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jimoshaughnessy · 11 years ago

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Sticking to a long-term strategy in a short-term world

CNBC asked me to participate in a program called the Platinum Portfolio, in which each manager was asked to come on Squawk Box in the spring with three stocks they thought would do well over the next year. I happily accepted the invitation – and picked my stocks in April. I participated in my second interview on Monday – the official checkpoint on the performance of my picks. Spoiler alert: the interview drove home the very nature of our time-tested, long-term approach to investing.

Let’s take a step back for some context here. My whole investment view is that you buy the shares that score the best on our various factor composites, (Value; Earnings Quality; Financial Strength and dividend yield).

To build a Global High Dividend Yield portfolio, we look for stocks that:

are cheap, based upon our value composite;

have good earnings quality, i.e., their books are clean and their account practices are sound;

have good Financial Strength, or the ability to continue to pay a good dividend.

We then buy all the stocks from this group paying the highest dividend yields. Since we run our screens once a month, a stock that continues to meet our criteria gets a larger weight in the portfolio, as its multiple appearances in the screens add to our conviction that they should be among the better performers in the portfolio as a whole. So we end up with a concentrated, conviction-weighted portfolio.

Now, back to my Platinum Portfolio segment.

The three stocks I focused on for CNBC’s Platinum Portfolio are:

Canadian Oil Sands Ltd ($COSWF), which has a market cap of $8.7 Billion; a dividend yield of 7.14% and is cheaper than 68% of the stocks in our Large Stocks Universe based on our value composite.

Ecopetrol SA ($EC), which has a market cap of $64 Billion; a dividend yield of 7.55% and is cheaper than 81% of the stocks in our Large Stocks Universe based on our value composite.

Telefonica Brasil ($VIV), which has a market cap of $14.1 Billion; a dividend yield of 3.95% and is cheaper than 93% of the stocks in our Large Stocks Universe based on our value composite.

So far, so good.

Wait. Not so fast. At the time of segment earlier this week, the three stocks were down on average 6.42% since I debuted them in April, whereas the MSCI ACWI ($ACWI) was up 4.61% over the same period. (We use the ACWI because all three names are non-U.S. companies.) So, the question becomes, do we keep these names or switch to better names? It’s a natural question – and one that gets at the very heart of my investment view: look long term. Because if we as investors let the short-term drive us, the results will be predictably bad. And I passionately believe the only way to have long-term success investing in equities is to have a rules-based buy and sell discipline.

Don’t listen to your gut

I can’t imagine how someone who isn’t using a rules-based process could handle having three of their picks down when the market is up. The stress of making gut decisions must be killer. But I think the long-term results of making gut decisions in investing is overwhelmingly negative. According to a study by Dalbar, for the 30 years ending in 2013, the average equity fund investor earned just 3.69% a year versus a total return for the S&P 500 ($SPX) of 11.11% per year! Indeed, the average equity fund investor would have been better off leaving their money in U.S. T-Bills, which earned 4. 01% a year over the same period. What’s worse, Dalbar said that “attempts to correct irrational investor behavior through education have been futile.” (Story here.)

The whole point of quantitative investing is to use a strategy that has done very well over the long-term and has a very high base rate of beating its appropriate benchmark. But another benefit of using a strategy tested over the long-term is knowing going into it that you will have a failure rate. If a strategy has a 70% annual base rate for beating its benchmark, you know that you will underperform the benchmark in three of every 10 years. Conventional investors would never buy a stock that they thought was going to go down, whereas we quants place all of our faith in the probabilities – not possibilities – of success, and accept willingly that we’ll have our share of losers.

Now, I have no idea how the three stocks I selected will end up doing when they reach the one-year mark (we use an annual rebalancing method), but I do know what the odds of our strategy of buying cheap, high-quality global stocks are—high. Without the discipline of our automated buy and sell rules, I am quite sure that I would behave just as emotionally as the next guy. But my experience on Squawk Box really drives home the difficulty conventional investors must face in trying to achieve long-term success in a short-term world.

Finally, if an investor can’t embrace a quantitative, rules-based investment strategy, my recommendation is simple—put your money in an index fund and remove the stress and uncertainty that all of the short-term news throws your way.

#$EC #$COSWF #$VIV #$SPX #$ACWI

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