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March, 2007


Folks who do not care to research individual stocks may not find this essay useful. The fact is that, for most of us, a mutual fund portfolio may be the best means to develop and later maintain a retirement nest egg.

But there is a place too for the more active investor, one who perhaps has some extra time, sees investing as a worthwhile hobby, and likes the challenge of competing against the pros.

Such a person might benefit from knowledge of approaches that enhance total returns while limiting risk. There are any number of these, but in the current issue I want to focus on stocks similar to what James O'Shaughnessy, in his book, How to Retire Rich, called "Reasonable Runaways."

In that late 1990s work, O'Shaughnessy cited back-test results showing that a relatively low volatility 50-stock portfolio of stocks meeting certain value plus momentum criteria had, over a 45-year period, averaged annual returns of over 18%. If one were willing to sacrifice some security and accept the higher risk of investment in a smaller group of stocks, his 25-asset portfolio had, in the same back-test period, shown average annual returns of over 22%.

With our nest egg, we have applied techniques like those he used for the smaller portfolio and, since beginning it in 2004, have had results such as he reported. Of course, our real money experiment has not been going on nearly long enough to prove anything statistically, but it is heartening that the outcome to date is not unlike what he suggests.

Since the performance he cited, for either the larger or the smaller portfolio, is substantially better than the 10-11% long-term annual average returns typically available from such major market averages as the S&P 500 Index, it could be helpful to know just how practical his method is or how easy to apply. For this, I heartily recommend a thorough review of his book. There is reason for optimism. I do not wish to steal his thunder or take anything away from the excellent explanations he has already provided. I believe O'Shaughnessy's work may be obtained online for as little as $4.00 (in new condition) plus a modest shipping charge, or the cost of a couple Starbucks coffee beverages. It would, in my opinion, be money well spent. (For a used copy, the price is hardly more than for a daily newspaper.)

The approach we are using is not the same as his. I have built in a couple safeguards and employed a screen or two that he has not, but the resulting list of stocks has characteristics like those he cites. I do not claim this method will provide better or safer outcomes than those he suggests. They are simply adapted techniques that make sense to us, seem to work pretty well so far, and let us sleep well at night. And they are consistent with other research showing performance about twice that of the market averages. (Unfortunately, as usual there are no guarantees with respect to future returns.)

What we do:

  1. Using an inexpensive online stock screening service (many being available, but the best one for us is free, through the Charles Schwab brokerage), we cull the thousands of common stocks for those that each have a debt to equity ratio of .33 or less, a one-year price increase at least 25% better than the S&P 500 Index, and a price to sales ratio of 0.50 or less.

  2. We then screen the one or two dozen candidates left after #1 and exclude any with negative earnings, negative free cash flow, or a dividend payout ratio above 0.50.

  3. Next, for the still remaining assets, we assure that the income and balance sheet info. used for the #1 screens is fairly recent. This can be done by just going to Yahoo Finance, entering the stock symbol of each stock, and clicking on the Yahoo menu for Balance Sheet or Income Sheet, respectively, then making sure the date shown for the data is no older than 6 months ago. Any with older dates are excluded from the final short list.

  4. Around every other week (or for a total of about 25 stocks a year), I pick the best of the candidates left after #1-3, based on such fundamental, value, or technical factors as the price to earnings ratio (not too high), the current ratio (not too low), whether or not there is a dividend or some other variable in the stock's favor, recent upward movement in the stock's price, price earnings to growth ratio (PEG), etc. (Step 4 could probably be skipped, and one might just pick randomly from the few candidates left after #1-3 without substantially hurting results but if one knows how to pick based on these additional criteria it helps a little, at least in giving a bit better sense of control. Learning the basics of such variables is not that hard. After all, I did it! Anyone interested is encouraged to do so as well. My expertise is hardly that of a professional, of course. Happily, the strategy does not demand it. A dedicated amateur should be able to master the fundamentals. Within a few weeks or months, one could, if so inclined, likely be comfortable dealing with any of the factors mentioned here, and more.)

  5. After each asset has been held for one year plus a day (to get long-term tax treatment by IRS), it is sold (unless still the best available), so the portfolio never gets much above 25. (A variation on this is to sell losing assets in the last few days before the end of a year's holding. To sell them earlier risks getting rid of ones that might bounce back, but the advantage of selling the losers shortly before a year plus a day is that they get short-term tax treatment and can more directly count against one's taxable income for that year, reducing one's tax bite with short-term losses.)

In case this investing style has appeal, here are five stocks that currently (as of the close of trading on 3/16/07) meet its criteria:

ABM Industries, Inc.ABM$25.970.460.0050.99%
Agilysys, Inc.AGYS$22.040.390.0048.52%
Sytemax, Inc.SYX$21.600.330.06206.82%
Westaff, Inc.WSTF$5.720.160.1244.08%
Zones, Inc.ZONS$


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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