I spent some time last evening playing around with the new issue of Value Line. While I am not a big fan of the new online version, I still consider the publication my one absolutely necessary resource for picking stocks. My first takeaway is something I haven't talked about in a while, but the Value Line Median Appreciation Index is screaming "sell" right now.
The median three- to four-year appreciation of a stock down to just 30% is a level consistent with a market that's ready to fall. Studies have shown when this measure is under 55, it is time to sell. When its above 100, one should be an aggressive buyer of stocks. It is not a precise indicator, and it can always go lower before the market turns over, but it does suggest this market is richly valued and continued caution is warranted.
I spent some time running various screens and reports, and I found that the Value Line Top Two rankings priced under $10 still outperforms the market by a pretty good margin. In fact, it has actually improved with age, as it beats the market in all of the past five years, and 9 of the last 10 years.
These are not traditional value stocks, as most of them do not trade below book value, but this strategy is a great way of identifying potential long-shot and turnaround stocks with outsized return potential. Value Line rankings are heavily based on price and earnings momentum, so this screen excels at finding companies with low-priced stocks that are seeing improved operating conditions and are attracting buying interest.
I suggest to my kids that they mix these types of long-shots and turnarounds into their investment mix, along with a pure value approach. The added returns can be huge, albeit with a great deal of volatility. Since its not baseball season, I have some extra time in the evening. I decided to test the idea using my perfect stock screen as the value component, and the low-priced high-ranked screens as the other half of the portfolio.
As a reminder, the perfect stock screen buys only those stocks that trade below book value, are profitable, and pay a dividend, with low debt levels and a strong balance sheet.
I found that the combined screen works as well as either screen by itself, but it greatly reduces volatility. Market conditions that favor the low-priced turnarounds offset the conditions in which perfect stocks lagged the market. One half of the portfolio zigged when the other zagged, and the combination reduces return of 50% greater than S&P 500 over the past 25 years. There were only four down years over that time frame, and only once in the wreckage of 2008, the combined strategy produce a double-digit decline.
It appears that using a combination of pure value, long-shot stocks, and turnarounds with momentum is a sound approach to managing your long-term portfolio. This is similar to the findings of Cliff Asness of AQR Capital in his 2013 paper, Value and Momentum Everywhere.
I have one other observation about the Value Line low-priced portfolio produced by the screen. I have been running this screen on a semi-regular basis, since I had uncovered it back in 2001. Over the years, I have found that it usually produces roughly 30 stocks most of the time. After a market decline, we might get as many as 50 or 60 stocks. In a big rally, the number might fall to 20 stocks. When I ran it last night, there were just 11 stocks on the list. I don't have all the prior results stored anywhere, but I am pretty sure this is the lowest number produced by this screen in the past 13 years. Again, much like the Median Appreciation Index, it is not a precise timing method, but another anecdotal piece of evidence calling for caution in the market right now.
The stocks produced by the screen right now are Alcatel Lucent (ALU), Amkor Technology (AMKR), AngloGold Ashanti (AU), Commercial Vehicle (CVGI), Fortress Investment (FIG), Office Depot (ODP), Rite Aid (RAD), Sprint (S), Smith and Wesson (SWHC), Synutra International (SYUT), and Vonage (VG).
The perfect stock screen gives us Rowan (RDC), Gulfmark Offshore (GLF), Tidewater (TDW), Hardinge (HDNG), Friedman Industries (FRD) and Gladstone Investment (GAIN).
I plan to study this more in the days and weeks ahead. This combination of value and momentum, along with a heavy dose of community bank stocks, could offer a market-beating portfolio with dramatically lower volatility for long-term investors.