Stock Screen Report Card
The Dow Rising Star strategy has great 20-year backtested results, but that doesn't necessarily make it a worthwhile screen in which to invest. When we run the strategy through some tough tests, it passes most, but comes up a bit short in others. Using predetermined rules to evaluate such screens can help us separate the wheat from the chaff.
By Ethan Haskel (TMF Cormend)
October 18, 2000
Last week I introduced a new stock screen, dubbed the Dow Rising Stars(DRS), complete with 20 years of backtesting. The DRS 4 portfolio had returned 26.4% annually since 1980, compared with 17.7% for the S&P 500 and 23.2% for the Foolish Four. Sounds great. So should we invest in these Rising Stars?
My intent in describing such a screen was not necessarily to persuade Fools to drop everything and invest, but rather to describe an interesting set of observations. Regular readers of the Foolish Four and Workshop columns realize there's a lot more to a worthwhile screen than great backtested returns. Before investing in any particular mechanical strategy, we should ask some tough questions. We need to put it under a microscope, dissect its potential strengths and weaknesses. We'll perform such a dissection today.
Before we start, let's quickly review the DRS strategy. A DRS portfolio simply includes the four or five most recent companies to join the Dow. We break any ties for the last position (or positions) by choosing the stock (or stocks) that has performed the best over the past year. After a year (and a day, if taxes are a consideration), rebalance the portfolio to invest in equal portions of the new stocks. That's all there is to it.
In evaluating DRS, let's run it through five tough tests suggested last year by Morris Chernick, tests he proposed for evaluating any mechanical screen. Using these rules, we'll grade ourselves in each category to see just how DRS scores.
Rule 1: The strategy must follow a simple and logical protocol.
We ace this one. We choose the DRS stocks by simply finding the newest Dow companies. Since we are looking for high-performing companies, we break any ties with the stock or stocks that performed best during the previous year. I'm not sure one can get any simpler or more logical. Grade: A
Rule 2: The rationale must make sense and be easily explainable.
DRS is based on the assumption that companies recently named to the Dow are in the prime of their corporate cycles. A company chosen for inclusion in the elite Dow is a very special one. Such a corporation must meet criteria that only a fraction of one percent of American companies can pass. A potential Dow company must not only be huge and financially rock-solid, but its prospects should seem golden. Basically, we're trusting the editors of The Wall Street Journal, who select the Dow components, to find the best large companies out there. It is a leap of faith that these promising Dow companies will make great stock investments for the next few years, but the rationale seems to make sense, and is certainly easily explainable. Grade: B
Rule 3: The screen must work with good but diminishing returns for lower-ranked stocks.
This hasn't been tested extensively, but there are two pieces of evidence to suggest that this criteria is met. First, the DRS 5 strategy (which takes the DRS 4 and adds the next best stock), outperforms the S&P 500, but doesn't perform quite as well as DRS 4. Also, about five years after a company joins the Dow, its performance tends to decline slightly compared to the newcomers. DRS chooses only the freshest stocks, which are held on average for four to six years. One can create a portfolio simply by buying a stock of a company when it joins the Dow and hold it for 10 years. For January start dates, such a strategy outperformed the S&P 500 for 13 of the past 15 years. Not bad. But even this strategy pales compared to the DRS 4, which beat or tied even this 10-year holding strategy for 13 of the past 15 years. Grade: B+
Rule 4: There must be at least 10 years of historic returns.
This is another easy one. Actually, we've come to be more strict about this criteria recently -- at least 20 years of returns is preferable. DRS has been backtested for 20 years, fulfilling this criteria. Most of us probably don't remember that the original Beating the Dow, by Michael O'Higgins, was published using 18.5 years of backtested data. Grade: A-
Rule 5: There should be peripheral data that supports the contention that the screens should work.
We're weak here. We don't have much evidence yet that the strategy would work using similar types of screens, different holding periods, or different renewal dates. Nor can we use some variation of the Beating the S&P or Value Line database to get corroborating data. The work simply hasn't been done yet. Grade: D
The overall grade, teach? I'd say the Dow Rising Stars merits a B average when all the rules are considered. As such, it's probably not quite ready for prime time. With a little more work on Rule 5, if we could find peripheral data, we'd be on more solid ground.
One thing that's clear is that the DRS strategy is not the result of data mining, a practice in which multiple strategies are tested in an attempt to find one that, by sheer chance, outperforms. DRS was conceived based on the original observation that Dow newcomers tend to outperform the companies they replaced, and was the only strategy I backtested.
We've certainly become more sophisticated about how to evaluate such screens since Beating the Dow was published 10 years ago. Our requirements for a good screen have become stricter. We've become more critical. Using predetermined rules to evaluate such screens can help us separate the wheat from the chaff.
Beating the S&P year-to-date returns
(as of 10-17-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> +5.8%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +34.9%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -13.3%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> -11.8%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> +14.2%
Beating the S&P +5.9%
Standard & Poor's 500 Index -8.1%
*Includes Visteon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VC)") else Response.Write("(NYSE: VC)") end if %> spin-off
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.3%
S&P 500 +16.2%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $177,800
S&P 500 $78,600
