Mechanical Bull Portfolio

In this post I present the current status of my Mechanical Bull portfolio which I set up on 24 May 2013 with an initial investment of £30,000. This is not my real-life portfolio. I am constantly adding cash to my real-life portfolio, which complicates measurements of performance. However, I use the same buy and sell principles and I have interests in 12 out of the 15 stocks currently held in the portfolio below. The only stocks I don't currently have an interest in are Keller, Matchtech and Microfocus International. The reasons are mostly just down to timing. For simplicity's sake I exclude trading costs, but I also exclude dividend payments. I believe this to be a conservative approach, which if anything should slightly underestimate actual performance.

The portfolio has increased in value by 29% since inception, which is annualised rate of over 52.5%. The FTSE AllShare has fallen by 2.3% over the same period. I see this level of performance as exceptional and I do not expect it to continue. Still, it appears pretty solid with 75% of past and current stock showing gains. The overall overperformance has not been driven by just a couple of stocks, which gives me a fair degree of confidence in the approach. I will update this spreadsheet every month around the 24th of the month when I will usually make my trades.

Creston and Microfocus International are currently in line for the chop. Creston had a disappointing set of results last week while Microfocus have just drifted down in the MB scoring stakes. Interserve and Kentz are looking likely purchases in the lead up to Christmas. I have bought and sold Interserve twice (in real life) since early 2011, making a small profit each time. The second time I sold was in August this year as a result of following my current strategy. So, there is a natural resistance to buying in again when the price has jumped up further. I also currently own Kentz in my real-life portfolio. It has done pretty well is now my second most valuable holding.
 

Mechanical Bull Portfolio as at 12 December 2013

The Mechanical Bull Method

An idea rooted in Stockopedia

Until now, this blog has been laying the groundwork for my investment philosophy. In this post I will provide the nuts and bolts of my investment method. In essence it is very simple. However, it will be very difficult to understand without reference to some particular features of the Stockopedia website. So if you haven't already please read the following post.

As I have mentioned, there are two features about the Stockopedia website that I find particularly intriguing. The first is their idea of the 'Screen of screens'. This takes the 60 or so 'guru' screens and counts the number of times a particular stock appears in each screen. The idea is that a stock that appears across multiple screens is displaying strengths across a number of criteria. These stocks are interesting because they may be considered by investors with very different investment approaches.

The second feature is their recently introduced StockRanksTM. This is calculated by first ranking stocks in terms of quality, value, and momentum using a number of different metrics. These ranks are then compiled into a composite rank of these three factors. As I have mentioned previously, I believe that this kind of approach is better than screening, because a screen will sift out stocks that are weak on only one criteria, whereas rankings are more forgiving of any particular weakness.

The 'Superscreen'

It seems to me that both approaches are using different methods to achieve the same basic objective, that is, to find stocks that are attractive from a number of different angles. This got me thinking about an approach for combining the Screen of screens with the Stockranks to produce some kind of 'Superscreen'. Where you get a similar answer following two different methods, you should have more confidence in your results than if you only follow one.

My method for doing this is childishly simple. The Screen of screens is a simple count with the highest count typically between 8 and 10. StockRanks give each stock a composite value of between 0 and 100. There is only stock with a value of 100, about 20 with 99, about 20 with 98 and so on. My method for combining the two approaches is to to simply add the two value together. Here are the results all those with a 'Superscreen' score of over 100 as at 8 December 2013:

Ticker	Name	# Screens (Long)	Stock Rank™	Superscreen score
RM.	RM	6	99	105
RNWH	Renew Holdings	6	99	105
DTG	Dart	7	98	105
TT.	TUI Travel	7	97	104
FRP	Fairpoint	4	99	103
CHRT	Cohort	4	99	103
VP.	VP	5	98	103
JD.	JD Sports Fashion	5	98	103
ATK	WS Atkins	5	98	103
KENZ	Kentz	6	97	103
TRI	Trifast	3	99	102
NWF	NWF	3	99	102
STCM	Steppe Cement	3	99	102
THG	Terrace Hill	3	99	102
CAMB	Cambria Automobiles	3	99	102
MTEC	Matchtech	4	98	102
HFD	Halfords	4	98	102
RCDO	Ricardo	5	97	102
IRV	Interserve	6	96	102
CDY	Casdon	2	99	101
HYDG	Hydrogen	2	99	101
MCM	Motivcom	2	99	101
NWS	Smiths News	3	98	101
TOT	Total Produce	3	98	101
STAF	Staffline	3	98	101
CSG	Sweett	5	96	101
BKG	Berkeley	5	96	101
TNI	Trinity Mirror	6	95	101

Effectively, what I am doing is using the Screen of screens to sift out the most promising Stockrank candidates in the high 90s.

Trading Rules

In terms of translating this screen into an executable strategy. The buy./sell rules are as follows:

1. New buys are restricted to the top half dozen or so stocks. If I were starting form scratch at this moment I would buy equal amounts of all stocks with scores of over 103.
2. Accumulate for any existing stocks with a scores of over 100.
3. Hold for any stocks with scores 90-100.
4. Sell when score drops below 90.
5. Look to hold between 15 and 20 stocks.

I generally look to make all my trades on the same day about once a month. The precise day varies for practical reasons that have to do with taking advantage of reduces trading commissions. I do not try to time my trades with any trends in either particular stocks or the broader market. This is all part of a deliberate strategy of 'strategic ignorance'.

Does it work?

I have been implementing this strategy since 24 May 2013, that is, for just over six months. The strategy has returned 27.6% during this period compared with 19.5% for the standard Screen of screens. The FTSE All share is virtually unchanged over this period (down 0.2%) although the FTSE250 is up 6.4%. This is not long enough to provide definitive proof of this being an effective strategy. However, the results to date are certainly very encouraging. I will aim to do a bit more analysis of the performance of the strategy portfolio in future posts.
 

The Importance of Self Reliance

Apologies for not posting for a while. My father passed away last week and so I have been rather pre-occupied with other matters.

This has been a period of intense reflection about my father and his life, which was quite extraordinary in many ways. He was a self-made man who started with almost nothing. He was both a very compassionate man, but also a hard worker who stressed self-reliance. It was a theme that featured prominently at his funeral and so I thought that this theme of self-reliance was worthy of a brief post.

The managed funds industry obviously likes to encourage investors to put money aside for a rainy day. However, in many respects, they abhor the notion of self reliance. Investing directly in the stock market is too difficult for ordinary investors - best to leave it to the experts. Oh and by the way, that so called expertise comes at a price, so be prepared to pay up, even if your investment fund under-performs the market.

Actually, investing in managed funds  is not necessary. Any, reasonably intelligent private investor with a clear strategy and discipline should be able to invest and outperform managed funds. This is because managed funds are, due to their size, dominated by large caps that are constantly being scrutinised. Thus opportunities to take advantage of mispricing are pretty low. In contrast, smallcaps offer more mispricing opportunities, Furthermore small private investors have a structural advantage over managed funds as they are able to build a stake in small caps without affecting the share price.

My father dabbled in the share market although he made most of his money through property investing. In any case, I think that his values around self-reliance are very similar to the basic theme of this blog. Don't trust anyone who is trying to get a slice of your hard-earned savings. There is not reason that you can't do this yourself. Start reading, develop a strategy that suits your skills and temperament, implement the strategy and most importantly, stick with it!

Review of Stockopedia

Stockopedia is  a UK based stocks and shares information service. There is some basic information available for free and a subscription is required to access the premium content. It currently costs £19.95 a month to access all their data on UK stocks. Is this worth paying for?

In a word, yes! Although ultimately all the underlying information is public data, Stockopedia does an excellent job of organising this information so that you can quickly make sense of it. Every UK listed stock has a raft of colour coded indicators and metrics. There are a range of different valuation tools that you can tweak to your hearts desire. There are also a host of different charting tools and metrics. Whatever you investing style, there are are a set of visually informative and easy to use tools to help you.

Stock screening

While all equities information services these days offer screeners, Stockopedia's is the best I've come across. It has a huge range of screening parameters and you can either create your own or 'fork' a pre-cooked screen from one of more than 65 guru screens. So if you want to emulate your favourite investment guru, Stockpedia makes it easy.

Stockopedia have also created their own unique guru screen called the "Screen of Screens". This counts the number of times a particular stock appears on any of the other long guru screens. This is an interesting idea as it highlights stocks that are attractive from a number of different angles. A hypothetical portfolio based on this screen has returned 77 per cent since the December 2011 compared with about 24 per cent for the FTSE 100.

StockRanks

In the last couple of months, Stockopedia have been experimenting with something they call "StockRanks". These are composite metrics for four broad factors, namely value, quality, growth and momentum. For example "value" combines six different valuation metrics namely: P/E, P/S, PBV, PFCF, earnings yield, dividend yield. Stocks are ranked in these score with 100 for the top scoring stock down to 0 for the lowest. Each of these ranking factors can then be combined depending on your investing style.

Initially, Stockopedia combined all  four ranking factors into a single composite score. However, their preferred composite measure now omits growth, just combining quality, value and momentum. Their research has established that there is a tendency to overpay for growth. Therefore, it is not a strong predictor of future share price movements.

More thoughts on Stock Ranking

I think that stock rankings are better than screens. A stock screener is essentially a checklist and if a share narrowly fails just one test, then it is screened out even if it scores very strongly on other criteria. Thus, stock screening will tend to leave some good candidates hidden. Ranking methods allow stocks to be weighted so that some moderate weakness in one criteria will not necessarily override strengths in others. Thus stock screens are quite blunt instruments, while stock rankings offer more careful calibration.

This idea of ranking stocks across multiple dimensions is key to my investment appoach. Greenblatt's argues that although his Magic Formula does not work all the time and the investor just needs to be patient. However, this doesn't seem completely satisfactory. If you are going to take a mechanical rules based approach to investing, it seems reasonable to aim to have something that works, if not all the time, then at least as often as possible.

The stock market goes through phases where certain investment styles do better. Over the last few years, value investing has performed better than quality based approaches. Momentum approaches have done particularly well in 2013. However, rather than trying to guess which style is going to do well in future, why not select stocks that have a number of strengths that should do well regardless of what particular style is performing best at the time? Stockopedia's StockRank does exactly that and therefore this is now the main basis on which I select stocks.

Back-testing

The only slight quibble I have with Stockopedia is the lack of any back-testing feature. The reasons given are that historical data are either unreliable or prohibitively expensive. However, some back-testing functionality may become available over time as Stockopedia build up their own data.

I went through a phase of doing a lot of back-testing for which I used Sharelock Holmes. This is what got me thinking about the limitations of stock screening and that some kind of weighted method on key metrics would work better. I didn't really pursue it as I didn't know how to go about it. Now that I have come across StockRanks, my conclusion is that these are going to be pretty hard to beat in terms of any mechanical rules based investing so back-testing seems like less of a priority.

Closing thoughts On Stockopedia

I really like the philosophy of Stockopedia. They are geared towards the DIY investor and do a great job at de-mystify equity investing. Why pay fees to fund managers, very few of whom consistently beat the market when for a modest fee you can access information and tools that give you every chance of doing better? Stockopedia has become my main source of information on UK stocks and I would be lost without it.

If you want to try it out go to the Stockopedia website.

Joel Greenblatt's Magic Formula

Introducing Greenblatt

I am keen to kick on and set out my investment manifesto. However, before we get to that I need to provide some more context.

Like musicians, investors are influenced by the greats that have come before them. Joel Greenblatt was influenced Warren Buffett who in turn was influenced by Ben Graham. From my first two posts you've probably guessed that I am a fan of Warren Buffett. Show me a private investor who isn't?

However, for me Joel Greenblatt is my single biggest influence.

The Little Book that Beats the Market 

Greenblatt's The Little Book that Beats the Market sets out in layman's terms the investment philosophy he used when running the hedge fund, Gotham Capital. Apart for being short (less than 150 pages), its written in a 'self help' style, full of whimsical anecdotes, like those self help books written in the 1930s by the likes of Dale Carnegie and Napoleon Hill.

Although a bit annoying in parts, Greenblatt does a good job of getting across the point that successful investing boils down to basic principles and discipline. In essence the advice is to buy great companies at bargain prices. While those words could have come straight from the mouth of Buffett, what Greenblatt does is to set out a mechanical approach for selecting stocks and managing a portfolio.

He selects stocks based on something he calls his  "Magic Formula". In very simple terms he uses earning yield as a  measure of value and return on capital employed (ROCE) as his measure of 'quality'. He ranks the universe of investable stocks on each these criteria and then adds them together. Stocks are then selected from the thirty or so lowest scoring stocks.

There is a good summary of "Magic Formula Investing" over on Stockopedia if you want to read more.

Does the Magic Formula work?

Greenblatt claimed that the MF is capable of making abnormal returns of up to 30% pa. However, independent testing has struggled to get anywhere near that. For example, over at Stockopedia the performance of Greenblatt MF screen has struggled to keep up with the FTSE 100, and currently ranks 50 out of 60 'guru' screens in terms of annualised performance.

There are a number of theories for this. Something I read a while back on a U.S. blog is that in recent years the MF has tended to flag up Chinese reverse take-over stocks that have mostly tanked. Ed Croft of Stockopedia has documented research by Wes Gray and Tobias Carlisle that suggests that the MF has a tendency to systematically overpay for quality. My own theory is something actually mentioned in the foreword of "TLBtBtM", which is: if lots of people start following a certain investment strategy then returns will diminish. I think that simplest explanations are most usually correct.

The MF is certainly the best known systematic/mechanical strategy around although I have no idea how many people are actually using it. I subscribe to a Yahoo group on MF Investing and if the recent postings, or rather lack of them, are anything to go by then it certainly seems like interest in the MF is waning.

Greenblatt himself says that the MF goes through phases when it doesn't work as well and that the trick is to be patient and wait for the inevitable upturn in performance. Interestingly, the Greenblatt MF screen on Stockopedia has had a bit of a surge recently increasing 14 per cent in the past 3 months. So, perhaps investors have given up on MF investing at just the wrong time?

Trust the Quant

Although I am inspired by Greenblatt I have reached the conclusion that his approach is not for me. First of all, I don't believe that following a well trodden path is an optimal strategy - its got to be better to seek an angle that fewer people are following.

Secondly, it seems to me that there has got to be better ways of identifying cheap stocks at good prices". Stockopedia have developed a more sophisticated approach for ranking stocks in terms of value and quality. For example, their method for ranking value uses earning yield with five other valuation metrics. That has got to give better results than just one.

However, the thing I do like about Greenblatt are the wonderfully simple things he has to say about mechanical investing. The idea of buying a stock and holding it for a year, The idea of buying and selling just once a quarter. The idea of selecting candidate stocks at random, rather than trying to apply additional discriminatory criteria. His overriding philosophy is to "trust the quant".

This is such a great mantra. My worst decisions always seem to be when I am panicked or acting impulsively. Learning to "trust the quant" is a way of allowing the intellect to subjugate those emotions that make us do stupid things. It is something I should start repeating to myself everyday!

Learning Emotional Detachment

So emotional

Investing in stocks is an emotional business. Once we've invested in a stock it is natural to will the price to go up. If the price starts dropping we start to worry.

The Buffett Way

Well, not if you are Warren Buffett. He points out that if the share price of your investment goes down, that is a good thing because you can buy more of the stock for less. Buffet is not looking to buy cheap and sell high. He is looking to buy stocks in companies with stable and growing earnings as cheaply as possible. He has his eye on long-term and short-term prices movements are just noise.

In fact he buys with the intention of never selling so he does not care what happens to the share price. The only thing that matters is long-term earnings. The only reason to pay any attention to price movements is to look for entry points to accumulate more good stocks on the cheap.

Buy? Sell? Hold?

But while temperament is important in being a successful investor, it is not everything. You also need to have the ability to analyse and recognise long term value.

This is why it is not easy to follow Warren Buffett. Every investor is trying to get edge. So when a stock we own starts ticking down we start to worry if there is something we've missed. What if this is dip is more than just noise? What if it is the start of a falling knife?

Should I just hold on and hope things come right? Should I stock up and average down? Or should I sell out and cut my losses? Certainly, I have done all these things at various times guided by no more gut instinct. Invariably, I ended up doing the exact opposite of what I should have done.

Buffet doesn't have these worries as he has inscrutable confidence in his ability to recognise long-term value. So, if a share price dips he will always buy more.

I am not Warren Buffett...

If there is one thing I am certain about it is that I am not Warren Buffett. I will never have his gifts at stock picking. However, there is one thing I can try to emulate - his emotional detachment.

Mastering your emotions is probably the single most important skill in becoming a successful investor. An emotional investor becomes part of the market but an emotionally detached investor can rise above it.

....I am the Mechanical Bull

This is why I have committed myself to a mechanical investing style. When faced with a challenge, I do not have to make a judgement about what to do that is coloured by emotion. The system will tell me what to do, a system that is designed on proven investment principles. I will never be as clever as Warren Buffett but I can be as disciplined.

10 Years of Stockmarket Investing

Early days

I started investing in shares in early 2003. My approach was pretty unsophisticated. I bought companies that I had heard of or that were tipped in newspapers. I made all the classic beginner mistakes - selling winners too soon, holding on to losers, on at least on occasion all the way down to zero.

However, I chose a good time to start investing as the FTSE 100 almost doubled over the next four and a half years. My modest portfolio did not do as well, but at least I didn't lose money.

Investing through the financial crisis

In about September 2007, as problems in the global financial started to emerge, I decided to liquidate my share portfolio and move (just about) everything into cash. There wasn't a whole lot of thinking that went into this - I just had a bad feeling. Although this was pretty naive I actually regard this as one of my better investment decisions. It helped me to preserve my modest gains through the depths of the 2008 crash.

In 2009 I started investing again. However, I completely misread the market, thinking there was a good chance that things would get even worse. I stuck to defensive shares that underperformed through to the end of 2010, but at least I didn't lose money.

Learning to do things properly 

In January 2010, I read a newspaper article about some ordinary guy who had turned himself into professional private investor. He claimed no specific gifts, just an eagerness to immerse himself in investment literature and company reports. I don't remember his name. The one thing I do remember was his belief that anyone could make it as an investor. This wasn't get rich quick - more like, get rich by learning how to enjoy the process of investing to get rich. In any case, this was an inspiration.

I began to read all kinds of stuff from Warren Buffett's "Letters to Shareholders" to "Value Investing for Dummies". I started using screens, following  a basic value based approach. I also started following rules like cutting losses of more than 20 per cent. The first time I did this was really hard, but seeing the share price subsequently fall in half, definitely took the edge off my disappointment.

The birth of the Mechanical Bull

Over the last two to three years I have moved towards a strict mechanical investing approach. I have come to the view that you need to follow an investment approach that suits your temperament and intellectual abilities. The type of forensic accounting favoured by most private investors does not suit me. To be perfectly frank, accounting doesn't interest me. I am a quantitative researcher by profession and so I like looking for patterns in numbers. A mechanical investing style suits me much better and I enjoy the challenge of understanding how they work.

Many people do not regard mechanical investing as a serious investment approach. However, it has been proven that very basic mechanical approaches can beat the market. For example, a strategy based on selecting a random selection of shares, selling just the losers and redirecting the funds into the winners, will on average beat the market. This is the basic principle behind momentum investing.

It is widely held that the average investor can not beat the market and so should simply invest in index funds. However, this very simple mechanical strategy that anyone can follow DOES beat the market. The fact that such a simple provable fact flies in the face of conventional wisdom never fails to amaze me. What's more if such a simple mechanical strategy can beat the market, what might be possible with something more sophisticated?

A final word

To be honest, part of the reason for starting this blog is that I thought that Mechanical Bull would be a cool name for an investing blog. But there is definitely a gap in the blogosphere around mechanical strategies. I hope this blog goes some way to filling that.

Finally, this blog does not aim to impart investment advice. I say this mainly because I am not qualified to do so. But I also believe that everyone needs to work things out for themselves...... like I have done and will continue to do.