Archer Portfolio

Archer portfolios are custom portfolios of individual stocks. Each Archer portfolio is unique and thoughtfully constructed using 5 factors that have proven through time to outperform the market averages:

• Value
• Quality
• Momentum
• Size
• Dividend Yield

What are factors? Investors have been searching for an edge in markets for as long as people have been investing. Greed is a powerful motivator and there is a long history of investors seeking an advantage through analysis. Investors throughout history have sought to identify the characteristics of successful companies, those investments that produce exceptional investment results. The characteristics they identified are known today as factors.

Modern factor investing is often credited to Ken French and Eugene Fama, who published their three-factor model in 1992. This model added value and size to the original capital asset pricing model which demonstrated the tradeoff between risk and reward. They later updated the model by adding two more factors, profitability and investment. It is ironic that Fama shared a Nobel Prize for his work on the Efficient Market Hypothesis when his later work essentially refuted it.

The scholarly roots of factor investing really aren’t important. All Fama and French really accomplished was to put an academic polish on what great investors have always known, namely that markets are far from efficient. Warren Buffet, in a 1987 letter to Berkshire Hathaway shareholders, opined that “in the short run the market is a voting machine, but in the long run it is a weighing machine”. What that means is that in the short term, investors and speculators buy what’s popular and sell what isn’t, pushing prices of securities above and below their intrinsic value. In the long run, though, it is the underlying fundamentals that matter.

Wall Street tends to take every good idea and push it to the extreme and they have done so with factors. Over the last few decades, there have been hundreds of white papers published that purport to identify another investment factor that outperforms the market. And Wall Street dutifully rolls out an ETF to take advantage of whichever one has captured the public’s fascination today.  Most of this “research” is nothing more than data mining and these new factors rarely work outside of the academic world.

There are really only those original five factors that have stood the test of time and worked in the real world. We use the traditional definition for the first four:

Value: Value stocks are those that trade for a low price relative to their fundamentals like book value, earnings, and cash flow.

Quality: Quality stocks are those of companies that have low debt, stable earnings, and consistent growth.

Momentum: Momentum stocks are those that have performed well recently. We generally look for companies whose earnings exhibit momentum as those are also most likely to exhibit price momentum. An earnings test also tends to eliminate more speculative issues.

Size: Stocks of smaller companies tend to outperform those of larger companies. As conservative investors, we tend to use this factor to identify midcap stocks.

Low Volatility: We focus on stocks that have a history of paying and increasing dividends. Dividend paying companies generally exhibit less volatility than those that don’t.

We use these factors in a variety of stock-picking methodologies:

Quality Momentum: US Large Cap stocks, high margins and margin growth, high free cash flow growth relative to asset growth, high levels of cash and low debt/equity ratios.

VQM (Value, Quality, Momentum): All cap stocks including ADRs (non-US), high margins and margin growth, high free cash flow growth, low debt/equity ratios, and high earnings momentum (rising earnings estimates).

Cash Flow + Innovation: US Large Cap stocks, low price-to-free cash flow, low price-to-innovation adjusted cash flow, high return-on-equity

Dividend Growth: US Large Cap stocks, high dividend yield, payout ratio < 50%, 5 consecutive years of rising dividends, high Quality Momentum rank

Earnings Revision: All cap stocks including ADRs, low price-to-sales ratio, low price-to-book ratio, low price-to-free cash flow, rising earnings estimates for current and following year.

Large Value: US Large Cap stocks, high quality characteristics, low price-to-sales ratio, low price-to-book value, low price-to-free cash flow.

ADR:  Applies the Large Value criteria to foreign stocks.

SMID: Applies the Large Value criteria to small company stocks.

We run hypothetical portfolios of each methodology and track the performance. Buffett’s observation that in the short run, the market is a voting machine applies to factors as well. We don’t try to time factors (all our research shows it is harder to time factors than markets) but we do think it is important to observe what the market is rewarding at any given time. The results show that over the long term, the methodologies all produce similar long-term results but different factors move in and out of style. We tend to focus on the ones that are out of style today to pick stocks for new portfolios with the obvious expectation that they will not stay that way.

An Archer portfolio could include stocks from any of the five factor-driven methodologies. New portfolios can be substantially different than ones built a year ago and will certainly be substantially different than ones built 5 or 10 years ago. An Archer that has aged will also likely contain stocks that no longer fit the criteria under which they were bought, especially if it is held in a taxable account. Tax-free or tax-deferred accounts will generally have a higher turnover rate.

Archer portfolios are customizable depending on client preferences. They can be concentrated to hold 20-30 stocks or more widely diversified, holding 50-100 stocks. More concentrated portfolios tend to outperform but at the cost of increased volatility. We can also restrict certain securities at the client’s request. For example, clients may not want to hold a certain stock or may want to avoid non-US stocks.

Archer Portfolios can be used as standalone strategies or used as part of a larger, more diversified approach. For instance, we substitute an Archer portfolio for a part of the equity allocation in our Citadel Portfolio with the resulting portfolio called the Alhambra Portfolio.

Archer Portfolios. Data driven with a human touch.