The Allure and Illusion of Mechanical Investing: Part 1

In my years of reading The Motley Fool, I've been particularly interested in the Fool boards on "mechanical investing," which discuss stock-picking strategies based on quantitative computer screens. This type of investing is "mechanical" because it requires the investor to pick stocks based on an objective set of fundamental (e.g., annual sales above $500 million) and/or technical (e.g., stock price above the 200-day moving average) criteria. Furthermore, there is literally no discretion on the part of the investor; if the screen spits out Altria (NYSE: MO  ) , you buy the stock regardless of whether you morally oppose tobacco companies, or think that litigation will bankrupt the company. So goes the strategy, anyway.

Some might argue that it's a form of brain-dead investing, but what's wrong with that? I'll take money however it comes to me. As Fool contributor Tim Beyers also recently pointed out, it's not uncommon for individual investors to have a difficult time deciding how many stocks to own. It's similarly difficult to endure the emotional roller coaster of a high-volatility portfolio. While Tim was advocating the Motley Fool Champion Funds newsletter as a solution, mechanical investing is another way to save us from our more irrational, emotional selves.

In all seriousness, mechanical investing is only brain-dead in the execution of the screening criteria. Formulating the appropriate criteria takes a lot of brainy analysis. You can learn more about the nuts and bolts of mechanical investing here and here, as well as on the Mechanical Investing discussion board and the now-defunct Foolish Workshop discussion board.

Why have I always been fascinated by "mechanical investing?" Well, I'm definitely a lazy person, and I like the idea of a computer spitting out stock picks with little effort on my part. However, I suspect that my fascination more strongly stems from the ability to backtest mechanical screens over many years, to see whether the stocks generated by the screens actually perform well.

My introduction to mechanical investing started in the early 1990s, with the publication of Michael O'Higgins' bookBeating the Dow. It pointed out that an incredibly simple mechanical system -- buying the 10 highest-yielding stocks among the 30 stocks in the Dow Jones Industrial Average -- beat the performance of the Dow index itself (and most mutual funds) over the long term. The system removed the uncertainty plaguing most individual investors by telling them which stocks to buy (Dow stocks with the highest dividend yield), how many to buy (top 10), and when to buy and sell (every 12 months around the end of the calendar year). It was called the "Dogs of the Dow" strategy because the Dow stocks with the highest yields usually were those stocks that had performed poorly in the previous year.

The Motley Fool picked up on the idea and improved upon it, renaming it the Foolish Four. The Fool's endorsement of the Foolish Four strategy lasted from 1996 through 2000. That was the Internet bubble stock market of the late 1990s, when tech stocks with no earnings but a dreamy story outperformed all other types of stocks, especially value stocks with high dividend yields like those in the Dow index. At the end of 2000, the Fool decided to abandon the strategy, primarily because it had underperformed the Dow 30 by 5.27% per year since 1996. Its long-term potential as a mechanical strategy, however, was still deemed promising enough to include in the short-lived Foolish Workshop Portfolio of investment strategies, as well as warrant its own chapter 20 in The Motley Fool Investment Guide.

The Foolish Workshop was closed down in May 2001. Former Fool Ann Coleman gave two reasons for the shutdown. First, many of the mechanical screens were based on Value Line's proprietary timeliness criteria, and the powers that be at Value Line didn't like the Fool's use of this data. The second reason was more interesting, in my opinion. Apparently, mechanical investing only appealed to "an elite few," and the costs of running the workshop were not justified by the low readership.

I hope to introduce more of our readers to elite status. The mechanical concept represents an exhilarating empowerment of the individual investor. Any individual investor can implement a mechanical investing system on her own with a minimal time commitment and without the help of investment professionals (and their associated fees). I can boil down a mechanical strategy to three key points: "(1) which, (2) how many, and (3) for how long." A mechanical strategy must tell you which stocks pass the screen, how many of the stocks you should buy, and what your holding period should be before you rebalance the portfolio with new selections and deletions.

There are a few simple rules of thumb for developing a logical stock screen. Fool member moebruin wrote an article to help us determine which stock-screen criteria probably have purely coincidental superior investment returns (and thus should be avoided), and which criteria have a logical underpinning that gives us confidence in their continued superior investing returns. His five criteria for a "good" stock screen are:

  1. The strategy must follow a simple and logical protocol;
  2. The rationale must make sense and be easily explainable;
  3. The screen must work with good but diminishing returns for lower-ranked stocks;
  4. There must be at least 10 years of historic returns (for purposes of backtesting, to confirm validity);
  5. There should be peripheral data that supports the contention that the screens should work.

Looking for an example of a logical and high-performing screen? The Motley Fool Hidden Gems newsletter regularly updates the Foolish 8 and modified Foolish 8 screens. The screen was originally developed by David Gardner in the first edition of the Motley Fool Investment Guide, and subsequently modified by the very Foolish Rex Moore.

While the modified Foolish 8 screen can be used as a mechanical strategy, the Gardners and Rex don't recommend it; the screen is intended merely as a starting point to generate a list of potential stock picks. Of course, a believer in mechanical strategies would say that the screen should be the endpoint; further research and editing of the list would nullify the excellent backtested results, introducing human error and biases into the investment process. The 10 criteria for the modified Foolish 8, for example, are:

  1. Revenues: $900 million or less
  2. Earnings and sales growth: 25% or greater
  3. Better than 15% return on equity over the last four quarters, and for each of the last three fiscal years
  4. Net profit margin: 7% or greater
  5. Daily dollar volume: $1 million or greater
  6. Insider holdings: 10% or greater
  7. Share price: $7 or greater
  8. Relative strength: 50 or greater
  9. Free cash flow: Positive
  10. Price-to-free cash flow-to-free cash flow growth multiple: 1.00 or less

According to a backtest (link opens a PDF file) performed by The American Association of Individual Investors (AAII), the stock portfolio generated by this screen has a cumulative return of 571.5% between January 1998 and July 2005, compared with a 195.9% return for all exchange-listed stocks and a 27.2% return for the S&P 500. The AAII backtest assumed that all stocks generated by the screen were bought, and holdings were adjusted on a monthly basis. During the backtest period, the average number of stocks in the monthly portfolio was eight but could be lower (only four stocks passed the screen when the AAII backtest article was written in early August 2005). As of Jan. 26, six stocks made the cut: AstaFunding (Nasdaq: ASFI  ) , BodisenBiotech (AMEX: BBC  ) , Center Financial (Nasdaq: CLFC  ) , NetLogicMicrosystems (Nasdaq: NETL  ) , optionsXpressHoldings (Nasdaq: OXPS  ) , and Wilshire Bancorp (Nasdaq: WIBC  ) .

This ends part 1 of my series. In part 2, I'll talk a bit about outside sources for generating mechanical investing screens, discuss the issue of trading costs, and offer up a few promising screens for your consideration. Stay tuned.

Fool financial editor Jim Fink does not own any of the shares cited in this article. The Motley Fool is investors writing for investors.


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