Take one of our top screens, PEG. Here are the compounded annual growth rates (CAGRs) for "slots" one through five of the PEG screen. A slot is the rank of each stock as determined by the PEG screening technique. The compound annual growth rate is shown for a 12-month holding period, and the returns are averaged across all starting months. (All data was gathered from Jamie Gritton's backtest website.)
You will note that, surprisingly, the top spot has underperformed numbers two and three, and positions one, four, and five failed to beat the market during the backtested period.
Now, imagine someone who wanted to cherry-pick a good stock from a good screen. He decides to invest only in the stock that is in position three of the PEG screen each year. As we can see, such a strategy would have averaged around 26% per year from 1986 through 1998. (This is actually the mean average return for 12 one-stock portfolios -- one that renews each January, one renewing each February, et. al.) Not bad.
But compare that with the historical returns for a five-stock PEG portfolio. The average return under identical circumstances was 30.2%. (Please note that these may vary slightly from the results from Elan Caspi's recent article.)
That's right. A five-stock PEG strategy has a higher annual return than any one of the top five slots on their own.
You're probably asking how this could happen. Here's a quick example. Take a five-stock screen. In the first year, slot 1 goes up 100%, slot 2 goes down 50%, slot 3 goes up 50%, slot 4 stays even, and slot 5 goes up 25%. If you started with $1,000 in each stock, at the end of the year you'd have:
Slot 1 Slot 2 Slot 3 Slot 4 Slot 5 Total Year 1
$2,000 $500 $1,500 $1,000 $1,250 $6,250
This works out to a total return of 25% for the year.
You then rebalance, and put $1,250 in each slot. In the second year, slot 1 goes down 25%, slot 2 goes up 100%, slot 3 stays even, slot 4 goes up 50%, and slot 5 stays even. At the end of the year, you'd have:
Slot 1 Slot 2 Slot 3 Slot 4 Slot 5 Total Year 2
$937.50 $2,500 $1,250 $1,875 $1,250 $7,812.50
And again, you'd have a return for the screen of 25%, and you would have an enviable total two-year return of 56.25%.
Now, instead, imagine if you had five different people, each investing in one "slot" from the PEG screen. Adam invests in PEG#1 each year (he runs the PEG screen, takes the top-ranking stock, and invests his entire amount in that one stock). Basil invests in PEG#2, Christine in PEG#3, Doris in PEG#4, and Eddie in PEG#5. Here are what their returns would have looked like after two years.
Adam =$1,000*2.0*0.75=$1,500 CAGR=22.5%
Basil =$1,000*0.5*2.0 =$1,000 CAGR=0.0%
Christine =$1,000*1.5*1.0 =$1,500 CAGR=22.5%
Doris =$1,000*1.5*1.0 =$1,500 CAGR=22.5%
Eddie =$1,000*1.25*1.0=$1,250 CAGR=11.8%
At the end of two years, if they all got together and pooled their funds, they
would have: $1,500+$1,000+$1,500+$1,500+$1,250= $6,750, for a total, two-year return of 35% and a CAGR of just 16% per year.
So, when you get together with Adam and the rest of the group two years later, you'll have over a thousand more dollars than their total, even though you invested the same amount of money in the same stocks that they did. The only difference was that your stocks were part of a balanced, five-stock portfolio, while they each invested in just one stock.
The same effect would be seen if an individual investor decided not to rebalance his portfolio each year, but instead invested in each new stock the proceeds from the sale of the stock that was in the same slot the previous year. And it wouldn't help much if Eddit and Basil had been in slot 3 with Christine. You would still have beaten them.
How is this happening? Each year some slots do well, and some not so well, but overall the screen has very good returns. Rebalancing each year prevents a drop in any one stock from ruining our returns, while allowing the gains to compound in the other positions. For at least some of our screens, the whole is greater than the sum of its parts.
Next week I'll have an in-depth look at the backtested returns on most of our screens. Until then, Fool on!
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