The objective of the Stock Superstars Report is to educate readers on how to build a portfolio based on time-tested investment research and proven risk-reduction strategies.
The SSR Concept
When building a stock portfolio, the overall objective should be to choose a mix of stocks that will appreciate at a greater pace than the market, both absolutely and on a risk-adjusted basis. While, for many, this is easier said than done, there are a group of well-known investment “superstars” whose approaches have beaten the market over very long time periods. It was the work of these investors—such as Benjamin Graham, William O’Neil, Peter Lynch, John Neff, Martin Zweig, Warren Buffett, David Dreman, John Templeton, etc.—that became our starting point for the creation of the Stock Superstars Report concept.
While the approaches of these superstars have performed well over the long run, no approach is able to outperform the market all of the time. In fact, each superstar’s approach has had extensive periods of underperformance. Since they each have a specific approach, a portfolio based solely on one superstar’s work will have high correlation between the stocks, and thus higher risk. It is also true that these approaches often deal only with initial stock selection and not overall portfolio management—which can be more important than the individual stocks selected.
The approach of the Stock Superstars Report is to build on the work of these superstars to develop a complete portfolio management system. We don’t select the best single approach because market conditions may change rapidly and we don’t want an entire portfolio vulnerable to a change.
We constantly monitor the success of each of the SSR approaches, as well as those approaches not being used at present, to judge when a change in the approaches used should be made.
The Stock Superstars Report focuses on the portfolio concept of investing. Periods of market volatility have made us all cognizant of the need for risk control. The best way to reduce portfolio risk comes from effective diversification.
Diversification can be attempted on several levels:
Level One is completely naive diversification that counts on achieving effective diversification from having many stocks. While theoretically you reduce risk significantly by having a 16-stock portfolio, the theory assumes that the stocks are randomly selected across a broad range of industries. In fact, most portfolios are selected based on approaches that tend to end up with highly correlated stocks. For example, the S&P 500 index and mutual funds based on this index are inefficiently diversified and are much riskier than a large portfolio should be. Because the index is weighted by market capitalization (current stock price multiplied by the number of shares outstanding), where the stocks with the highest market cap make up the largest portion of the portfolio, the top 10 stocks of the S&P 500 may account for as much as 20% of the holdings. Furthermore, the stocks may be concentrated in the same or similar industries (i.e., tech stocks). The Stock Superstars Report approach avoids inefficient Level One diversification.
Level Two tries to obtain diversification by making sure that stocks are divided among categories to reduce correlation. This involves balancing stocks among industries, capitalization sizes, and national or regional boundaries. All of these approaches reduce correlations and improve diversification, but they don’t measure the actual correlations between the stocks in a portfolio.
Level Three looks at the actual correlations in a potential portfolio. This approach can be used to check for correlation after selecting stocks and making effective adjustments to the stocks or to the selection techniques. The Stock Superstars Report employs Level Three diversification at both the strategy and individual stock level.
AAII regularly tests a universe of over 60 stock investment strategies to find a select group of superstar approaches that have performed well during both bull and bear markets and have little correlation to one another. The correlations of potential SSR stocks based on our selection methodology are examined and only stocks with good prospects that also help to control overall portfolio risk are ultimately added to the SSR portfolio.
Deletions From Portfolio
The underlying philosophy of when to delete a stock from the SSR portfolio is to:
- Allow each investment strategy to dictate when a stock is removed from a given portfolio group;
- Remove stocks experiencing significant underperformance relative to the overall market, but avoid selling based solely on downward price movement; and
- Let winners ride.
As well as being a time-tested approach, this philosophy is also very tax-wise. We are not trying to predict or time the market, but rather to use the feedback of the factors important for a given stock group as well as the market itself to develop the best selection approaches for current market conditions.
The SSR divides its portfolio into four distinct groups. These groups may change over time as performance and risk warrant. The following SSR groups are presented as examples. See the glossary on the SSR website for current group definitions, as the groups change over time.
Group 1: Profitability and Relative Strength
This group consists of companies with a proven record of earnings growth that also show strong relative price strength. Key elements sought when selecting these stocks include:
- Consistent quarterly earnings momentum;
- Consistent and strong long-term earnings growth; and
- Strong relative price strength and price momentum.
Group 2: Value & Financial Strength
This group consists of value-oriented companies that pay a dividend and exhibit positive historical and projected earnings growth. Key elements sought when selecting these stocks include:
- Low price-earnings ratio;
- Dividend paying;
- Positive historical earnings growth;
- Positive projected earnings growth; and
- Moderate levels of liabilities.
Group 3: Growth at a Reasonable Price (GARP) Revisions
This group consists of companies with acceptable valuation levels relative to their expected earnings growth that have also experienced recent positive earnings surprises and upward revisions in consensus earnings estimates. Key elements sought when selecting these stocks include:
- Reasonable valuation levels relative to expected earnings growth;
- Positive quarterly earnings surprise;
- Recent upward revisions of consensus earnings estimates;
- Debt level within industry norm; and
- Minimum level of price momentum.
Group 4: Reasonably Priced Growth
This group consists of stocks with a combination of low price-earnings ratios and solid growth in earnings and sales. Key elements sought when selecting these stocks include:
- Reasonable dividend-adjusted price-earnings to growth ratio relative to that of the overall market;
- Reasonable levels of estimated earnings and historical sales growth;
- Positive free cash flow; and
- Strong profitability relative to the industry.