Methodology

Methodology 2018-05-14T13:27:58+00:00

Our Archer Portfolios are run using a quantitative methodology that seeks to achieve superior long-term returns versus other strategies by selectively targeting and investing in a concentrated portfolio of approximately 15-25 stocks. Archer Portfolios use a rules-based system that employs quantitative stock screens. We think this provides a useful layer of diversification by being independent of our research and analysis. We also think there is a role for concentration in our client’s investment strategies, as picking the best stocks in our screens, resulting in potentially stronger performance, outweighs the risk inherent in picking fewer stocks.

Furthermore, we believe employing strategies that seek stocks offering superior value propositions to peers has been proven to be one of the few strategies that can work over time. For all these reasons we think there is a place for the quantitative, concentrated and value-centric Archer Portfolios in most client accounts. We think an Archer Portfolio is best employed as a compliment to a larger Alhambra Portfolio in an overall account strategy. Archer Portfolios require a minimum of $55,000 and are typically included in accounts of over half a million dollars as about a ten percent allocation. However, the sometimes high turnover of this strategy is best suited for being employed in a tax-sheltered account, like an IRA.

Our tactically-adjusted Alhambra Portfolio with both an Archer Portfolio (VQM) and the Pathfinder Portfolio might look like this:

Although all of our Archer Portfolios are concentrated stock portfolios created with value screens, we run three different types:

  • Value-Quality-Earnings Momentum (VQM)
  • Dividend Growth
  • Earnings Revision

The rules-based quantitative screens differ, but we expect the performance and results to be largely similar. Based on your needs and our overall diversification concerns, we will recommend one of the three. However, these portfolios are largely identical from one client to the other. Archer Portfolios are concerned only with investing you in the strongest performing stocks that we can identify. We provide customized diversification with our Alhambra Portfolios. Our Archer Portfolios are focused on simple performance.

 

Archer Portfolio Risk Hedging

To reduce the risk of substantial losses in an Archer Portfolio due to a stock market downturn, a hedging system may be employed where 40 percent of stock holdings are moved to cash or some other hedging vehicle if the 50-day Exponential Moving Average (EMA) of the S&P 500 falls below the 100-day EMA in conjunction with our Fundamentals Pricing Indicator (earnings estimate versus price trend) turning negative. Our Fundamentals Pricing Indicator is deemed negative when the 10-day change in the price of the S&P 500 is greater than the 10-week change in the consensus earnings-per-share estimate for the S&P 500.

Conversely, the hedge is removed and cash reinvested in stocks when the 20-day EMA rises above the 40-day EMA and our Fundamentals Pricing Indicator turns positive upon the 10-week change in the consensus EPS estimate becoming greater than the 10-day price change in the S&P 500. There are no guarantees for the future, but in the past, this hedging system has helped reduce exposure to losses in major bear markets, while still largely participating in the gains of bull market periods.

 

VQM Portfolio 

The VQM (Value, Quality & Earnings Momentum) Portfolio is a quantitative model with set buy and sell rules. The research behind this focuses on the use of three long-known style factors in an attempt to outperform the market.

Value: Over the last thirty years, numerous academic papers have documented the successful outperformance of value strategies. Value strategies use fundamental metrics to find cheap stocks. We use three main value ratios in our ranking system:

  • Price to Sales
  • Price to Book Value
  • Price to Cash Flow

Quality: Quality generally refers to a company’s assets. Logically, stocks of companies that are profitable, stable and growing tend to outperform the market. Our approach concentrates on profitability and ranks stocks based on these criteria:

  • Gross Margin Growth
  • Operating Margin Growth
  • FCF/Assets Growth
  • Net Change in Cash TTM
  • Debt/Equity

Momentum: The momentum effect is almost as well known and documented as the value strategy. Momentum is the tendency of assets to show persistent, positive relative performance. It isn’t just confined to stocks but is present in almost all asset types. The most basic approach to momentum investing is to purchase the stocks that are performing the best over some time frame. However, this approach ignores fundamentals completely and is therefore vulnerable to including fad stocks with poor fundamentals. Research shows, however, that price momentum is actually a function of fundamental momentum. More specifically, most of the momentum effect can be explained by earnings momentum.

The momentum portion of our ranking system is based on the change in earnings estimates for this year and next year’s earnings.

This strategy is our core equity strategy. The simple idea is to buy the stocks of companies that are profitable and exhibiting momentum of earnings at low valuations.

A simple screen is used:

  • Market Cap > $2 billion
  • No industry greater than 40% of the portfolio.
  • Rank in top 10% for ROI.
  • 80th percentile or better on our proprietary VQ2 ranking system.

The stocks that pass the screen are then ranked using our Value/Quality/Momentum system and the top stocks are chosen for the portfolio. We can use either of two versions of this portfolio, one with 20-25 stocks and one with just 10 stocks. The portfolio is checked monthly for sell criteria:

  • Falls below the 85th percentile of our VQM ranking system.
  • 20% down from purchase price.

 

Dividend Growth Portfolio

The Dividend Growth Portfolio uses a dividend income investment strategy. Our research on dividend strategies focuses on the use of dividend yield, cash flow and value criteria to construct a portfolio. The Dividend Growth model uses a ranking system with three factors:

  1. Value
  2. Profitability
  3. Earnings Momentum

You’ll notice that none of these are directly related to dividends and that is intentional. We want to identify attractive stocks first and then further screen candidates for dividend yield and growth. We also do not want to own stocks in this portfolio that are unlikely to be able to continue raising their dividend. Dividend growth requires earnings and cash flow growth to be sustainable.

You’ll also notice that we don’t include stock buybacks as part of this systematic portfolio. That too is intentional. We want companies whose cash return to shareholders is predictable and sustainable. Stock buybacks are generally neither. In addition, future changes to the corporate tax code may make buybacks less desirable.

We use this initial screen:

  • Market Cap > $1.5 billion
  • No industry > 40% of the portfolio
  • Positive earnings
  • Debt/Equity < 70%
  • Yield > 2%
  • Payout ratio < 70%
  • This year’s dividend > last year’s dividend
  • A rank in the 50th percentile of the Market For Lemons ranking system

Stocks that pass the screen are then ranked by our Dividend Income ranking system and the top stocks chosen for the portfolio. Like the other two portfolios, we can run this portfolio with 20-15 stocks or 10. The holdings are checked monthly for sell criteria:

  • Dividend Income ranking < 85
  • 20% down from the purchase price

 

Earnings Revision Portfolio

The Earnings Revision Portfolio is a quantitative model with an emphasis on earnings momentum. This strategy is a more growth-oriented strategy than our other portfolios. The value metrics applied in the initial ranking system are not as stringent as the ones in the VQM portfolio allowing for more growth-oriented companies to clear the screen. Emphasizing changes in expectations for current-year and next-year earnings produces a more momentum-focused portfolio.

The Earnings Revision portfolio starts with our Value Ratios ranking system which ranks stocks based on three criteria:

  1. P/E/Recent Growth rate
  2. Earnings Yield
  3. P/E/LT Growth Rate

These ranked stocks are then further winnowed with our Earnings Revision ranking system, cash flow, and a check to make sure at least two analysts are following the stock.

Another screen is employed:

  • Market Cap > $1.5 billion
  • No industry > 40% of the portfolio
  • Rank in the top 20% of our Earnings Revision Model ranking system
  • Positive earnings and free cash flow

Stocks that pass the screen are ranked using our Value Ratios ranking system and the top stocks chosen for the portfolio. Like the VQM portfolio, we can run this portfolio with 20-25 stocks or 10. The portfolio is checked monthly for sell criteria:

  • Rank < the 80th percentile of the Value Ratios ranking system
  • 20% down from purchase price

All the Archer Portfolios work well over time, but it should be noted that they are unlikely to all work well at the same time. There are times when market participant prefer growth strategies and at such times the ER portfolio will tend to outperform. The other two Archer Portfolios – Dividend Growth and VQM – are more likely to work well when Value is in favor.

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Citadel Portfolio
Alhambra Portfolio
Pathfinder Portfolio

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