Screens from the AAII

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The American Association of Individual Investors is home to a fascinating petri dish of investing formulas based on the approaches of famous money managers. They began tracking their portfolios in 1998. This is an illuminating point in time to begin comparison against the S&P 500 index (the "Index") because it marks the peak euphoria of the greatest bull market and the wrenching onset of a new bear cycle. I will talk about the results and characteristics of several formulas of interest to me, and compare them to both the best three years of the Index since 1998 and the worst three years, in order to see if the strategies were robust in both fat and lean broad conditions.

Fat Years - Index
1998: 27%
1999: 20%
2003: 26%
Average: 24%

Lean Years - Index
2000: -10%
2001: -13%
2002: -23%
Average: -16%

Piotroski Formula (6 average monthly holdings)

Based on the academic work of Joseph Piotroski, who examined the lowest price-to-book quintile of the market (shown to produce out-sized returns, aggregately) and created nine criteria to detect a minimum level of financial performance with an improving trend during the prior year in an effort to separate the wheat from the chaff of this large segment of stocks. He found that stocks scoring high on his "FSCORE" test did much better than their peers. AAII's Piotroski-inspired screen has produced the following results:

Fat Years - Piotroski
1998: 18%
1999: 27%
2003: 155%
Average: 56%
Relative to the Market, per year: 32% in excess

Lean Years - Piotroski
2000: -1%
2001: 100%
2002: -16%
Average: 19%
Relative to the Market, per year: 35% in excess

As you can see, Piotroski results, though high, are quite lumpy (never, however, worse than the Index). This is probably due to the poor information flow about companies that meet his criteria and the very concentrated portfolio that stems from his test (an average of six companies per year). Over the course of the 7.5 years from 1998 to the mid-point of 2005, the Piotroski method returned a cumulative 961% compared to the Index's 29%.

Buffett - Hagstrom Formula (30 average monthly holdings)

Robert Hagstrom is one of the standouts in the cottage industry of folks that condense Warren Buffett's investment approach into book form. He is also notable as a fund manager in the Legg Mason group since 1995. I include his formula here not so much because it is particularly outstanding in any way, but to compare the autonomous formula to the performance of the actual man that espoused the Buffett-based tenets.

Fat Years - Hagstrom Formula
1998: 28%
1999: 31%
2003: 35%
Average: 31%
Relative to the Market, per year: 7% in excess

Lean Years - Hagstrom Formula
2000: 11%
2001: 14%
2002: -9%
Average: 5%
Relative to the Market, per year: 21% in excess

Clearly, this is a formula that does best in absolute terms in favorable market conditions, but handily outperforms in bear markets. The 7.5 year cumulative return is 273% to the Index's 29%. This is a CAGR of around 18%. However, the seven year CAGR of Robert Hagstrom himself is 5%. This astounds me.

John Neff Formula (18 average monthly holdings)

Neff describes himself as a low P/E investor, through thick and thin. He stuck to this approach during his Hall of Fame performance as manager of the Vanguard Windsor fund from 1964-1995. The formula based on Neff's methods focuses on P/E ratio, dividend yield, and estimated growth rates.

Fat Years - Neff Formula
1998: 9%
1999: 17%
2003: 85%
Average: 34%
Relative to the Market, per year: 10% in excess

Lean Years - Neff Formula
2000: 37%
2001: 65%
2002: 15%
Average: 38%
Relative to the Market, per year: 54% in excess

Neff's strategy is quite robust through bull and bear conditions, but the relative performance is amazing when the market is swooning. The full 7.5 year return is 764% to the Index's 29%.

Graham Defensive Investor (17 average annual holdings)

Ben Graham, of course, is the originator of value-oriented investing and a strong proponent of formula investing. Perhaps the most famous of his formulas (though not necessarily his most effective) is his set of criteria for "defensive" investors, concerned with capital preservation and satisfactory returns.

Fat Years - Defensive Investor Formula
1998: 10%
1999: 4%
2003: 33%
Average: 15%
Relative to the Market, per year: 9% deficit to Index

Lean Years - Defensive Investor Formula
2000: 12%
2001: 62%
2002: 3%
Average: 23%
Relative to the Market, per year: 39% in excess

Though a laggard during raging bull conditions, capital was surely preserved. During bear romps, returns were more than satisfactory. Cumulative for the 7.5 years is 296% to the market's 29%.

This has been a very concise presentation of various value-oriented formulas relative to the market over a very interesting period of market history.

Final Notes

1. Subscribe to AAII for the rediculously low price of $53 (http://www.aaii.com/stockscreens/) and study the screens for yourself.

2. I will go into much greater detail into the methods of the master investors and the AAII screens and results in the future. I will not compromise their copyrights.

3. When analyzing any formula, it is important to note its conformity to the 3GV tenets and performance during different market conditions.

- Ian