“When b.s. baffles brains”

Value Line offers convincing proof that since 1965 through 2008, their 5-point rating system works.

Here is the methodology: http://www.valueline.com/why_use_how.html

Here are the results: Cumulative and Per Annum Returns Allowing for Annual Changes in Rank (1965 - 2008). http://www.valueline.com/pdf/modelperf1.pdf

Group 1: 13,413% 11.9%
Group 2: 8,746% 10.8%
Group 3: 3,450% 8.5%
Group 4: 1,411% 6.4%
Group 5: 168% 2.3%
DJ Ind’l: 862% 5.3%
S&P 500: 925% 5.5%

I use the same basic principles in managing the Cara 100: it’s called Quality Growth. Invest only in companies that have superiority over their peer groups in terms of financial strength, management, business model, products, and proven historical performance. Appreciate the fact that business conditions of every company go through periods of thick (opportunity) and thin (risk); however, weed out the few that appear to lose their edge. Buy shares of these companies at the low points of their price cycles, and sell at the high points as reflected by technical indicators. Continuously reduce the cost basis of those shares so that the Total Return (capital growth and dividends as percentage of cost) rises year over year by a minimum of 10-20%.

Over a half century of operating the Value Line service, the proof is in the pudding. The performance results are so stunning as to be irrefutable. As I say, people with working brains use the proven system. Those who ignore it are losers.

However, at infrequent times over the past 50 years, this “proven system” does not work. In fact, the exact opposite works. These are the times when the absolute lowest rated company performs best. This is amazing, but true.

If you check the Value Line records for the past 30+ years, you will discover that for the one year following every significant Bear phase of a market price cycle, the “5” Timeliness rated stocks – which represent the absolute lowest Quality Growth stocks; the 100 out of 1700 in the watchlist – outperform all the others. Not only do these 100 outperform the other 1600, they outperform the top-rated 100 stocks rated “1” and the next 300 that are rated “2”. Moreover, they don’t just outperform; the capital growth is shockingly higher than any other rating group.

I call it the “B.S. baffles brains” pattern. It just doesn’t sound possible; but it’s a fact.

Here are the results:

For the Annual Changes Only results:

• See 1979 vs 1978 Group 1:+25.6% Group 5: +39.9%
• See 1983 vs 1982 Group 1:+25.2% Group 5: +30.0%
• See 1988 vs 1987 Group 1:+16.0% Group 5: +20.0%
• See 1992 vs 1991 Group 1:+10.1% Group 5: +19.9%
• See 2001 vs 2000 Group 1: -07.4% Group 5: +16.4%
• See 2003 vs 2002 Group 1:+40.1% Group 5: +90.1%

I can’t wait to see the results for 2009 vs 2008.

Why does this phenomenon happen? I think that, when under stress, humans have a tendency to both over-rate and under-rate quality. Traders over-rate the companies that are most successfully managing to get through the difficult operating conditions and they under-rate those that get briefly caught in the vortex, fearing the worst.

Let’s take a couple of the Cara 100 for instance:

• Brunswick Corp (BC) dropped from about $35 at the top of the S&P 500 in mid-2007 to just $2 in 4Q2008 and 1Q2009. Then BC soared to almost $14 by the end of 2009.
• Teck Corp (TCK) was trading in the $50 range for part of 2007 and 2008, then collapsed to under $3 at the bottom before reversing up to $40.
• Silver Wheaton (SLW) traded over $19 in March 2008, then collapsed to under $3 in November 2008 before moving all the way back to $17 by the end of 2009.

These companies never left the Cara 100 because I continued to have confidence in the reasons why they were put there in the first place. Yes, when things got really tough for Teck and Silver Wheaton, I did have one-to-one discussions with the senior executives at these companies, and concluded there was no reason to drop the names from the Cara 100. I even told you so in the blog near the time of their absolute price cycle lows.

What should traders learn from this?

As portfolio managers – for others or for ourselves -- we are all first and foremost managers of risk. Yes, we must pay attention to the real concerns expressed by well informed and sophisticated analysts, but we must also pay attention to the trends and cycles of the stock prices.

It is a fact that deception plays an important role in the market, where predators generate disinformation at timely periods when they seek to catch their prey. Wild game hunters use decoys; fishermen use lures. This is life. Regrettably, there are people and organizations in our society who carry on these practices in the capital markets. Those of us who understand the market as a game that plays people see evidence of this most every day.

Market scams are a terrible thing but they go on because the regulators and the courts understand that the markets operate on the basis of both qualitative as well as quantitative reasons, and since the qualitative aspect always involves a matter of degree, the authorities have a difficult time in judging whether a specific behavior, even if it can be isolated and recorded, is believed to have crossed the line.

When we are talking morality and ethics, how does one draw the line? In life, there is behavior that many people consider highly objectionable that many others practice as an important way of their lives. So, some of us rant because we believe certain behavior is unacceptable, hoping that the regulators and the courts “get it”, but by and large we spend our day coping with the reality that deception and disinformation is part of the game and also that maybe our line in the sand is not the same as others.

We also know, regardless of the transparency and integrity of markets, that many investors have difficulty controlling their fear and greed. So, we try to control ours and exploit the weakness of others. Another fact is that all of us make plain old mistakes, using bad information or bad judgment, which hurts our performance.

But, as I see it, if, at the end of the day, we continue to think about these factors, and continue to trade the shares of a Quality Growth watchlist of companies, I think we reduce the number of mistakes we otherwise would make. In doing so, it’s possible for us to perform better than the average.

As a side note; by allowing for changes every week, the Value Line results show that the “1” rated stocks outperform the “5” rated stocks to a much greater degree than the Buy-and-Hold for a year approach.

Cumulative and Per Annum Returns Allowing for Changes in Rank Each Week (1965 - 2008)
http://www.valueline.com/pdf/modelperf2.pdf

Group 1: 28,913% 13.9%
Group 2: 3,611% 8.6%
Group 3: 169% 2.3%
Group 4: -77% -3.4%
Group 5: -99% -10.9%

This is further proof that active management of a stock portfolio is likely to be more successful than buy-and-hold investing.