The Daily Workshop Report
by Randy Befumo (TMF Templr)

WILLIAMSBURG, VA. (June 16, 1997) Since my Friday column in this space sucked so bad, I figured I would attempt to make sense today in advance of the sorely missed Robert Sheard's return tomorrow. For those who ached for Robert's succinct prose as you read through my write-up, my apologies.

Anyway, what I was trying to say last Friday was that mechanical models that focus on the short term are probably not the most fruitful for the individual investor. A mechanical model, or screen, is designed to quickly identify stocks that are undervalued based on some predetermined set of criteria. In Fool Workshop land, this normally translates into five-year growth rates, relative price strength, and Value Line rankings (which actually already include long-term growth rates and relative price strength as part of their formulas), although there are a few others kicking around that look at revenues, earnings growth, and other quantifiable numbers that have to do with the business.

The individual investor (namely you) wants to find stocks that for some reason the have been "mispriced," or assigned the wrong value, by the Street because of some "inefficiency" in how investors choose to look at the information available about the company. And let's face it, stock picking can be hard work. The lure of a mechanical approach is that you get all the returns that would come from careful stock selection with a minimum input of time. Looking at the Dow Dividend Approach and its historical performance, it seems obvious that there are definitely some things that clearly "work on Wall Street." The objective becomes figuring out what those things are that help an investor identify a stock that has been mispriced, or priced inefficiently, with a minimum amount of work.

Unfortunately, the individual investor has two limitations when it comes to playing this "game," if you will, on a shorter-term basis, as well as facing a systemic problem that has to do with the market as a whole that is not limited to any particular category of investor. The first problem individual investors face is that they have a limited amount of capital to deploy using any particular "strategy." Each time you pay a commission, each time you pay a "spread" for a listed stock or an over-the-counter transaction, each time you are taxed on a transaction, you lose a dollar that could potentially be invested and instead hand it over to the person who facilitated the financial transaction or the government.

When you are dealing with billions of dollars, these commissions amount to only a few pennies per share. But even when you have brokerages that will hook you up for $10 a trade, if you are trading a lot in a fairly short period of time, it begins to add up. This frequent trading also tends to vault the investor into the most unfavorable tax bracket. Earning 20% in the 28% tax bracket is the equivalent of earning 24% in the 39.6% bracket. No matter what the absolute return, frequent trading works against individual investors more than institutional investors and is something that they should consider. Individual investors should consider returns that include all costs and taxes, as these are very real expenses for them.

Individual investors also, unfortunately, have less access to the management of public companies. This means your access to information over short periods of time is significantly less than that of the garden-variety institution. When you are relying on an information source like Value Line that only gets updated once a quarter, what can happen in the space of three months becomes frighteningly relevant. Given the high relative strength stocks that Fool Workshop readers seem to favor, just one whisper of a bad quarter can suddenly a knock a stock is down more than 25% on twenty times normal volume. Institutions deploy billions of dollars of capital to play the short-term trading game, squeezing out every bit of incremental information possible that could affect returns over the next three to six months. Flying into the face of this with a two or three step screen seems somewhat risky.

Throw on top of these two limitations the fact that over short time periods markets can get kinda wacky, and the short-term game suddenly does not have as much to recommend itself as the long-term game, something that pitifully few institutions appear to be playing these days. Add in the benefits of minimal costs and tax efficiency and there are suddenly reasons to consider exploring strategies that emphasize a long-term approach, meaning at the very least one year. In the end, if a company really can generate 25% earnings growth per year over the next five years, does gunning for a 40% one-year return or trying to compound five years of 25% returns make more sense?

Certainly, the individual investor dream of a simple, mechanical approach to buying publicly traded businesses is not a bad one. Using these multi-factor "models" as screens to ferret out potentially interesting businesses to invest in has a lot to recommend it. But creating strategies that result in more churning than the average full-service broker could ever dream of instilling in his or her client base... this might be the wrong direction. Although I could indulge in another overly philosophical ramble about how a simple market inefficiency revealed by a two-step screen probably would be corrected rather quickly after it is discovered, in the end the point is quite simple.

Purchasing businesses after careful research actually takes up less time than in the long run than almost any other method, including approaches that eat up a few hours a month. When you actually understand the business and have your own objectively determined intrinsic value, the meandering of Mr. Market becomes a mere inconvenience rather than a source of heart palpitations. Although the success of the Dow Dividend Approach suggests that there is something else out there, in the end using these as screens to generate ideas for good, old fashioned security analysis seems to this Fool to be the best way to go.

Monthly Growth Screens
(Jan. 3 to present)
 31.90%   Relative Strength   
 19.50%   S&P 500 Index   
 16.74%   Low Price/Sales   
 -1.22%   YPEG Potential   
  1.59%   Investing for Growth   
 -1.88%   Unemotional Growth   
 -8.73%   EPS Plus RS   
-19.47%   Formula 90   


Annual Value Screens
(Jan. 1 to present)
21.05%   Dogs of the Dow   
20.53%   Dow Jones Ind Avg   
13.63%   Beating the S&P   
12.31%   Unemotional Value   
12.31%   Beating the Dow   
11.24%   Dow Combo   
 5.35%   Foolish Four