A simple mechanical investing strategy that picks large-cap growth stocks has been churning out terrific returns this year. However, an extended back test shows that although the strategy has done well in the current bull market, it didn't do so well prior to that.

By Ann Coleman (TMF AnnC)
July 10, 2000

A few months ago I wrote about a Foolish Five of Growth Stocks. This was a mechanical strategy that looked for large-company stocks that were rapidly appreciating in share price. Some readers will recognize this as the Keystone 100 strategy that was developed, along with a number of other promising strategies, in our Foolish Workshop.

The Keystone 100 starts with the 400 stocks that have been ranked highest for "timeliness" by Value Line. The timeliness rankings are proprietary so we don't know exactly what that means other than the rating is based on earnings information and how the price of the stock has changed relative to the market. Value Line says it means the stocks should do well over the next six to twelve months. We accept that because the Timeliness ratings have proven to be pretty accurate.

The 100 largest stocks (in terms of market capitalization) are selected from the 400 stocks with the highest timeliness rankings, and these large companies are ranked by recent price appreciation (relative strength). The five stocks with the best recent price appreciation are purchased and held for one year.

In March I reported that the Keystone 100 was down from its high a few weeks previous (along with the entire market). Taking a look today I found that, while the strategy still hasn't risen back to its late-winter high (what has?), it is still up an impressive 38% for the year.

Despite its wonderful performance this year, I've been having second thoughts about recommending it. That's because of the results of an extended back test performed by the Workshop community that provided returns for the Keystone 100 strategy all the way back to 1969. Previously, we only had the data to test it back to 1986. From 1986 to 1998, a five-stock strategy, renewing annually, racked up an impressive 31% average annual return with moderate volatility (moderate for such a high return, anyway).

But that was in one of the greatest bull markets of all time. Folks in the Workshop community recognized that this was a weak spot and performed Herculean tasks to develop a database that would let them test the strategy back as far as the Value Line timeliness ratings went. The results were organized and presented by cybersol on the Mechanical Investing discussion board.

When the new time period was studied, the results were disappointing -- and an excellent lesson in some of the pitfalls of mechanical investing.

They found that during the time period of 1969-1985, the Keystone 100 strategy beat the market, but by a much smaller margin than in the later period, and it did so with such high volatility that, frankly, I doubt many investors would have been able to sustain an investment in the strategy during that period. Returns varied wildly from year to year.

This period included the recession and bear market of 1973-74 and the high inflation of the late '70s and early '80s so an increase in volatility should be expected, but considering that the strategy picks very large companies, I didn't expect to see volatility four times as high as the returns. But that's exactly what the back test revealed. See for yourself:

Strategy      CAGR 1969-85   CAGR 1986-98
Keystone 100      11.15%           31.02%
S&P 500            8.88%           17.75%

Strategy      GSD* 1969-85   GSD* 1986-98
Keystone 100      42.52%           34.33%
S&P 500           18.91%           12.13%

In contrast, the Relative Strength Workshop strategies beat the market by about the same amount in the earlier period that they did in the later period, and, in most cases, the GSD was not as markedly different between the two time periods (although it was higher in the earlier periods). But in the extended back test, the Keystone's high returns all but vanished and the volatility increased more than any other strategy.

Before the back test, Keystone's moderate volatility was one of the reasons that I found it attractive as a growth stock version of the Foolish Four. But now Keystone seems to be a case of confusing genius with a bull market.

The question is, was the Keystone strategy just a case of "data mining," or did the market change? I tend to think that the explanation is that the Keystone 100 strategy works well when the market is strong but not when it is weak or unsettled. But, hey, we're in a bull market right now, right? So it's OK for now?

Uh, no. I don't think so. The problem with bull markets is that they are always over before you realize it. So any strategy that falls apart during a bear market is one that I would avoid -- especially when the relative strength strategies that were tested at the same time handled the early period just fine. Their returns were not as high earlier -- and neither were those of the overall market -- but they beat the market by about the same margin. They also exhibited about the same degree of volatility, meaning a lot. These strategies are not for the risk-adverse.

So what does a cautious investor do if he wants to invest in growth stocks? First, he learns to love volatility, or at least realize that it's his friend. Then, if he is comfortable with mechanical investing, he could check out the Relative Strength strategies in the Workshop. If mechanical investing is not to his taste, then the Rule Breakers, Rule Makers approach is a great way to learn to pick growth stocks on your own. Or consider one of the growth-oriented ETFs (Exchange Traded Funds) that Barbara Bayer described last week.

As for the Keystone 100, well, so far, so good. It's doing well at the moment, but my confidence in it as a long-term strategy has slipped.

Fool on and prosper!