The Strategy Is the Stock
In the Workshop, we select strategies like other Motley Fool portfolios select stocks, and we commit to buying and sticking with those strategies as our version of buy-and-hold. However, the right mix of strategies is necessary to achieve diversification.
By Ann Coleman (TMF AnnC)
November 2, 2000
Remember "The medium is the message"? That was Marshall McLuhan's take on the explosion of television and other media in the '60s. I've never been precisely sure what it meant, but it sure got a lot of press at the time. In the Workshop, the strategy is the stock, and I am sure of what that means.
In the other Motley Fool portfolios -- and indeed all over our website, in our books, radio shows, newspaper columns, the occasional television appearance (quite a few media there!) -- the message the Fool teaches is simple and consistent: Learn how to pick good stocks, buy and hold them in spite of market fluctuations, re-evaluate their potential periodically, and adjust as necessary.
Substitute strategies for stocks, and you have the Workshop philosophy. Where other Fools evaluate the history and future potential of individual stocks, we look at strategies that are small collections of stocks with a few characteristics in common. Where other Fools commit to buying and holding a company, we commit to following a strategy for the long term. Where other Fools check quarterly and annual reports to make sure a company is staying on track, we stay alert to the possibility that a strategy may need adjusting or changing as new ideas work their way into community consensus.
The analogy continues when we look for diversification. Since our strategies use key fundamental factors (such as earnings and Relative Strength) to select stocks, often the stocks selected by a given strategy are very similar to each other. After all, if wireless companies are making good money and running up like crazy, then strategies that look for strong earnings growth and high Relative Strength will select a lot of wireless stocks.
However, Mr. Market tends toward serial infatuations. He falls in love with one sector after another. At first, nothing is too good for biotech. He takes it shopping, pays for its apartment, shows it off at parties. Then he detects a small flaw and drops biotech like a pair of old gym socks and is off dating the Internet the next week. Until the Internet flubs an earnings report.
Workshop strategies will adjust to Mr. Market's fickle ways, but they aren't necessarily great at picking up the first signs of his roving eye. The Relative Strength component is the one factor shared by every strategy except the Foolish Four, and a drop in Relative Strength tells us that Mr. Market has packed his bags. Relative Strength is the best indicator we have, but it is a relatively imperfect one.
Since strategies tend to select stocks in similar sectors, and since we don't have a perfect indicator to tell us when a sector is losing favor, we need to think about diversification. In the Workshop, that means diversifying strategies -- not stocks. (Diversifying strategies will result in stock diversification, though.)
Take a look at the current rankings. This page list all the stocks selected by the 12 screens we are following this year. Two of the stocks -- Network Appliance <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NTAP)") else Response.Write("(Nasdaq: NTAP)") end if %> and Siebel Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SEBL)") else Response.Write("(Nasdaq: SEBL)") end if %> -- appear in seven of the 12 screens! BEA Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BEAS)") else Response.Write("(Nasdaq: BEAS)") end if %> and IMPATH <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IMPH)") else Response.Write("(Nasdaq: IMPH)") end if %> appear on six out of the 12 lists, and six other stocks appear either four or five times. That's a lot of overlap. (If you're wondering if those overlaps might make a good strategy, yep, it's been done.)
Now, look at the Plowback screen. Not a single one of those frequently appearing stocks shows up on Plowback. Like the Foolish Four, Plowback is not doing well this year, but from 1986 through 1999 a five-stock Plowback strategy, renewed annually, returned 36% per year with a geometric standard deviation of 25%.
The Foolish Four also picks from a very different universe of stocks. If you want diversification, the Foolish Four and Plowback will guarantee diversity, but what about performance?
Back in February, I suggested that a growth strategy like the Keystone 100 might be a good strategy for Foolish Four investors to consider for adding some diversity to their value stocks. Here's why: The table below shows how a 50/50 blend of the Key100 and the Foolish Four strategies would have done over the last 14 years, compared with each strategy individually and with the S&P 500.
Blend Key100 RP S&P
1986 37.82% 45.98% 29.67% 18.66%
1987 28.90% 40.06% 17.74% 5.25%
1988 24.71% 27.34% 22.08% 16.61%
1989 62.38% 77.31% 47.45% 31.69%
1990 -11.31% -5.02% -17.60% -3.10%
1991 43.65% 52.51% 34.79% 30.47%
1992 18.31% 6.69% 29.94% 7.62%
1993 44.35% 58.45% 30.26% 10.07%
1994 6.46% 5.32% 7.59% 1.32%
1995 43.87% 40.70% 47.05% 37.58%
1996 25.25% 23.95% 26.56% 22.96%
1997 29.61% 46.23% 12.99% 33.36%
1998 43.88% 67.73% 20.02% 28.58%
1999 88.86% 156.26% 21.46% 21.04%
CAGR 32.77% 41.62% 22.45% 18.06%
GSD 19.84% 28.31% 15.53% 11.69%
Sharpe 1.20 1.01 1.09 1.03
What is interesting is that, even though the overall return for the blend is lower than the return for the Key100 on its own, the lowered volatility gives the blend a much higher Sharpe Ratio than either strategy -- higher even than the market, as represented by the S&P 500.
That's the power of diversification. I'm sure that, as we get into the actual mechanics of selecting strategies for our portfolio, we can come up with even better blends.
Some of the blends already proposed on the discussion board are fantastic. If you want to see them for yourself, check out this thread. (Click the link, then make sure the word Threaded is in black type. If not, click on it to follow the thread.)
If you would like to try your hand at testing a few strategy combinations, Jamie Gritton's Backtest Engines, which provided the data for the chart above, lets you do it effortlessly through the magic of many, many hours of hard work on Jamie's part.
Fool on and prosper!
