-and-hold investing worked well, as you can see in this chart:

Many investors long for the easy days of 'Buy and Hold' investing that dominated the two decades prior to the 2000. 
Chart courtesy of StockCharts.com.

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.

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 are on the far right. The top 1% of stocks shows a loss of -17% based on P/E alone:

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.

Criteria Using Price/Sales, and Price/Free Cash Flow As the Primary Criteria Are Performing Best. In the current environment, investors are skeptical of reported earnings and reported 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 strong 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 voluminous number crunching to assure robustness. This ranking system emphasizes five basic, fundamental-value criteria that emphasize price/sales, price/cash flow and cash on the balance sheet. These are the most important factors in maintaining a business through tough times:

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

A Portfolio Based on This Ranking System is Extraordinary. 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, this 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 days with the biggest winner gaining 119.35% and the biggest loser at -26.90%.

Not Good Enough. 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 an annual return of 300% plus. But, after many years of publishing IntelligentValue, our experience is that subscribers do not tolerate a drawdown this high. At times when there was anything over a -15% drawdown, subscribers go elsewhere.

There seems to be a pain threshold among individual investors at about the -15% level. Therefore, we have spent a great deal of time refining the market timing system with the goal of reducing drawdown without losing much return.

We've developed a new market Entry/Exit system that we've dubbed "Intelligent Market Timing." This system was built from the ground up based on massive amounts of objective testing of a wide variety of technical indicators. Our goal was to find an indicator (or set of indicators) which provide a highly predictive correlation with the broad stock market. On average, 70% of an individual stock's performance can be attributed to movements in the broad market. If we can get the direction of the broad market correct, we can significantly increase the returns of our value-based portfolios.

We call this combination of fundamental value-oriented stock selection - combined with the judicial use of technical analysis to determine exposure levels - "DYNAMIC VALUE INVESTING™."

THE "INTELLIGENT TIMING" SYSTEM

The Results Are Astonishing. When these timing inputs, either long in stocks after Market Up signals or in cash after Market Down signals, 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 overall returns. 'No pain, no gain' as they say. So how much are returns lowered? None. Zip. Squat. Nada.

In fact, at the time of this writing, backtested returns are increased to 702% annually! In more than 35 years, it's one of the few times we've seen risk reduced and reward increased in an investment context. It's never occurred at this level, with nearly doubling the original backtested results.

When applying the "Intelligent Timing" system to this portfolio in the market rally from April 2009 to April 2010, the annualized return jumps to +702% while the drawdown was reduced to just -11.8%. Overall winners were 80% of the portfolio with the highest gain being 125%. The average hold time was 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 Timing' system. Past performance and/or backtested results are not indicative of future returns. Model portfolios are for educational purposes only. IntelligentValue does not handle client's funds. Chart courtesy of Portfolio123.com.

In a more volatile and lower-growth period, the backtested return is still impressive, at 270%. Remember that backtested returns rarely are realized with a real-time portfolio. But with returns this high in a backtest, we've found that actual returns are usually still very high.

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. Running the portfolios without the market timing system results in far lower returns.

Readers should understand that this is our approach and be prepared for various periods of time out of the market while downward volatility plays out. As Warren Buffet is quoted as saying, "In this game, the market has to keep pitching but you don't have to swing. You can stand there for six months until you get a fat pitch."

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 11.2% in all studies done.

NOTE: To see the current return of the portfolio above, see the Aggressive Portfolio in the RESULTS section (next page).

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!