It was spring of 2009 and I limped back to my brokerage accounts after several months of self-imposed isolation from the market and my accounts. I hadn't even visited stockpickr since November of 2008. My steadfast refusal to sell my holdings at what I perceived to be near the bottom of the market and the market not agreeing with me had left me confused and disoriented. I had a grasp of what the market was doing until the elections and was even managing to beat the market. At times I was even profitable. It felt great to be up 10% on the year when the overall market was down twice that. But that was short lived. Eventually those gains evaporated. At some point the rules changed and no one sent me the memo. The selling was endless and without, in my eyes at the time, reason. The Fed was continually cutting both the Funds rate and the Discount window rate. TARP had been passed. Surely with all this government intervention the financial system had been saved and if that was the case then the market had to be close to bottoming. The selling continued in spite of me and I no longer understood what the hell was going on.
So I walked away. Didn't sell anything, just quit looking. Maybe once a week I would turn on CNBC to see where the market was, hoping for a glimmer of light. Instead I continued to stare into the darkness of the abyss. I never looked at my brokerage accounts. In early April of 2009 I noticed the market was higher than when I tuned in the last time and things just felt different. I visited stockpickr and it was a ghost town with just a few people I recognized left. I visited my brokerage accounts. Let me tell you, that was like a punch to the kidneys followed by a kick to the groin. Ouch! I had a decent cash position that had built up from the dividend payments of several preferreds I had been buying blocks of prior to my departure. But that was the only bright spot. Most of my holdings were trading below my purchase price. Some were down 50% or more. I have erased the exact number from my memory but I was down at least 35%, perhaps more. I guess the dividend support theory worked because I could have been down a lot more. Those preferreds had saved me to an extent.
While I did not immediately start buying and selling positions, I started analyzing the market and my past mistakes. I looked at historical charts and read about market behavior both past and present. In short order I concluded I should start going long with what cash I had on hand. I figured the worst was behind us, especially after looking at the '29 crash and ensuing bear market. I concluded that one of two things would occur. Either the bottom was in and the financial system had been saved or we would eventually fall off the cliff to our demise. If the cliff scenario happened than I wasn't going down without a fight and if I failed then at least I would be no worse off than anyone else. The more likely scenario was that the market was in the infancy of a bull market in my opinion. I needed in on that rally! I was mad as hell that I had walked away and missed the bottom. I wanted to get back at the bears and recoup my losses as quickly as possible. I set a goal of making back all my losses within a year's time. I had to come up with a system.
I knew that following the crowd wasn't going to help me. I had done that before my hiatus and I saw where that had gotten me. I needed to operate in an area where I had an edge. In my mind everyone knew about IBM and similar companies. But what about companies not followed by analysts? Those companies were in the small and microcap arenas. In addition I knew that the smallest companies rallied the most off the bottom of bear markets historically. First because they were beaten down the hardest during a bear market and two because they had survived the recession and the worst was inevitably behind them. I knew these stocks would be part of my system. But I sure as hell wasn't going to just start buying random micro caps. I wanted to find something I could use as a starting point. A screen that would weed out most of the bums. Of course it would be fundamentals based since that's how I roll!
I could continue to write about why I used the particular metrics that I did. In part I will discuss this in my next blog entry. I'll explain my original simplistic view on the dividend and insider ownership requirements today. The dividend requirement came from the theory that my portfolio was saved from more severe losses because several holdings paid dividends. The dividend payout helped soften the losses and at times provided price support in my opinion. The insider ownership requirement came from my belief good managers create shareholder value and if they own a significant position in the company they run then that adds incentive to create value. Their interests will obviously align with those of shareholders since they hold a significant portion of shares themselves.
I could tell you that I used proprietary programs at TradeStation and back-tested the shit out of the initial screen. But I would be lying. The truth is much more simplistic. I used the Yahoo Finance stock screener. I will now pause and allow you to yell at your computer screen about how this approach was so flawed. (insert random expletive filled commentary here) Are you done yet? Do you feel better? LOL
Anyway here are the requirements for the screen; a minimum Return on Equity(ROE) of 20% for ttm, a minimum Return on Assets(ROA) of 10% for ttm, a minimum dividend yield of 1.5%, minimum insider ownership of 25%, and a market cap of 500 million or below. (ttm) stands for trailing twelve months. If you have experience in fundamental analysis I won't insult your intelligence and explain what ROE and ROA are. If you are and always have been a technical analysis junkie, then the short explanation is they are measures of profitability. Check out investopedia for the definitions if you don't know. This blog entry is long enough as it is without fundamental analysis 101 class time! LOL
Most of the time I run the screen I'll have no more than 50 candidates, usually 20 or 30 total. Once the candidates have been found using the screen, the tricky part begins. Candidates found on the screen are just a beginning point. I would not invest blindly in a name just because it appeared on the screen. I think the first time I ran the screen I had a total of 27 candidates. I invested in two of them, TPI and HSR. TPI still appears on it, though I am no longer in it. How did I come to pick those two names? This requires further explanation.
After I ran the screen, I threw out any with outrageously high ROE. If a name had a 1000% ROE, something was amiss. Generally it was due to a one time, probably not repeatable event or an accounting trick. Followed the old adage, if it looked to good to be true it probably was. I also threw out commodity related companies and royalty trusts. Earnings and payouts tend to be erratic and unpredictable because of the underlying link to commodity prices whether it be oil or iron ore. I also eliminated closed end funds that appeared on the screen. Performance of the fund managers could potentially be erratic. Plus funds that did well during the bear market probably were going to lag in a bull market. Basically I looked for companies that had fairly predictable earnings and that had stayed profitable for the most part during the crisis and recession. Low debt was also a factor I looked for. I wasn't going to be fulled by good present performance that had been achieved by mortgaging future performance.
So after I reviewed the financials of the remaining candidates I was left with a total of four; HSR, LZR, LPHI, and TPI. To help confirm my analysis I looked at institutional ownership. In particular, I looked for ownership by small/micro cap boutiques and specialist firms. The names I looked for were Dimensional Fund Advisors(DFA), Royce, Wasatch, Oberweis, and Perritt. By chance all remaining candidates had institutional ownership by one or more of the firms mentioned. A few weeks later I started positions in TPI and HSR. I picked HSR because the ROE was over 60% and the ROA was above 40% and I liked the sector. HSR was an aerospace related company that made parts for aircraft and satellites. It's market cap was around 50 million. I picked TPI because it's a generic drug maker based in China and it had blow out quarters for over a year. I was thinking big time growth. Sexy pick. Why did I just pick two? Well I was being aggressive but I wasn't going to get crazy, yet.
So how did they turn out? TPI blew the next quarter badly. Seems that the reason the previous quarters were so good was because the Chinese government had been stockpiling medications the previous year. Then after I invested the orders dried up. To make things worse, management failed to pre-announce anything reference a short fall in earnings. They left their investors holding the bag while top level executives had already sold some of their holdings. Self serving asshats! I got out at a roughly 15% loss and was lucky to do that. I told myself that that would be the last time I ever bought a Chinese stock. A rule I haven't broken since.
HSR was a whole other story. They either hiked the dividend or paid a special dividend a few months after I invested. The price popped and I was getting a bigger payout. Sweet! In September '09, I came home one day and checked how my portfolio was doing for the day. HSR was up 40% on the day. I looked through the news and found that they had received a buy out offer. Yeehaw! My cost basis was 6.92 a share. The offer was for 19.10 a share! Almost a 3 bagger to put it in Peter Lynch terms. One stock single handedly recouped 2/3 of my bear market losses in less than 6 months.
With the lessons learned from these two stocks, both my failure and my success, I jumped head first into the remaining candidates, starting positions in both of them. I also named my screen, "The Greed Screen." I'll discuss my theory developed after the fact on why the screen works, why even the failures validate the theory, and why in the hell I named it what I named it in the next blog entry. I'll also discuss how I did with the remaining candidates, as well as what to expect if you decide to use the screen.
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