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September 10, 2008

The Rempel Report - Value System
by Bill Rempel

Value is a moderately low-beta, medium-turnover trading plan for stocks traded on major U.S. exchanges. It focuses on providing exceptional long-term returns with somewhat less attention paid to the shorter-term variability of those returns.

Value takes its name because it references criteria traditionally used by "value investors" when analyzing companies for purchase. The plan only has a minimum market capitalization of $100 million for consideration in the portfolio. It uses strict, fairly low absolute filters for two popular valuation ratios and four quantitative metrics to filter for the quality of the underlying business. Stocks that meet the basic screening criteria are ranked in ascending order by Price/Book ratio, and the highest-ranking qualifiers are then held. In the not-uncommon event that fewer than 20 qualifiers are found, the system will hold cash in lieu of stock positions that cannot be filled.

Backtesting

The system was backtested from August 31, 1997 through August 8, 2008, holding the top 20 qualifiers sorted in ascending order by Price/Book ratio, making changes on approximately a monthly basis. The tests below show a hypothetical $10,000 investment traded according to the plan, although a system of this nature is better suited for starting capital of six figures or higher, in my opinion.

In "slow mode" the system was tested with screens run every month from August 31, 1997 through August 24, 2007, with holding periods of one year on each test. Returns do not include dividends:

Average Return 16.59%
Standard Deviation 21.77%
Lowest Return -29.07% from June of 2007
Highest Return 93.12% from February of 2003
Negative Returns in 29 periods of 121 tested
Positive Returns of less than +10% in an additional 20 periods of 121 tested

Like every mechanical system, it has periods of underperformance and periods where the system loses money, but overall the results are extremely favorable from both a return standpoint, although less so from the standpoint of return variability. Variability in relation to compounding rate is still low, however.

The initiation date for the backtest period was a very poor time for valuation-based systems; a period of time during which such systems lagged the overall market.

My charts are relatively wide; if the chart is truncated in your browser, click on it to view it in full size.

Another measure of risk is equity drawdown. The methodology doesn't eliminate the risk of sharp drawdowns, such as the one in 1998 and 2008, but it was able to hit new equity highs several times during the bear market at the beginning of the decade. Max drawdown for the system was 25.4%, versus nearly 50% for the S&P 500.

The equity curve shows how the system performed over the backtest period.

Graphing the returns of the Value system against the corresponding returns for buy+hold on the SPY, an ETF tracking the S&P 500 index, shows that the system has moderately low beta, and quite a bit of alpha on a monthly basis.

Model Allocation

Based on beginning with a $100,000 portfolio at inception, the target allocation is a 5% weight in the top twenty qualifiers, with cash held for positions if there are less than 20 qualifiers. There are no current allocations, as this is the introductory post.

Returns

Based on beginning with a $100,000 portfolio at inception.

Equity: $100,000.00
Gain, Past 4 Weeks n/a
Gain, Year to Date n/a
Gain, Since Inception at 09/11/2008 n/a

Changes To Model Allocation

The screen combines two valuation filters with several measures of the companies' fundamental strength, holding the cheapest stocks that meet the requirements, and holding cash for positions where there are less than 20 qualifiers.

The new model allocation is a 5% holding of each of the following stocks, sorted by Price/Book ratio (ascending).

Companhia Paranaense (ELP)
Asta Funding, Inc. (ASFI)
Grupo Aeroportuario (PAC)
Companhia De Saneame (SBS)
Allied World Assurance (AWH)
Endurance Specialty (ENH)
Flagstone Reinsurance (FSR)
Pc Connection, Inc. (PCCC)
Platinum Underwriter (PTP)
Lg Display Co Ltd (LPL)
Mohawk Industries (MHK)
Axis Capital Holding (AXS)
Cimarex Energy Co (XEC)
Kt Corp (Korea) (KTC)
Arch Capital Group L (ACGL)
Ducommun Inc. (DCO)
Conocophillips (COP)
Etablissements Delha (DEG)
Harvest Natural Reso (HNR)
Methode Electronics (MEI)

As this system is to be initiated today, the target allocation is a buy for 5% weight holdings of each stock listed.

Tracking

The above stocks will be bought by the tracking portfolio tomorrow morning (Thursday Sept. 11), market at open.

Commentary

This system has an alternative "slow mode" of trading.

Instead of following a monthly rebalancing and restructuring of the portfolio, the system could be initiated with a full slate of holdings, with those positions being left alone for a full year. In such a case, winners would be sold after a year's holding, and losers just before the end of a year's holding, to maximize tax efficiency. I have run some tests on this "slow mode" and found that it does degrade the compounding rate of the system, but it is still effective and may be a valid choice for some traders.

Another alternative "slow mode" would be to accumulate the complete portfolio over several months or quarters, buying several top qualifiers each time, and holding them for the approximately one-year period. I did not test this version.

Finally, the screener results could simply be used as a first step in a discretionary program of value investment.

If you'd like to become of member of The Rempel Report, you can register here. At The Rempel Report, I track model portfolios for five different mechanical trading systems, as well as my personal portfolio, and disclose all results (good and bad) at regular intervals. Members receive email notification of new posts and can contribute to the site through comments.

Bill Rempel
The Rempel Report

Disclaimer: Nothing at The Rempel Report, or any communication from The Rempel Report or its author, should be construed as personal advice, on investing or anything else, and at all times you are responsible for your own actions and you should perform your own due diligence. I'm not an investment professional, and you should probably consult with one, in addition to doing your own due diligence, before making any investment decisions.

I may have a beneficial position in any potential investment I mention. My positions in, and opinions of, those potential investments may change over time. I have no obligation to reveal those positions, and if I should reveal those positions, I am under no obligation to notify you, though this site or through any other means, if I change those positions.

While I do try to verify much of the data presented, I can make mistakes. I rely on third party vendors for data, and sometimes that data could be incorrect. Therefore, I cannot and will not be held liable for incorrect or erroneous data presented in text, table, chart, or other format. This is one more reason why you should consult with an investment professional, in addition to doing your own due diligence, before making any investment decisions.

Modeling is prone to error, and no statistical model is perfect. The output from statistical or predictive modeling should be viewed with skepticism.

Fundamental analysis is based on examinations of company filings such as income and cash flow statements, balance sheets, quarterly and annual filings, proxies, and other such items. Even though a company appears fundamentally sound today, that doesn't imply they actually are, or will remain, fundamentally sound. Fundamentals can change over time, and there is always the possibility that the company filed information that was either fraudulent or incorrect. I might make an oversight or error when examining company filings. In many cases, I will rely on a third party's presentation of filing data, such as a stock screening program's output, without actually reviewing the filings personally.

Technical analysis is based on the study of historical price, volume, and sentiment data over time. Past performance is no guarantee, and there are no certainties hidden in patterns, charts, indicators, or formulae.

FundaTechnical analysis involves those items which mix elements of Fundamental and Technical analysis, including valuation metrics such as the Price/Book or Price/Earnings ratios. Therefore all the warnings for both Fundamental and Technical analysis apply.

Take responsibility for your own actions. You should consult with an investment professional, in addition to doing your own due diligence, before making any investment decisions.

Copyright © 2005-2008 Bill Rempel

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