Warren Buffett's investing prowess may well outlive him.
That's because a couple of finance and computer wizards at a Connecticut money management shop believe they've found a way to program software to mimic the stock-picking behavior of a few great investors, including Buffett and Fidelity Investments legend Peter Lynch.
So far, it's working.
Since I first wrote about Validea Capital Management in 2004, most of its computerized guru portfolios have handily beaten the market:
- A portfolio designed to mimic the moves of contrarian investor David Dreman has advanced the most. As of Feb. 8, it's up 173% since a July 2003 launch, compared with gains of 44.8% for the S&P 500 Index ($INX).
- A deep value portfolio based on the teachings of Benjamin Graham, considered by many to be the father of value investing, has advanced 154% over the same period.
- Validea's Buffett portfolio has even beaten Buffett, though the site's founder, John Reese, who honed his artificial-intelligence skills at Massachusetts Institute of Technology, is too modest to point this out. The Validea Buffett portfolio has gained 64% since it was launched in early December 2003, compared to 29% gains for Berkshire Hathaway (BRK.A, news, msgs).
Just one of Validea's 13 guru portfolios -- a portfolio meant to mimic momentum investor William O'Neil -- has underperformed. The rest of the winning portfolios have trounced the market with plenty of room to spare, one reason the firm has raised an impressive $70 million in assets under management since 2004.
Too good to be true?
"I'm a little skeptical, but if they've found a way to take the teachings of great investors and boil them down to a formula, more power to 'em," says Pat Dorsey, the director of stock analysis at Morningstar. Dorsey's chief concern: Many purely quantitative systems sparkle in certain kinds of markets, but then fail miserably when market conditions change and the systems can't adapt the way humans can.Jack Forehand, who helps Reese configure Validea's portfolios, says that back testing shows the guru strategies have worked for the past few decades in changing market conditions. "These individuals have done well in a variety of markets, and that is why we picked them," he says.
There are other potential problems with these portfolios that we'll get to in a moment. But first, here's a look at 15 picks from Validea's guru-tracking portfolios.
Warren Buffett
One thing that helps the Oracle of Omaha beat other value investors is that he likes rugged brand names that protect a company from competition. That's what he'd find in Harley-Davidson (HOG, news, msgs), a top pick in Validea's Buffett portfolio. How many other brands' logos, after all, are tattooed on their customers' bodies? According to Reese, Harley has another quality that Buffett covets: earnings predictability. Harley-Davidson's earnings have increased steadily over the past 10 years and should continue to grow more than 12% a year in the medium term, according to forecasts by Wall Street analysts.- Video: The tao of Warren Buffett
Buffett also likes at least 12% return on total capital, defined as net earnings divided by equity and debt, says Reese. Graco (GGG, news, msgs), which makes equipment used to mix, spray and apply liquids like paints and sealants, has that in spades. It has an average return on capital of 41% over the past 10 years.
Retailer Abercrombie & Fitch (ANF, news, msgs) has another quality Buffett would like, says Reese. It generates $1.59 per share in free cash flow, and Abercrombie's managers put it to good use. Over the past 10 years, the company has earned 22.4% on retained earnings, which would be more than acceptable to Buffett, says Reese. The company also is increasing shareholder value by buying back shares -- another quality Buffett likes.
Peter Lynch
If you had invested $10,000 in the Fidelity Magellan Fund (FMAGX) when Peter Lynch took the helm in 1977, you would have had $280,000 by the time Lynch resigned as manager in 1990. That kind of rare success makes Lynch a guru worth tracking. Fortunately for Reese, Lynch laid out his strategies in his classic investing book, "One Up on Wall Street."One kind of stock Lynch favors is what he calls the "fast grower," or a company with earnings growth of 20% to 50% a year, little debt and a price-to-earnings ratio below its earnings growth rate, Lynch's so-called PEG (price-to-earnings/growth) ratio.
One company that currently fits the bill is truck maker Paccar (PCAR, news, msgs). It has a P/E of 11.7, compared with a five-year average earnings growth of 47%. That gives it a PEG ratio of just 0.25. It also has an exceptionally low debt-to-equity ratio of less than 1%.
Another standout "fast grower" is inVentiv Health (VTIV, news, msgs), which offers staffing, data management and communications services to the health care sector. The company has a P/E of 22 compared to annual earnings growth of 49% on average over the past five years, for a PEG ratio of just 0.46. The company has a fair amount of debt, so it barely squeaks by on that measure.
Lynch also favored what he called "stalwarts," or companies with moderate earnings growth but the potential for 30% to 50% stock price gains because they are cheap. These companies must have positive earnings, relatively light debt and a low PEG ratio. Reese says Citigroup (C, news, msgs) fits the bill.
John Neff
John Neff liked his stocks cheap, as long as they had decent earnings growth and reasonable dividends. His belief that you could do well by owning stocks that simply move from being undervalued to fairly valued helped him beat the market 22 out of 31 years while at the helm of the Vanguard Windsor Fund (VWNDX), which he left in 1995.Validea believes the following three stocks top the list of names Neff would like now. Wachovia (WB, news, msgs) looks cheap with a P/E of just 12.4. Expected earnings growth of 9.4% and a dividend yield of 3.9% help Wachovia clear two other hurdles to make the Neff portfolio. Printed circuit-board maker TTM Technologies (TTMI, news, msgs) doesn't pay a dividend, but its rapid growth and low valuation make up for that.
The insurer StanCorp Financial Group (SFG, news, msgs) also makes the grade.
David Dreman
David Dreman, of Dreman Value Management, likes stocks that are unwanted and cheap. That's what makes him the consummate contrarian investor, one who relishes going against the crowd. This approach helped him beat the markets for much of the 1990s. Dreman won't go for just any ignored stocks; they have to have good earnings growth, good return on equity and low debt levels, says Reese.Three stocks that fit the bill now are: the bank PNC Financial Services (PNC, news, msgs), the energy company Unit (UNT, news, msgs) and Citizens Communications (CZN, news, msgs), which provides phone, Internet and television to small towns in rural areas.
Benjamin Graham
Considered by many to be the father of value investing, former Columbia University professor Benjamin Graham favored stocks that were significantly undervalued compared to their intrinsic worth, which he measured in part by gauging their future earnings potential, says Reese.Three stocks that fit the bill here are toy maker JAKKS Pacific (JAKK, news, msgs), Schnitzer Steel Industries (SCHN, news, msgs) and BlueLinx Holdings (BXC, news, msgs), which sells building materials.
What would the gurus think?
As cool -- and successful -- as Validea's system is, it does put some unlikely picks in guru portfolios. Graham favored companies that have to have long history of paying dividends. Yet a top Graham portfolio pick, JAKKS Pacific, pays none. Buffett says he avoids technology companies because he has a hard time understanding what they do. Yet Validea's Buffett portfolio currently holds the software company SAP AG (SAP, news, msgs).- Video: The tao of Warren Buffett
And while teen apparel maker Pacific Sunwear (PSUN, news, msgs) has a decent brand, it probably doesn't rise to the level that the Oracle of Omaha expects, says Morningstar's Dorsey. But the stock is a top pick in the Buffett portfolio right now.
While Validea's Web site portfolios produce the proverbial "eye-popping" returns, its managed accounts -- minimum: $250,000 -- don't all do as well. Three out of eight underperformed the S&P 500 last year, though the two best finished the year with 44.8% and 38% gains, way more than the S&P 500's 15.79% gains. Validea says this is because it takes steps to reduce volatility in managed accounts -- steps like owning more stocks. The flip side of this is that investing along with the online guru portfolios may take you on a volatile ride from time to time. So be prepared.
