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Part 1: Why It Works

I am often asked why our algorithmic, or formula-based approach to picking stocks for Systematic Wealth, works so much better than most other investing systems.

The answer is complicated, but also helpful in understanding why a passive approach to investing in the stock market will no longer work as well as it used to.

Why Algorithmic Investing Works

When I first became a stockbroker in 1983 I was taught that the key to investment success was in identifying companies that can grow earnings at a faster rate than their competitors. Since the current price of a stock represents the present value of expected future income, the quicker those earnings could be pushed forward towards the present, the less they are discounted.

That makes a lot of sense, and back in those days (i.e., before the proliferation of personal computing) a stockbroker could ferret out nuggets of information on a company that others could not hope to find. Good analysts were worth their weight in gold since having a close working relationship with a company often led to insights that could only be gleaned in person.

Of course, that is rarely the case anymore as the combination of increased SEC disclosure requirements and advent of electronic filing have made all of those once-rare nuggets of information available to anyone with internet access (in other words, just about everyone in the world). A good analyst may still occasionally trip across some neglected piece of data that others have overlooked, but generally speaking the old days of limited access to information are long gone.

Simultaneous to the growth of computing capability was a surge in data analytics, with an emphasis on examining historical data to predict future events. In the investment world this led to mass acceptance of a body of research referred to as Modern Portfolio Theory (“MPT”) which postulates that future behavior is, in large part, impossible to predict but possible to quantify based on historical performance.

More to the point, it suggests that you don’t need to know which direction the stock market will go; you only need to know that a certain combination of stocks, bonds and commodities will most likely behave a particular way given whatever set of conditions exist at the time.

In other words, MPT is based on the belief that trying to identify individual stocks that will outperform the overall market is impossible to do, so instead it attempts to identify a group of stocks whose behavior is consistently predictable compared to how other groups of assets perform.

And that is precisely where the opportunity lies for you to beat the stock market. So much money is now managed based on the same outdated formula that it is possible to identify stocks that are mispriced compared to the rest of the market.

For example, if the average stock is trading at a price-to-earnings ratio of 18 and pays a dividend of 2%, then a stock trading at 14 times earnings with a yield of 4% should be worth more if future earnings growth for both companies is comparable. That’s just simple math, not rocket science.

So if it’s that easy, why isn’t everyone doing it? Remember, most money these days is being managed based on expected future group behavior, not current relative value. If you sincerely believe that it is impossible to identify stocks that will perform better than others then you would have no interest in trying to figure out which ones will do better, because you wouldn’t believe that is possible.

The result is a very large amount of money concentrated in the same group of companies that comprise the major asset classes used by most formulas based on MPT, with little interest paid to the other companies that are not component members of those index funds. The result is less liquidity and price efficiency in the stocks that are largely ignored by MPT until their inherent value become apparent to the rest of the market.

Why Systematic Wealth Works

Meanwhile, the stocks that our system favors tend to trade on their own merits irrespective of the ups and downs of the major index stocks. That allows us to track them over time and buy them when our model tells us that they have become undervalued, and then sell them when they are priced correctly. Those two points in time are when we issue our buy and sell alerts.

By the way, that’s also why you won’t see a lot of so-called “blue chip” stocks in our portfolio; it’s not that we don’t like those types of companies per se, but those stocks are components of the major index funds and therefore tend to get screened out by our selection process. And with so many analysts following those stocks so closely, it is difficult for them to become significantly mispriced, thus leaving less room for the type of substantial price appreciation we are aiming for.  

The reason the Systematic Wealth approach to algorithmic investing works so well is because we take an entirely different approach to evaluating individual stocks than almost everyone else in the market. Our model is completely unbiased and zeroes in on companies that have become mispriced and are likely to appreciate in value in the near future based on solid fundamentals, and are not subject to the whims of computerized trading programs with no concept of intrinsic value.

Click Here to continue to Part 2: How it Works