The investing strategies of the Workshop are worth exploring if you are interested in mechanical stock picking. But the Workshop confuses most people. Today and Monday, we try to relate the Workshop to the Foolish Four's methodology and see if we can make it, if not simple, at least understandable.
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You buy them, hold for a year or two, and if the magic works, whatever temporary ills the companies were suffering from pass. In the process of returning to a more reasonable valuation, the stock rises more rapidly than the Dow as a whole.
It's a simple system, but one that isn't working well right now -- possibly because the market is focused on growth stocks and is ignoring undervalued, old economy stocks. That's my opinion, anyway. There's a lot of discussion about that, of course, on our discussion board.
But back when it did appear to be working well, such a system naturally inspires some people to look for other simple systems. Better ones. Robert Sheard, the original TMF Dowman, was one such guy. He came up with a number of excellent ideas, so many that he decided to spin off the Workshop area to concentrate on them. The Workshop developed its own community, which took up Robert's work, and the darn place exploded.
Problem is, most people find the Workshop a mess. You wander in there and get hit with a discussion of RS-IBD, Timeliness 1 stocks, 12-Month % EPS Chg Latest Q, EPS, RS, % retained to common equity, CAGRs, GSDs, and three-sigma events. The typical reaction is to throw up your hands and leave.
I've been doing my best to clean the place up, but it's still pretty confusing.
Confusing, but profitable. So, once again, I am attempting to explain what's going on in the Workshop so that those of you who read this column and might be inclined to take mechanical investing a bit farther can venture in there without a hard hat. (If you are interested in the Workshop, be sure to read Dangers of Mechanical Investing and check out the Related Links at the bottom of that article.)
Let's see if we can relate the Workshop strategies to the Foolish Four -- which is, after all, where it all began. The Foolish Four starts with just the 30 stocks that make up the Dow Jones Industrial Average (DJIA). It is limited to the Dow for two reasons. First, 30 stocks is a manageable number. After all, the system is supposed to be easy. But, more importantly, those 30 stocks usually represent financially sound companies with enormous resources behind them.
If you tried investing in just any out-of-favor stock, chances are fairly high that it would continue to flounder, but Dow companies that can maintain their dividend yield usually have the strength to weather most storms.
In place of the Dow, most Workshop strategies use Value Line's Timeliness ratings as their pre-screener. A stock that is rated 1 or 2 for "Timeliness" is one that Value Line's proprietary formula predicts will outperform the market over the next 6 to 12 months. That prediction is also mechanical, by the way. It is based on price momentum and earnings. Timeliness rankings take the company's earnings history, earnings growth, and recent earnings surprises into consideration.
As a group, the stocks that Value Line has rated above average for Timeliness have beaten the market since 1965, but there are 100 stocks rated 1 and 400 rated 2. Individual investors can't normally handle 100-stock portfolios. Even if they had the time, the trading costs would really cut into profits.
Another reason why you wouldn't want to just buy the Timeliness 1 stocks is that Value Line's ratings don't outperform the market like they used to. Most of the great returns shown in the link we provided above were generated in the '70s and early '80s. The average for the last 10 years is much closer to the average return of the S&P 500.
Still, Value Line's Timeliness ratings serve a very valuable purpose -- keeping out some of the more dubious stocks that might show up when one is trolling for great stocks. Companies that don't have earnings, for example, don't rate high on the list. (That may explain why the top ratings haven't beaten the market over the last five years -- quite a few companies with no earnings have seen their share prices soar.)
So, the Value Line Timeliness ratings serve the same function in the Workshop as Dow membership serves for the Foolish Four -- as a pre-screen that eliminates many companies that might look good, but don't have the financial strength to perform as expected.
The trick is to find additional criteria that will help you select some of the more promising companies from that universe of timely stocks. The two most widely used criteria are earnings and price momentum. Yep, those are the same two criteria that Value Line uses in the first place. They are also the two most-tested and widely recognized factors that correlate with stock-price appreciation. How do they work? Very well, thank you.
Monday we will take a closer look at these two criteria, and we won't kid around about how they work.
Fool on and prosper!
Related Links:
Timeliness Rankings, Part 1, Workshop, 5/17/99
Timeliness Rankings, Part 2, Workshop, 5/20/99