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Virtual Buffett: How software is beating the masters
Last summer, Validea.com unveiled stock screens designed to mimic the strategies of such investing legends as Peter Lynch and Warren Buffett. Early results are promising, but experts caution the results are still very early.
By Michael Brush
Its every investors dream. Program your computer to act like Warren Buffett or Peter Lynch. Set it free to fetch winners in the stock market. Then sit out on your deck and drink iced tea while the money rolls in.
It all sounds too good to be true. But for subscribers of a little-known Web site called Validea.com, thats been the surprisingly rewarding reality for almost a year.
Since last summer, when the site unleashed robotic stock picking screens designed to imitate the real-life strategies of market all-stars like Buffett, Lynch and Marty Zweig (a frequent guest on Louis Rukeysers "Wall Street Week" and, later, CNBCs Louis Rukeysers "Wall Street), Valideas 14 stock portfolios have simply trounced the Standard & Poors 500 ($INX).
As every investor knows, creating just one stock portfolio that beats the most popular market benchmark is hard enough. So to come up with 14 is, well, downright impressive.
Take Valideas top-performing Peter Lynch portfolio, for example. It picks stocks with superior growth and reasonable valuations and debt levels, among other things. As of May 7, the Lynch portfolio was up nearly 46% since its launch last July 15. Thats over four times the gains of 9.8% for the S&P 500 index in the same time frame.
Or what about Ben Graham, the grandfather of value investing? Hes been dead since 1976, but his Validea portfolio thrives, with gains of 43.6% since last July 15, when it was launched along with all the other Validea portfolios.
The top honors, however, go to the Validea Hot List portfolio, a group of stocks that represent the best picks from the best guru portfolios. Its up over 59.4% since last summer. Even the worst Validea portfolio produced results most investors would be happy with. Supposedly designed to imitate investment strategies used by the Motley Fool investment Web site, this portfolio went up almost twice as much as the S&P 500 since last summer.
Whats the trick?
Validea isn't a new company, actually. It was founded in 1996 by John Reese, an MIT and Harvard Business School graduate who had held a variety of strategic and technical positions at companies including Texas Instruments (TXN, news, msgs) and GE Capital. For years, Validea was perhaps most notable for ranking the stock picks of various commentators in the media (including myself for a time). But last summer, the company dropped that business because it didnt look like it would become profitable.
These days, seeing strong returns from mechanical stock screens it now offers may stir up the same sensation you got the first time you saw a three-card Monte game on a city sidewalk. You know theres a trick there somewhere, but you just havent found it yet.
The truth is, there are no tricks. (That does not mean, however, you should sell all your mutual funds and pile into Valideas portfolios tomorrow. More on that in a moment.) And most of the plausible explanations you might use to write off the results dont really hold up either.
Professional portfolio managers, for example, point out that the average stock went up so much last year that it was difficult not to do well. We went from a period where the typical stock underperformed, to a period last year where the typical stock outperformed significantly, says John Buckingham, who manages The Al Frank Fund (VALUX) and edits one of the top market newsletters, the Prudent Speculator. The last 12 months have been a bizarre time, and, if you didnt beat the S&P 500, you were doing something wrong.
Theres some logic to this. But it doesnt really explain Valideas success. A quick check with Morningstar, for example, reveals that the average actively managed stock mutual fund (domestic and international) was up about 15% between July 15 and May 7. In the same period, two-thirds of the Validea portfolios launched last summer were up anywhere from 30% to 59%.
Next, you could try to shoot down Valideas returns by pointing out that they dont include trading costs. Theres something to this. After all, everyone does have to pay commissions. And the best results at Validea come about when its 10-stock portfolios are rebalanced monthly. That produces a lot of turnover, since as many as three or four new stocks are added each month. Whats more, professional money managers inevitably move stocks up as they take a position. So youd expect pros to do worse than a theoretical portfolio that has no impact on stock prices.
But there are good comebacks to these criticisms, too. Validea points out that investors can cap commissions on portfolio turnover at $20 a month by using FOLIOfn.com. FOLIOfn is a service that keeps costs down for active traders, in part by matching orders internally. Besides, individual investors typically dont manage so much money that they move stocks up when they take positions. So this type of trading cost doesnt apply.
The real deal?
OK, fine, so theres no sleight of hand. But can Valideas computer programs really imitate the thinking and strategies of the masters, who pore over company filings and meet eyeball-to-eyeball with corporate executives before buying a stock? Does it make sense to rely on systems like these?
I think that is dangerous, says Mark Petrie, a money manager with Hokanson Capital Management in Solana Beach, Calif. I think there is a lot more to Peter Lynchs approach than just screening. The quantitative aspects to stock selection are important. But it is by no means the whole game. There is a lot of intuition and judgment involved.
But Validea CEO Reese responds that his approach -- based on years spent culling the details of master strategies from books and articles -- brings in elements that help his screens act like their human counterparts. There is actually quite a bit of human logic built into it, he says.
Consider the Ben Graham screen. It applies different rules for utility companies -- because the grandfather of value investing knew it was OK to tolerate higher debt loads at utilities. And the Peter Lynch screen has one set of rules for measuring acceptable debt levels at industrial companies. But since those rules dont apply to banks, Valideas Lynch screen brings in different rules for financial companies.
| Benjamin Graham Value Portfolio | | Current holdings | Date added | Start price | Current price* | Return | | Portfolio return* since inception: 43.6% | | | | | | Orthodontic Centers Of America (OCA, news, msgs) | 12/05/03 | $6.85 | $7.00 | 2.2% | | Natuzzi S.p.A. (NTZ, news, msgs) | 12/05/03 | $9.60 | $10.70 | 11.5% | | Fresh Del Monte Produce (FDP, news, msgs) | 01/02/04 | $23.80 | $23.46 | -1.4% | | Atlantic Coast Airlines (ACAI, news, msgs) | 02/27/04 | $7.24 | $5.78 | -20.2% | | Bon-Ton Stores (BONT, news, msgs) | 03/26/04 | $14.84 | $10.14 | -31.7% | | Rex Stores (RSC, news, msgs) | 03/26/04 | $14.64 | $13.36 | -8.7% | | Group 1 Automotive (GPI, news, msgs) | 03/26/04 | $35.82 | $32.01 | -10.6% | | Shoe Carnival (SCVL, news, msgs) | 04/23/04 | $13.98 | $12.75 | -8.8% | | Warnaco (WRNC, news, msgs) | 04/23/04 | $20.81 | $18.08 | -13.1% | | Janus Capital (JNS, news, msgs) | 04/23/04 | $15.17 | $15.21 | 0.3% |
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*As of May 7
Besides, says Reese, working with numbers alone removes the possibility that humans could make the wrong judgment about a management team, or let emotions lead them down the wrong path.
Validea also makes the case that its only offering another way for investors to analyze and pick stocks. It doesnt really think its portfolios will accurately replicate the holdings of the gurus it tries to imitate. We dont pretend with any of these portfolios that the guru would actually be buying these stocks now, says Jack Forehand, the director of research at Validea.
But thats the easy way out for a Web site that names its investment portfolios after market all-stars. So we checked around to see how much overlap there really is.
How well do they mimic the masters?
In some cases, the Validea guru screen can easily replicate a gurus strategy. One portfolio, for example, is based on the system used by James OShaughnessy, director of Systematic Equity for Bear Stearns Asset Management and author of What Works on Wall Street.
With my stuff, it is absolutely viable because you can get most of what I do from my book, OShaughnessy says. Valideas replication of his approach, however, doesnt incorporate several refinements made over the years, says OShaughnessy. But it gets at the heart of his approach -- buying cheap stocks (based on price-to-sales ratio) that look like they are on the mend because they have good earnings growth and relative strength.
| James P. O'shaughnessy Growth/Value Portfolio | | Current holdings | Date added | Start price | Current price* | Return | | Portfolio return* since inception: 42.4% | | | | | | Foot Locker (FL, news, msgs) | 12/05/03 | $21.42 | $22.45 | 4.8% | | Pulte Homes (PHM, news, msgs). | 01/30/04 | $43.14 | $46.84 | 8.6% | | A.C. Moore Arts & Crafts (ACMR, news, msgs) | 02/27/04 | $22.75 | $25.35 | 11.4% | | John B. Sanfilippo (JBSS, news, msgs) | 02/27/04 | $33.79 | $29.35 | -13.1% | | Michaels Stores (MIK, news, msgs) | 02/27/04 | $48.04 | $45.80 | -4.7% | | ChevronTexaco (CVX, news, msgs) | 03/26/04 | $85.34 | $91.65 | 7.4% | | Tele Nordeste Celular Part. SA (TND, news, msgs) | 04/23/04 | $27.85 | $23.81 | -14.5% | | Ross Stores (ROST, news, msgs) | 04/23/04 | $31.46 | $27.83 | -11.5% | | Jos. A. Bank Clothiers (JOSB, news, msgs) | 04/23/04 | $34.00 | $29.50 | -13.2% | | Exxon Mobil (XOM, news, msgs) | 04/23/04 | $42.97 | $43.25 | 0.7% |
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*As of May 7
And while we couldnt reach Graham or Buffett, Valideas value portfolios based on their value strategies, indeed, contain many of the top holdings of the most well-respected value shops in business today. Valideas Graham portfolio, for example, holds shares of Italian furniture maker Natuzzi SpA (NTZ, news, msgs), one of the top holdings of the Tweedy Brown Global Value Fund (TBGVX). The Graham portfolio also has Orthodontic Centers of America (OCA, news, msgs), held by Buckinghams Al Frank Fund and the Muhlenkamp Fund (MUHLX). Other Validea value names like Fresh Del Monte Produce (FDP, news, msgs) and World Acceptance (WRLD, news, msgs) are top holdings at the Oakmark Select fund (OAKLX), Aim Basic Value fund (GTVLX) and Columbia Wanger Asset Management.
Elsewhere, though, Valideas attempt to mimic the pros breaks down. A spokesman for William ONeil, author of the classic investment book How To Make Money In Stocks -- A Winning System In Good Times Or Bad, points out that Valideas ONeil portfolio fails to jettison stocks once they fall 7% below their suggested entry prices. Thats a crucial part of their approach because it preserves capital. ONeil also typically starts taking profits after a stock has gone up 25%, something Valideas ONeil portfolio fails to do.
At its worst, Validea fails badly. For example, none of the picks in the Motley Fool portfolio has ever been recommended by any of its newsletters in the past two years, says one source familiar with Motley Fool buy lists. And the Motley Fool strategy delineated by Validea doesnt look like anything its newsletters use.
Proof is in the returns, so far
Still, you cant argue with the returns Validea has posted by copying the market gurus -- results that are three or four times better than the market for two-thirds of its portfolios.
Whats more, investment pros give Validea kudos for the insights built into their screens. Buckingham, an experienced value investor, has no qualms with the way Validea boils down the wisdom of Ben Graham, whose 1934 book Security Analysis is still a bible among value investors. Breaking his approach down into a handful of items is an excellent idea, because that is everyones holy grail, Buckingham says.
Despite all the praise, Valideas success to date doesnt mean you should sell all your mutual funds and put all your money into their guru portfolios. And thats not just because past returns dont guarantee future results, as the clich goes.
More importantly, to judge whether the success of a system was just a stroke of luck -- or something that will produce consistently good returns -- you need to see how it performs in different market conditions. Many systems simply dont stand the test of time. Id like to see how their systems do over several years, says Buckingham. It is hard to draw any conclusions over a period of 10 months. In 10 months, you cant judge anybody.
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