Written by Liam Flavelle on 19 December 2017
- We detail the performance of our GARP trading strategy over the last 3 months.
- The strategy has returned 11.5%, a 4% out-performance of its S&P 500 benchmark.
- We document how the strategy works and examine the risks we are taking on by following it.
- You can follow the strategy in real time here.
Back in August this year we published How to generate 29% annual returns from an easy to follow trading strategy, an article that outlined a trading strategy that invested in dividend-paying companies that exhibited strong recent growth in their financials and were reasonably priced when compared to their book value and free cash flows.
The system backtested so well, showing average compound returns of 23% annually over the past 7 years, that we added it to our InvestorsEdge portfolio of strategies. We've tracked its performance over the last 3 months, and the results have been encouraging:
|From 1-Sep||Model||S&P 500|
|Win Rate (Closed)||64%|
As of the 4th December the strategy held the following positions:
|Deckers Outdoors (DECK)||23||11.8%|
|FTI Consulting (FCN)||23||3.7%|
|Financial Engines (FNGN)||1||0%|
|Schnitzer Steel (SCHN)||1||0%|
|Citi Trends (CTRN)||1||0%|
|Ellis Perry Intl (PERY)||1||0%|
|Brooks Automation (BRKS)||1||0%|
|Ternium SA ADR (TX)||23||-4.2%|
Deckers Outdoors - $2.4bn market cap
As stated in this excellent article by Jared Orr, DECK designs, markets and distributes footwear apparel and accessories, including the UGG brand. They have recently completed a strategic review and look to have successfully defended a proxy fight with Marcato Capital. DECK don't pay a dividend, so it has been selected for this strategy purely on its strengthening financials and valuation ratios.
FTI Consulting - $1.6bn market cap
FTI Consulting provides corporate finance, forensic, litigation and economic consultancy services to its clients. Earnings guidance from the company is for similar performance to 2016 (with EPS around $2.20 per share), whilst Q3's free cash flows have increased to $100m from $60m at the same time last year. The strategy has selected FTI based on its low Price to Book and Free Cash Flow ratios.
Financial Engines - $1.8bn market cap
Financial Engines provide fee-based investment advice and asset management, founded by William Sharpe, the inventor of the Sharpe ratio (a measure of risk-adjusted investment returns). The company generates decent free cash flows and has an improving financial position, but according to this great article by Praveen Chawla, suffers from excessive dilution due to very generous executive compensation. Our strategy will have bought this anticipating a bounce back from the 25% share price decline in November.
Schnitzer Steel - $806m market cap
Schnitzer Steel has one of the highest dividends in our universe of stocks (2.5%), together with relatively low price to book and free cash flow ratios, despite showing a 60% increase in its share price since April. Schnitzer collects and recylces raw scrap metal and sells its output to mills and foundries around the world. The company is showing a healthy 10% improvement in earnings per share in an industry that is seeing improving demand and prices for its services.
Amdocs - $9.5bn market cap
Amdocs historically provides software and services to communications and media companies, and excels in the areas of subscriber management, billing and customer care. A recent shift in strategy has seen the company shift focus to include Artificial Intelligence and the Internet of Things - without setting the world on fire, Amdocs has shown steady and consistent growth over the last 5 years.
Citi Trends - $378m market cap
Citi Trends operates 545 discount apparel stores in the southeastern United States. The company has a strong balance sheet and is showing increasing sales and margins compared to the same time last year, and its price has been trending upwards in recent months. Shawn Kravetz authored an extremely accurate price guide here in September, valuing the stock at $27-37 per share (the share price was languishing at $19 at the time). SeekingAlpha shows that the stock doesn't pay a dividend, however it actually paid sharesholders a 1.2% yield last year.
Perry Ellis - $393m market cap
Perry Ellis designs, distributes and licences quality men's and women's sportswear apparel, accessories and fragrances. Key brands such as Ben Hogan, Calloway and Penguin haven't been enough to stop the company suffering from the same headwinds as the rest of the retail industry, and our strategy has selected this company based on its very low Price to Book and Free Cash Flow ratios.
Brooks Automation - $1.8bn market cap
Brooks Automation, a company that provides automation and cryogenic solutions for the semiconductor manufacturing and life sciences markets. It has experienced a 35% drop in share price since announcing results in November, a drop that is slightly bewildering as the company beat estimates. Even with this drop, the stock is showing YTD growth of 42%.
Graco Inc - $7.5bn market cap
Graco is a manufacturer of fluid handling systems and components. Q3 earnings, announced in October, show a 12% and 50% increase in YTD sales and net earnings respectively. The company was selected based on its low PEG and Price to Free Cash Flow ratios and high dividend yield of 1.1%, and has shown good share price appreciation in the past 12 months to match its rosy outlook.
Ternium SA - $6.0bn market cap
Ternium is a Mexican manufacturer of a range of steel products to the construction, automotive, manufacturing and transport industries. It's share price has appreciated by 25% this year based on improving profitability, favourable exchange rates and improving global steel prices. Ternium has the highest yield (3.5%) and lowest price to book of all the companies in our universe at the beginning of December.
Our realized win rate (the number of winner divided by losers) stands at 63%, versus the 64% indicated by our backtests. Here are the realized transactions over the past 3 months:
|AdecoAgro SA (AGRO)||5-Sep||4-Dec||-3.6%|
|Columbus McKinnon (CMCO)||5-Sep||2-Nov||17.9%|
|KB Home (KBH)||5-Sep||4-Dec||41.5%|
|Knowles Corp (KN)||5-Sep||2-Nov||6.5%|
|Pharmerica Corp (PMC)||5-Sep||4-Dec||-1.3%|
|Steel Dynamics (STLD)||5-Sep||2-Nov||8.2%|
|Stantec Inc (STN)||5-Sep||4-Dec||-4.6%|
|Vishay International (VSH)||5-Sep||2-Nov||20.3%|
|Lyon William Homes (WLH)||3-Oct||4-Dec||25.8%|
How the Strategy Works
Each month we rebalance our portfolio using the following rules - we begin by defining a universe of stocks that have:
- Market capitalizations greater than $150m and share price greater than $2.
- A PEG ratio less than 0.9.
- An average EPS growth rate greater than 10% for the past 8 quarters.
- Net Current Asset Value of greater than $-750m.
- Gross Income greater than Gross Income from the last quarter.
On 1st December (our last rebalance point) this would have returned 76 stocks, which we then rank using the following factors:
- PEG ratio
- Trailing Yield
- Price to Book Value
- Price to Free Cash Flow
We then buy the top 10 stocks in our ranked universe of securities, dropping existing positions unless they continue to rank in the top 10.
Our original backtests displayed compounded average returns of 29% a year since 2000 with remarkably low volatility for a strategy that invests primarily in small cap companies.
A key risk that we always examine with mechanical investing strategies is that the data phenomenon that we are exploiting will simply stop working. To combat this we look to see if a strategy intuitively makes sense - our model invests in companies with high historical and estimated EPS growth, high yields and assets and that are cheap relative to their book value and free cash flows, and that are showing improving gross income figures. To us, these are all logical and understandable factors as to why our system works and should continue to be profitable.
The average company our strategy invests in has a market capitalization of $250m - $2.5bn, leading to potential problems exiting positions at the lower end of our range in a market downturn. Risk appetite is an individual thing - for us the enhanced returns that come from focusing on smaller companies more than compensate the liquidity risk we take on. If this is a concern, operating the strategy with a higher market cap threshold would have resulted in smaller but still substantial historical profits.
Our Growth at a Reasonable Price strategy looked promising in our backtests, and has got off to a great start showing an 11.5% gain in the first 3 months of operation.
As you can see by the disclosure, we have invested in this strategy with our own funds - now that we've got a few months of history under our belt we'll be reporting how we are getting on on a monthly basis.