I've developed more of a quantitative mindset over the years, as I've found that talking to management and analyzing companies down to the cost of toilet paper actually adds little value.
If I can find cheap stocks with a margin of safety, I'll do pretty well over time without needing to know management on a first-name basis or drilling down into the financials so far that I find myself in a deep hole.
I've read all of the papers by LSV Asset Management, Cliff Asness and others over the years about combining value and momentum and have been pretty much in agreement, but never really implemented such a strategy.
But after talking to Gary Antonacci last fall about his book Dual Momentum, I built and tested a "Value Momentum Portfolio" using some of his concepts in combination with deep-value fundamental characteristics:
The column titled "Last" in the attached chart refers to each stock's Dec. 31 closing price, while "MktCap" refers to Dec. 31 market capitalization in millions of dollars and "p/tbv" stands for "price to tangible book value."
My model for this portfolio wasn't very complicated. I simply searched for stocks that trade at tangible book value or less, then added two momentum factors. First, the stock has to be trading higher over the past year. Second, it has to be beating the S&P 500.
I took all stocks that passed those screens and isolated the 50 cheapest ones in price-to-book-value terms, rebalancing the resulting portfolio every six months. (The model performs almost as well rebalancing just once a year, but six months appears optimal.)
The results for this model portfolio are surprisingly good. I back-tested the system and found that it outperformed the broad market across all two-, three-, five-, 10- and 15-year time frames checked. It beats the market handily in rising markets and does an incredible job of playing defense in weak ones.
There are very few stocks with positive performance when markets are collapsing, so the portfolio shrinks in those periods. For example, the model was 80% cash when I looked at the rolling portfolios constructed between January 1999 and March 2002.
It was then fully invested in stocks from mid-2002 to late 2005, but began to scale down and was back to 80% cash by 2008. Then it returned to fully invested in stocks during early 2009.
A few things really stick out when I run the portfolio's screen today. First, there are no energy or materials names in the portfolio at all.
And although many stocks in the portfolio are trading at below book value, none have positive 52-week price performance. That was true at the start of 2015 as well -- and a big reason why the portfolio performed well last year. The momentum factors act as a safety net by keeping out value traps and stocks that are in a free fall.
Another observation is that community banks dominate the portfolio right now, accounting for more than half of the group's 50 stocks. That shouldn't come as a surprise, as small banks have been doing much better than their larger counterparts in terms of revenue and earnings growth.
I'm sure everyone also knows by now about the prospects for continued small-bank mergers and acquisitions during 2016, which should help the portfolio a great deal. We're seeing some signs that institutional money is taking an interest in these little banks, which could help drive the sector upwards in the year ahead.
You'll also notice that the current portfolio includes some of the best mortgage REITs and business-development companies, like Apollo Commercial Real Estate Financing (ARI), Arbor Realty (ABR) and Gladstone Investment (GAIN).
While many of these high-yield vehicles have struggled in the past year amid interest-rate fears, those that bucked the trend should lead the way higher as their sectors recover. They also add a nice yield element to the mix.
There's also very much of a small-cap flavor to this year's portfolio. When you back out shares of American International Group (AIG), the average stock's market cap is about $281 million. The average price-to-book value is also 85%, so this is definitely a deep value portfolio.
Now, some of my academic friends are concerned about the portfolio's small-cap bias, but I actually prefer it. I've made far more money with small-cap portfolios than I have with large-cap ones. The only time I really like large-company stocks is when the market is in full crash mode.
The bottom line: My Value Momentum Portfolio looks well positioned to outperform the broad market again this year, but I'll check back during the year to test this system in real-time.