Sticking With the Mechanical Approach

 | Apr 11, 2013 | 5:00 PM EDT
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Today I will continue examine the portfolio produced by simple guidelines and managed on a mechanical basis. The root of the approach is a simple valuation model that is primarily based on the balance sheet. The system looks for stocks with solid balance sheets  that are selling at steep discounts to asset value and pays no consideration to the income statement. The early, quick-and-dirty results show substantial outperformance over a long period of time and I think it's worth further investigation. It also turns up some pretty good stock ideas.

On Wednesday, I examined a few of the stocks in the portfolio that probably would have never made it into one of my discretionary accounts. I either didn't like or didn't understand their businesses enough to consider buying these stocks. Today, I will examine a few of the model's picks that I am more enthusiastic about and which I would be happy to include in discretionary accounts.

I hope Hartford Financial Services (HIG) misses earnings horribly and that the stock gets whacked. The company's restructuring is ahead of schedule, it has disposed of several wealth management divisions and the annuity run off appears to be going as expected. The individual life insurance business is gone and management is concentrating on the property and casualty (P&C)business. It is one of the largest P&C companies in the U.S. and has a robust commercial lines business. Most of its personal lines business comes from a relationship with AARP. The stock is cheap, selling at at 50% of tangible book value, and its upside is enormous. A mechanical approach would serve me better here, as the stock is trading near 52-week highs, and that makes it psychologically difficult for me to pull the trigger. I own a lot less of this stock than I should at this point.

I have a similar problem with Lincoln National (LNC). Selling at 70% of tangible book value, the stock is very cheap. I bought the shares last year so I have a nice gain; I just have a natural revulsion to buying near the highs of the year. The company has managed its way through the difficult years of the credit crisis and business is picking up in its life insurance and retirement plans operations. With its heavy exposure to the stock market, many of its products are equity linked, which could make the shares more volatile. However,  it is a solid company and the stock is cheap.

I owned shares of Real Network (RNWK) in 2010 and did fairly well with them. The stock is now trading back down near net-cash levels and is worth adding to a long-term value portfolio. The company is searching for an identity and needs new products to reinvigorate any hope of growth, but the parts here are worth more than the sum the stock market is attaching to the company. If you read the last year's headlines carefully, you will see that the makeup of the board has been changing. They have added experienced entrepreneurs and finance types to try to remake the company. If they succeed, the stock could be a huge winner. If they fail, the company can be liquidated for about 30% more than the current stock price.

We had a solid winner last year with shares of Kimball (KBALB); I sold the stock after an incredibly fast double during the year. A series of unfortunate events -- including a large purchase of raw materials for an order that was never fulfilled and a slowdown in government sales in the furniture division -- have pushed the shares back down to 80% of tangible book value. Its electronics manufacturing segment is seeing strong demand from several sectors, most notably the auto industry. The furniture division is probably going to see more weakness due to sequester and budget changes. The company has plenty of cash on hand and the balance sheet is solid. I like the stock and will buy it again -- if and when the stock market finally has a pullback.

The mechanical quantitative approach to value investing is intriguing and I will be doing more research along these lines in the upcoming months. As a bonus, researching the model is producing some stock picks that can be used even in the most discretionary of accounts.

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