Mechanical Investing Strategy – What is it?
The basics of Mechanical Investing Strategy
A big part of my investing involves number crunching. Basically I’m very much a quantitative guy.
Meaning, I like to create various types of strategies based on historical numbers and spend a lot of time thinking how I can improve and test it.
It’s why I created the list of value screens and why I’m always in search of new and better ideas.
Of course, once I’ve narrowed down my ideas to a few stocks, I spend time to study and understand the company.
But, there are many investors called mechanical investors, who buy without performing any in depth research.
And many have had plenty of success.
Joel Greenblatt is the best example with his introduction to the Magic Formula investing approach. Another guru investor that I am introducing today is James O’Shaughnessy of O’Shaugnessy Asset Management.
Quant Investor James O’Shaughnessy
According to O’Shaughnessy’s background, he grew up listening to his father and uncle argue about their portfolio holdings. The arguments were heated and passionate which O’Shaughnessy enjoyed, but he also began to think that there must be a way to invest without the heated arguments and emotions.
That day came when he was granted access to Standard & Poor’s 45 years worth of stock information. He tested, tested and tested a truckload of strategies, screens and methodologies.
A surprise result from one of his tests was that, PE ratios wasn’t the best method to value a stock and that small cap stocks as a group didn’t offer an edge over large cap stocks.
Mechanical Investor James O’Shaughnessy
O’Shaughnessy is purely a quantitative approach investor.
That is, once he has narrowed a list of stocks, he will buy a bunch of 20-50 stocks by sticking to the numbers.
His books “What Works on Wall Street” and “How to Retire Rich” detail the investment strategy of growth and value.
O’Shaughnessy’s defines growth and value by the typical Wall Street standard.
Depending on the P/E, P/S or P/B of the stock, it will be considered either growth or value. But because I disagree with his definitions, I’ll label O’Shaughnessy as a mechanical investor, instead of a growth/value guy as he simply buys the top 25-50 stocks based on a certain strategy and then re-balances the portfolio every year.
The following is an investment checklist of O’Shaughnessy’s strategy for growth and value.
Cornerstone Growth & Value Strategy
With NFLX unstoppable lately, it will be a good example to use.
1. Market Cap shall be Greater than $150 million [Pass]
- $150 million market cap is the cut off point
The $150 million mark is required to eliminate illiquid stocks but at the same time allow for a small growth company.
Market cap is now $9 billion which satisfies this criteria.
2. EPS Persistence [Pass]
- Earnings per share must increase each year over the last 5 year period
NFLX is scorching hot. EPS has been $0.64, $0.71, $0.97, $1.32 and $1.98 over the past 5 years. Passes this test.
3. Price to Sales ratio
- Price/Sales ratio should be below 1.5
This is more of a “value” criteria. But when used in conjunction with EPS growth numbers, it can identify growth stocks that are still cheap to buy.
NFLX has a TTM (Trailing Twelve Month) price to sales ratio of 4.55, which is way above the required 1.5.
Too late to be buying NFLX.
4. Relative Strength [Fail]
- Relative Strength Index (RSI) should be among the top 50 of the stocks screened
A technical analysis term for momentum. It measures the speed and change of price movement. RSI is considered overbought when above 70 and oversold when below 30.
NFLX has a RSI of 97. From a momentum and technical analysis view, the stock is overbought.
5. Dividend Yield [Fail]
- Select the company with the highest dividend yield
O’Shaughnessy’s studies showed that the best performing shares in the three year period after substantial market declines are high dividend paying stocks.
NFLX has no dividend yield and therefore fails the test. Since it has already failed two cases, NFLX would be discarded.
6. Shares Outstanding [??]
- Shares outstanding should be greater than the market average
This condition is harder to figure out because statistical data of the entire market is required.
7. Trailing 12 Month Sales [??]
- TTM sales should be 1.5 times greater than the mean of the market’s TTM sales.
Another condition that is difficult to screen and test without detailed statistical data of the market.
The Good and Bad of Mechanical Investing
As you can see from the investment checklist above, there is nothing difficult at all (except no. 6 & 7 due to the lack of data).
Mechanical investing has its advantages..
- No emotions involved
- Easy to keep track of
- Easy to buy and sell
- Can quickly filter a big list of stocks down to 50
- You don’t know what you are buying
- Lots of commission and fees involved
- There isn’t much of a way to improve. It’s either a hit or miss and you give up.
- Requires sticking to the strategy all the time
I am actually testing my own OSV mechanical investing strategy portfolio at the moment. Up about 27% YTD. Ironic how it is killing my actual real portfolio performance.