There are two main types of professional stock investors: top-down and bottom-up.
I used to favor top-down investing (or the stock selection process that starts at the economic level and filters down to sectors and then stocks), but then I discovered that the stock market can ignore important macro issues for a very long time. Bottom-up investing can discover great stocks in (almost) any environment, but formerly ignored macro issues sometimes can refuse to cooperate with company fundamentals.
After years pondering the pros and cons of top-down and bottom-up investing, I decided it is best that both work in unison to achieve superior results over time.
Then I talked to (father and son) Arnold and Larry Langsen, and I discovered that they have a third way of approaching the market.
“We are neither top-down nor bottom-up,” Arnold said. “You are looking at it the wrong way. To the best of our knowledge, no one does what we do.” I think they sensed my skepticism over the phone, as I heard them call their way of investing Defensive Alpha. “We don’t predict anything. We just go with the flow and try to beat the market.”
“But how exactly do you do that?” I wanted to hear details, as those that have been around financial markets for a while know to always kick the tires extra hard on anything that looks too good to be true.
Arnold L. Langsen, Ph.D., was named Outstanding Professor of the Year by the Trustees of the California State Universities in 1984. He was invited to be Professor of Finance at the University of California at Berkeley from 1985 through 1990. When he stopped teaching full-time, he kept investing full-time with the theories he had worked on over the years. His proprietary algorithms are based primarily on the works of Sharpe, Markowitz and Fischer Black.
I saw that the Langsens had produced intriguing results with an overall 0.65 correlation to the S&P 500 for four years — through a bad bear market without taking any short positions — but I still wanted to see more details. This time, Larry began to elaborate.
“We use a proprietary Dynamic Asset Allocation model (based on the algorithm developed by Fisher Black called “Simplifying Portfolio Insurance”),” he said. “That determines the percentage of equity and cash in the portfolio and is based on current market conditions. As we mentioned before, we do not forecast or guess.”
As a second step, Larry mentioned they begin with a set of proprietary screening constraints. They usually end up with about 100 candidates for the portfolio. From this point, they do not throw everything into a “black box” and use blindly what they have, but they actively manage to meet the portfolio formation constraints.
“So what are those constraints?” I asked.
This is where it got interesting.
- The Lagsens screen for securities with high alpha (using a financial database).
- That usually gives them securities with high beta, so they constrain the portfolio to a beta of 1.
- To constrain the weighted beta of the portfolio to 1, they discovered they need to offset the higher-beta securities with lower-beta securities. For example, while Dollar Tree’s* (NASDAQ:DLTR) Go Ratio might not be within the desired range (see Step 4), it is included in the portfolio as a “cost of doing business.”
- The Lagnsens are looking for a “Go Ratio” between 0 and 0.5. The Go Ratio is the intellectual property of The Langsen Group. It is a calculation of the present value of a security and its future growth. As an example, if a security has a Go Ratio between 0 and 0.5, that fits their criteria for getting into the portfolio. If a security has a negative Go Ratio, it means one of two things: It is undervalued, or it has negative future growth (they don’t guess which is correct) so the security is not used … with the exception of DLTR, keeping the portfolio’s beta at 1. On the other hand, if the security has a Go Ratio greater than 0.5, it indicates one of two things: It is either overvalued, or it has great future growth. Again they don’t guess, so these securities are not used, with the exception that between 0.5 and 0.6, they can use the securities but watch them closely.
- The Langsens are seeking positive momentum (“What are you doing for me lately?”). And if a security in the portfolio has its momentum turn negative or goes “too high,” it becomes a sell candidate.
Larry and Arnie typically use up to 20 stocks. What struck me as unusual is that they were willing to sacrifice on alpha (or the excess return of the stock relative to the return of the benchmark) to keep total portfolio beta (or the risk of the portfolio relative to the benchmark) at 1. They do not reach for performance and aim to minimize the portfolio risk.
Using only their quantitative approach, only by looking at the above parameters, they found Monster Beverage* (NASDAQ:MNST) — the energy drink maker that delivers operating margins of 26.8% and revenue growth of 28.65% on a YOY basis in the latest reported quarter, and revenue growth that cannot be matched by any industry player of a similar size, making it a (rumored) Coca Cola* (NYSE:KO) takeover target. They also found Ulta Salon* (NASDAQ:ULTA), the cosmetics superstore and salon chain that has delivered a five-year compounded annual growth rate of net income of 38%, as no one really competes in the new store format it has invented. Dollar Tree, even if marked as “a cost of doing business,” is a well-run dollar store with strong operating margins.
Using the above strategy, the Langsens have produced very intriguing results and have been willing to stay out of the market at times of great volatility. Many portfolio managers have to stay fully invested, justifying their stance that otherwise they might miss the best part of a market rally.
However, most fully invested managers won’t say what happens if they miss the market’s worst days. The Langsens have been willing to take that well-calculated risk, as their algorithms suggest it, in order to do something unique — they have gone against conventional wisdom to try to beat it.
*Stocks are among the top 10 holdings, based on percentage of assets, of the Navellier Defensive Alpha Portfolio as of March 31, 2012, with the exception of Coca Cola, which is a top-10 holding in the Navellier Large Cap Value Portfolio.
This information has been provided by Navellier & Associates, Inc. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment making decision. The views and opinions expressed are those of the author and portfolio manager at the time of publication and are subject to change. There is no guarantee that these views will come to pass. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. Past performance does not guarantee future results.