Benjamin Graham's Net Current Asset Value Strategy

Benjamin Graham, the father of value investing, had a strategy to identify stocks with great value. (See my review of his classic book, The Intelligent Investor, here). Graham's net current asset value (NCAV), according to one published study, returned 29.4% annually from 1970 to 1983 if stock picking was done at the beginning of each year (and each stock held for a one-year period). This compares to 11.5% for the S&P 500 Index.

The Basics

Essentially, the strategy seeks to find stocks that trade below their calculated value, but how Graham defines "value" might differ from the typical definition. Graham looks at book value based only on current assets; that is, he ignores long-term assets, but includes long-term debt. In other words, the net current asset value is total liabilities subtracted from current assets (for how to break down a balance sheet, see this article by Richard Loth).

The strategy calls to purchase shares of stocks that are currently trading at 2/3 or less of their NCAV. Most companies have a negative NCAV, so this criteria really limits what companies will come through to a small (sometimes zero) number. Graham is really looking for the deep discounts, and then seeks to sell it when the share price rises up to its NCAV. He also posits that a company whose current assets are 1/3 greater than its total liabilities is financially sound. Unfortunately, there is no website tool that I know of that screens for NCAV stocks, and investors must come up with their own screens to determine them.

Graham's NCAV often results in tiny microcap companies that trade for very small amounts. Thus, there is certainly increased risk involved. I always avoid penny stocks, and micocap companies (typically defined as those with a market caps less than $250 million) need to be evaluated and monitored very closely as they can be disastrous. So, while this strategy looks for deep discounts, to me, it seems like a high-risk, high-reward strategy on first glance since it typically results in small little-known companies. Having said that, Graham himself even acknowledges that his strategy would yield several companies that end up failing, so he recommended that investors buy a large number of stocks to diversify risk.

How do we find the stocks that meet Graham's criteria?

Using the stock screen feature at Charles Schwab, I used the following criteria: 

1.) Stock Price - Really cheap stocks usually indicate the company is in trouble and lead to a huge increase in risk. Thus, I set a minimum price of $3.  
2.) Price/Cash Flow (TTM) - This is a profitability measure. To eliminate high-risk companies and stocks likely to meet Graham's criteria, look for positive cash flow. I set a P/CF minimum of 0.1.  
3.) Price/Sales (TTM) - A low P/S ratio is a typical trait of NCAV. I set a maximum P/S ratio of 0.3.  
4.) Price/Book (MRQ) - NCAV stocks will have a small P/B ratio. I set it to <1.  
5.) Debt/Equity - Low debt is key to meet NCAV criteria. I set a maximum of 0.1 D/E ratio. 
6.) Market cap - To help offset some risk, I only wanted to view companies with a market cap of at least $100M (still considered microcap).

    This yields only 7 stocks (HVT, IMN, KBALB, PSUN, PCCC, TUES, and VOL). To determine if they meet Graham's criteria, there is a convenient calculator located here. (Update 9/21/2009: Unfortunately, this calculator is no longer free. Instead it is part of the $14.99 Stock Research Pro Valuation Software that is available for download here. I recommend performing the calculations on your own as they're not very difficult.)

    Go to Yahoo! Finance or Google Finance and look at Financials -> Balance Sheet -> Quarterly Data. Look up Current Assets, Total Liabilities, and Total Common Shares Outstanding. Enter the data in the calculator and voila! If a company is both healthy and bargain, it meets the criteria. Unfortunately, none of the 7 above are both healthy and bargain. That criteria certainly is stringent, isn't it?

    So, I set to make my criteria a little less strict. I reduced the market cap to $20 million, set the minimum stock price to 2, and eliminated the Price/Cash Flow using Google Finance's stock screener (P/CF isn't even an option with Google Finance). You can see the criteria by clicking this link.

    This resulted in 12 companies: ACAT, BBW, FRD, FFEX, GAI, KCP, PSUN, RCMT, SCVL, SLI, TONE, and XRTX. Of these, only two are both healthy and bargain. The lucky two? RCM Technologies, Inc. (RCMT) and Global-Tech Advanced Innovations Inc (GAI). A couple others - ACAT and FRD - just barely miss being at Graham value level. ACAT would have met the criteria just a month ago, but it is up a whopping 44% since then!

    As you can see, this is a very limited group, and if your screen results in no matches, just try again later. When stocks have been battered, there will be many more to choose from. I'm sure if I ran this screen in March or last November, there would have been a lot more results.

    You can check out the following blog that chronicles stocks below NCAV:


    As of right now, I can't really recommend this strategy. It certainly isn't for everybody and results in speculative plays. If, however, you have a portion of your portfolio (hopefully, it's small, as in 5-10%) that is dedicated to speculative micro-caps that you can live with going to zero, then this method is certainly a great one to utilize. And to diversify risk, choosing several companies as opposed to one would also be preferable. But these companies need to be monitored closely, so only invest if you have both the time to dedicate as well as the knowledge base to know when to get in and out. In the end, this strategy identifies companies that are in seemingly strong financial positions at a great price - but can lead to risky companies.

    Update 10/6/10:  How are the two stocks mentioned above doing over a year later?  Well, RCMT is up to 5.00, a 100% gain!  GAI, on the other hand, is down to 8.49, for a decrease of 1.6%.  This is too small of a sample size to make any conclusions, but I still find it interesting.   RCMT increased from 3.5 to 4.93 in a day (June 4, 2010) after an unsuccessful takeover bid by CDI Corp for $5.20/share.  (RCMT rejected the offer.)

    Mutual Funds vs. ETFs: Which Makes the Most Sense?

    Both mutual funds and Exchange Traded Funds (ETFs) offer instant diversification with a basket of stocks, the potential for low costs, and myriad investment options. But which of these collective investment schemes offer the best performance and flexibility after taking costs, taxes, and other criteria into account?

    Let's examine the differences, analyze the pros and cons of each, and then lay out when it makes more sense to purchase a mutual fund over an ETF and vice versa. Note that when talking about mutual funds, I will be referencing and referring to low-cost index funds; not their higher cost active fund counterparts. For more on the advantages of index funds over actively managed funds, use google to find articles, pick up a copy of Will McClathy's Index Funds, or continue to read this blog as it will be outlined in a future post.

    Mutual Funds

    First, the basics. Mutual funds hold a collection of stocks based on the fund's objective and manager's research. Passive index funds offer much lower costs than active funds since they require much less effort and have been shown to outperform active funds after taking fees into account. When buying funds, you purchase shares for the NAV (net asset value) at the end of the day (4 PM ET) no matter when you place the order. That is, if you place the order at 10 AM, 3:30 PM, or even 4:30 PM the day before, your shares will be purchased for the same price at the close of the trading day. Typical index funds offer around a 0.20% net expense ratio (such as the most widely held fund, VFINX Vanguard 500, which offers a 0.18% expense ratio with over $77 billion in assets).

    Some funds have front or back-end load, which is a percentage commission paid to the broker when shares are purchased. Others have 12b-1 marketing fees. Avoid these funds. Most brokerage firms charge transaction fees for every time one wants to purchase shares outside of their own firm (e.g. Charles Schwab charges a whopping $49.95 every time an investor wants to purchase shares in VFINX, while charging nada for investing in their equivalent, Schwab S&P 500 Index Inv (SWPIX), which has virtually identical returns and a 0.09% expense ratio). Thus, it makes sense to open a brokerage account directly with the firm that offers the fund. Only invest in no-load, no transaction-fee funds. Mostly for this reason, I have brokerage accounts with Charles Schwab, Vanguard, and Fidelity.

    All else being equal, I always choose the fund with the lowest costs (i.e. fees). Vanguard has always been known as the flag bearer of low costs and still wins out with many of its funds, but Schwab recently reduced its fees on its funds to compete with Vanguard. Additionally, most Vanguard funds require a minimum investment of $3,000, while many Schwab funds can be purchased for as little as $100. In any event, the important thing is to open an account directly with the firm that manages the funds.

    Exchange Traded Funds

    ETFs, on the other hand, trade exactly like stocks. They, like mutual funds, hold a collection of stocks, but unlike mutual funds can be shorted, limit orders can be placed on them, and they dynamically change price throughout the day. Once the trading session has ended, you cannot place a transaction. Since they trade like stocks, there are no minimums, but you have to pay a commission every time you place an order. The prototypical ETF following the S&P 500 is SPY with nearly $64 Billion in assets and an expense ratio of 0.09% (slightly lower than VFINX).

    Now, with the knowledge of the basics of mutual funds and ETFs, let's examine the pros and cons of each. Some mutual funds have relatively high minimums that are out of reach for very small investments (however, if you're a small investor, the transaction costs for placing order for ETFs would prove to be prohibitive to positive returns as well), while ETFs have no such minimums. ETFs charge transaction costs for every order placed (even with low commissions from a variety of available brokerage firms), those $9.95 commissions can quickly add up, especially if you're dollar cost averaging. ETFs trade like a stock, so they can be traded intraday, shorted (not recommended for the average investor), can use options (not recommended for the average investor), and limit orders (always recommended for all investors).

    Comparison and Conclusion

    Mutual funds almost always offer automatic dividend reinvestments for free. ETFs, on the other hand, distribute the dividends in the form of cash in your brokerage account. Thus, you must pay another transaction fee to buy more shares unless your broker allows automatic reinvestment for free (most do and you probably should change if yours doesn't). ETFs also behave in a slightly better way for tax advantage purposes since ETFs avoid the outright selling that triggers undistributed capital gains that plagues mutual funds. Thus, even if you lost money with a mutual fund, you could still be subject to capital gains taxes on top of the loss! Talk about shooting yourself in the foot! But I think these tax advantages, while certainly valid, are often exaggerated. While taxes should be considered, they aren't usually what makes the difference. And if you hold mutual funds in tax-deferred retirement accounts such as a 401(k) or IRA, then you don't have to worry about the tax ramifications at all.

    Following is a comparison in table form:

    Criteria Mutual Fund ETF Advantage
    Min. Investment Varies based on fund None ETF
    Transaction Cost Typically none Standard trading fee applies Mutual Fund
    Trading Flexibility Purchased for NAV at end of day Trade like stocks; dynamically change price, limit orders, shorts ETF
    Dividend Reinvestment Automatic Varies based on broker Mutual Fund
    Tax Ramifications May be subject to capital gains even if investment loses money Avoids outright selling ETF
    Management Fees Expense ratio ~0.15% for index fund Expense ratio ~0.09% for index ETF ETF

    Leonard Kostovetsky, an Assistant Professor of Finance at the University of Rochester, takes the quantitative differences even one step further by looking at the costs inherent in both ETFs and Mutual Funds in his article "Index Mutual Funds and Exchange-Traded Funds," published in the Journal of Portfolio Management (2003). In his Summary of Cost Comparisons, he examines fund transactions, cash drag, dividend policy, rebalancing, management fees, shareholder transaction, and taxation. In the end, Kostovetseky's analysis leads to the conclusion that the costs associated with such criteria favor index funds for most passive individual investors. According to investopedia, if you had a holding period of one year, you would need over $60,000 of an ETF for the fees and taxation benefits to offset the increased transaction costs. With a horizon of ten years, the break-even point would be approximately $13,000.

    In conclusion, for the average investor who has a long-term investing strategy and dollar cost averages into their investments, low-cost, no-load, no-transaction fee index funds are the way to go. If you, however, have a large lump sum to invest at one time, then ETFs make more sense due to their slight tax advantages (only relevant in non-retirement accounts) and lower associated fees. Thus, institutional investors with gobs of money should purchase ETFs. In addition, active traders should choose ETFs for their increased trading flexibility as they offer investors the ability to place limit orders (which everybody should do), go short (only experienced traders should go short), use options (only for the experienced), and they dynamically change prices throughout the day.

    Update June 2010:  With Charles Schwab, Fidelity, and Vanguard now offering free trading on particular ETFs (8 stock ones for Schwab with 3 bond ETFs in the works, 25 iShares ETFs at Fidelity, and 43 Vanguard ETFs), the above is somewhat outdated assuming you are an index investor.  That is, you can now cheaply dollar cost average into various indexed ETFs assuming you are using transaction-free ones.  Consult each individual site for a specific list.  For those who want to automatically invest an exact dollar amount on a schedule or not deal with limit orders in the middle of your work day and whole shares (you cannot purchase partial shares of ETFs, so the dollar amount won't be even), mutual funds may still offer some more conveniences.  This convenience has to be weighed against the differing cost structure (namely, the net expense ratio) to find the best value.  The difference may be insignificant or may be significant.  Also note that Vanguard has a unique patented mutual fund-ETF structure such that you can convert your mutual fund shares to ETFs absolutely free at a later date if you so choose without realizing any capital gains.  The reverse, however, is not possible.

    Book Review: Active Investing

    In Peter Sander's Active Investing: Take Charge of Your Portfolio in Today's Unpredictable Markets (Adams Media Corporation, June 2005, 262 pp), the author espouses a mixture of various trading and investing strategies serving as a compromise between buy and hold and frequent day trading. Sander posits an investing strategy in an increasingly dynamic market that is not as simple as "set it and forget it" (i.e. buy and hold), but certainly doesn't require daily monitoring of the market. He argues that this "active investing" protects against the downside and leads to a modest outperformance of the S&P 500 during bull markets. The book is a valuable resource for those who want a broad-based investment strategy for their portfolio and are willing to take the time and effort required to partake in such strategies.

    For investing neophytes and those with a more advanced background, Sander also provides a very nice overview of key topics - such as the history of the market, broad economic indicators, financial statements, options, resources to utilize (he finds Yahoo! Finance and Value Line among others especially useful), the process of determining price during buy and sell orders in the NYSE and NASDAQ, technical indicators, market versus limit orders, and much more. The book consists of many short sections that give brief introductions to these concepts. This broad coverage leads to a greater understand of the market forces at play and the history of financial markets more generally; but may not be entirely necessary to read in order to grasp the main thesis he elaborates throughout the other chapters (that is, the active investing strategy). Although he speaks generally about how to leverage such a strategy to your benefit and the various techniques at one's disposal, he talks very broadly about the strategies and doesn't outline detailed examples and procedures. Thus, if you wanted an in-depth analysis of a particular investment strategy, this is probably not the book for you.

    At times, I found myself somewhat disappointed at the lack of detailed analyses that arise from the two sections per page organization of the book. In reality, the meat of the book (the active investing strategy) could easily be consolidated to a 20-page article. However, the other pages certainly aren't worthless as Sander provides helpful information (assuming you aren't a well-seasoned veteran of the market) about a wide array of investing areas and commentary of general market conditions. The topics are relatively eclectic and broad-based such that Sander is limited to giving brief overviews and doesn't dedicate too much space to one particular topic. The negative aspect of this structure is that the reader tends to crave more details and perhaps feels jolted when going from topic to topic. The book can also be a fairly densely packed full of terms if you're new to the game. Overall, though, Sander makes the text flow relatively well considering the varied topics he seeks to cover and is easy to read. A couple of the charts have the wrong time range (the chart is different than what is referred to in the text), which I personally find ridiculous and makes me question the editors, but doesn't really cause any detriment to the understanding of the concepts. Sander definitely knows his stuff.

    The main purpose of the book is to provide a basic framework by which the "active investor" can seek to "modestly outperform the S&P 500." An underlying purpose, as I previously stated, is to give a fair overview of many aspects of the market; these are helpful for general understanding, but won't be particularly helpful in giving you an investment edge.

    The active investing strategy can be summarized as follows. Sander encourages dividing your portfolio into various segments based on their investing strategies and your goals for the segment. The "foundation" portfolio is long-term in nature and requires little to no active management. This segment is typically invested in stock index funds, bonds, commodities, real estate, etc. and includes retirement accounts. This portion is mostly left alone as it's meant to grow over the long-term. The "rotational" portfolio is managed fairly actively and seeks to adapt based on current market conditions and business cycles. It invests in stock and funds as well, but rotates based current conditions as a vehicle of practicing "intelligent market timing." Sander encourages the use of easily traded ETFs for this portion. Finally, the "opportunistic" portion is the most active part of the entirety of the portfolio and is for stocks and options held a few days to a few weeks. This is definitely a "swing trading" technique and seeks to find undervalued assets at a particular point in time generate income and cash reliably. The investor then sells these assets to profit generously. This is the portion that is supposed to be doing the heavy lifting. Sander gives the following segmentation of allocating funds to the foundation, rotational, and opportunistic portions, respectively:

    Classic: 50-80%, 10-30%, 10-20%
    Conservative: 80-90%, 5-20%, 0-5%
    Aggressive: 30-70%, 10-30%, 20-40%

    Thus, for the vast majority of investors, the foundation portfolio should be the largest and most significant portion; something I certainly agree with. Although the author claims that the "rotational" and "opportunistic" segments of one's portfolio only need to be monitored once a week, based on the methods described in the book, these segments would realistically take a great deal of research and dedication on the order of at least one hour per day, in my opinion. If an investor rids him or herself of the opportunistic segment of the portfolio (which I would encourage the large majority of investors to do), I suppose a once-a-week monitoring schedule is doable for the rotational portfolio, although still less than ideal.

    Sander also encourages the use of options for certain individuals and spends quite a few pages detailing them. I don't think options are appropriate for the average investor and instead should be used exclusively by experienced traders. The author does pose a caveat that these techniques are sophisticated and typically are not used by the average investor; rather, he posits that the active investor ought to be well-prepared and practiced before using these tools. But I still don't think he emphasizes it enough as I tend to err more on the side of caution and believe that nobody except truly seasoned trading veterans should use options.

    The book's philosophy of using several short-term strategies - although not day-trading - to optimize results is somewhat counter to the strategy I espouse, but I don't think these techniques are without any merit. Although these strategies are not for an "average" person, with the right amount of research, commitment and knowledge, they can be done right. The investor just has to be able to come to grips with and accept the added risks involved in such techniques. But since only a small portion of one's total assets are even in the rotational and opportunistic segments, the risk is somewhat abated and there is a potential for increased returns.

    Overall, this book does a very good job of giving an overview of many topics that can be helpful to investors. It encourages one to not only be diversified in assets, but also in investment strategies, which is the main point of the book, and certainly a valid point. It might be too dense and full-of-terms at times for the beginner (although it's certainly manageable) and too basic for the advanced, but strikes a particularly good balance for those mildly familiar with indicators, etc., but want a bit more. In the end, I enjoyed the book and utilize many of the same strategies (although mine are more in line with the foundation and rotation portions and not the opportunistic segment). I'd encourage investors to read the book if for nothing else than the nice recap of market history and resources to use; the investing strategies themselves are also noteworthy, but certainly not earth-shattering, and I think that two of the three segments are actually inappropriate for the majority of investors.

    Rating: 3.5 out of 5 stars

    Book Review: The Intelligent Investor

    Benjamin Graham's classic book, The Intelligent Investor: The Definitive Book on Value Investing (Collins Business; Revised edition July 8, 2003; 640 pp) was first published in 1949 and has since been read my millions of interested parties and declared the "best book on investing ever written" by Warren Buffett.

    Money senior editor Jason Zweig added extensive footnotes and commentary after each chapter to update the latest 1972 Graham version to today's marketplace and expand the book to a hefty 640 pages, while Buffett wrote the Preface in the newest 2003 version.

    This book is a must read for all investors.

    Graham offers no guarantees or quick get-rich schemes like so many other books, but rather professes the importance of long-term value investing with sound analytics and no emotions attached. His philosophy speaks to the importance of loss minimization as opposed to profit maximization and is certainly intended for investors as opposed to traders. Graham encourages investors to find bargains in companies relative to their current asset value by using sound research tools and criteria. He also espouses a fairly conservative (at least, by most current standards) approach to asset allocation of stocks and bonds (approaching 50/50 for most investors), and emphasizes that the investor's asset allocation plan must be stuck to in the long-term no matter what your emotions are telling you. In the long term, this approach has proven to produce larger gains and smaller losses in both bull and bear markets than the emotion driven investing approach of getting in and out of the market.

    What's particularly amazing is that Graham's advice is still overwhelmingly applicable to today's market and investment vehicles. Zweig's commentaries following each chapter also prove to be informative bridges between Graham's theses and how they apply to current conditions. Whereas in Graham's day, low cost index funds were non-existent, now they are clearly abundant. Before his death in 1976, Graham highly recommended such funds.

    Even though the pages are filled with information and reading all 640 pages might sound intimidating for a casual investor, the chapters are clearly organized and the writing is clear, easy-to-understand, and direct. For a brief summary of the most important points in the text, one can read just Chapter 8 (The Investor and Market Fluctuations), where Graham explains his concept of Mr. Market and Chapter 20 (Margin of Safety), where he speaks to the importance of leaving sufficient room to counteract misjudgements of a share's intrinsic value.

    In the end, Graham argues that investors need not worry or be concerned with (or even bother to follow) the day-to-day fluctuations of the market as it is often illogical in its behavior. Rather, investors ought to seek to find solid companies that are underpriced, pay attention to the real-life performance of these companies, and be happy to accumulate dividends over a long period of time. Using this simple approach often leads to a significant outperformance of perhaps the more enthralling trading that many people partake in. At the very least, it minimizes the risk involved in investing and the possibility of stratospheric losses that occur occur when investing on emotion or day trading.

    Rating: 5 out of 5 stars

    Google Finance Revamped

    Google Finance just redesigned their website and added new features, and I think the modifications are great. The redesign of the site itself is an improvement on its own - some might argue that the less-simplified new version is un-Google-like, but I personally don't think it's even close to being too busy. It's still a more basic interface than many counterparts, such as Yahoo! Finance.

    There is now a convenient left navigation bar that lets users explore different parts of the site with one click as well as uncovering a particular company's financials and historical prices (still can't adjust prices for dividends like Yahoo, though). Other small updates to the layout give a more enriching experience and easier navigation of the site. However, the best changes undoubtedly are the additional content provided. For example, users can now view OHLC and Candlestick charts among other things by clicking "Settings" under the chart.

    But the single biggest welcome addition is the ability to chart advanced technical information. Simple moving averages, Moving Average Convergence Divergence, and much more! This was long overdue and now makes Google Finance a viable alternative to Yahoo! Finance, which had offered those technical analysis tools for a while now. I especially like the fact that it gives past historical values when you move the mouse over the chart. Some sites just print the lines without even giving you the latest values, let alone historical ones.

    It seems that Google also added more statistics and profile information about a particular company's fundamentals. One can easily view the range, market cap, volume, dividend/yield, P/E, beta, net profit margin, return on equity, and operating margin among other things on the Summary page, and get more information by clicking the Financials tab. It still probably trails Yahoo! Finance a bit, but is a marked improvement from the past.

    All in all, I'm very happy about the changes! Google Finance was my favorite finance site for charts from a graphical/user perspective, but it lacked so much information (technicals and fundamentals) that it was only a starting point. is the best site I've found with regard to having the most types of charts available with ample information including technicals, but the navigation and graphical interface trails Google by a significant margin, in my opinion. Now with the enhanced features, Google Finance is a more "all-in-one" site.

    Also of note is the recent redesign of The site has some cool features not available on other sites, such as easier comparison of financials between a company and its peers, viewing metrics over time, and industry specific metrics (such as sales per restaurant for McDonald's). The charts are also very customizable and the data is organized in a very user-friendly manner. However, it lacks technical indicators among other things. Certainly, another interesting site to peruse.

    Sector Rotation Strategies

    Even in the worst bear markets, there are almost always certain sectors that perform moderately well. Likewise, in bull markets, there are always sectors that lead the way with huge outperformance of the market at large. Those facts are what motivates many individuals to pursue a sector rotation strategy. The basic premise is to swap between various sector funds that specialize in a particular industry in the hope of pinpointing the best-performing sector (or sectors) and reaping the benefits.

    Frequently used are Fidelity Select Mutual Funds, which include 41 such targeted funds for pretty much every imaginable industry. Fidelity allows unlimited trading (and no loads) with no redemption fees as long as the fund is held for at least 30 calendar days. And if you trade through a Fidelity brokerage account, there are no transaction fees either. With just a $2,500 minimum, the Fidelity Select funds are a great place to find such targeted funds to meet your needs. If you instead want to trade more frequently without restrictions and don't mind transaction costs, there are a plethora of sector-specific ETFs available such as the very popular Select Sector SPDRs. There are even funds that purport to do sector rotation automatically (such as on a quarterly basis) such as Claymore/Zacks Sector Rotation ETF (NYSE: XRO). (XRO, around since September 2006 is down 33% vs. down 32% for the S&P 500. XRO's current allocation is 36% medical, 32% retail/wholesale, 12% finance, 8% business services, and the remainder spread around in four industries.)

    Sectors and Stock Market Cycles

    Throughout history, there have been sectors that continually perform best during downturns, and sectors that perform best when the market is bullish. In general, it is accepted as truth that stock market cycles precede economic cycles by several months (perhaps six or so). That is, the stock market begins its early bull right before the economy reaches its lowest trough, while the stock market already reaches the middle of its bear when the economy peaks. The basic pattern of sectors goes Financials and Transportation during the early bull of the stock market, then technology, then capital goods, then basic industry at the late bull phase, then energy and precious metals when the stock market is peaking, then non-cyclical consumer goods (i.e. staples) and health care when the market is starting to turn sour, then utilities at the middle of the bear, and finally, financials and consumer cyclicals (i.e. discretionary) during the late bear phrase. See the below chart from S&P for a graphical presentation of this generally accepted cycle. Now, knowing when the "early bull" and "middle bear" start and end is completely subjective and almost impossible to pinpoint.

    (Click to enlarge)
    Source: S&P
    Going back to the point about potential for great performance; if you were able to choose the best Fidelity Select fund annually from 1992-2001, you would have posted an astonishing 66% annualized gain (vs. 12.3% for the S&P 500). But is it possible to know which fund is going to perform the best?

    The Strategy

    We'll explore a commonly discussed sector rotation strategy using Fidelity Select Sector Funds. I was unable to find a detailed performance analysis of such a strategy, so I sought to find out the performance myself. The basic premise of my analysis goes like this:
    1. Monitor the one month performance of ten broad Fidelity Select Funds: Telecommunications (FSTCX), Industrials (FCYIX), Consumer Discretionary (FSCPX), Technology (FSPTX), Financial Services (FIDSX), Consumer Staples (FDFAX), Health Care (FSPHX), Energy (FSENX), Materials (FSDPX), and Utilities (FSUTX). These ten sectors match the sectors and align with the nine Select Sector SPDRs (with the addition of Telecom). I used great PerfChart feature to easily compare historical performance over one-month periods (see example below).
    2. Through the last day of the month (e.g. 12/31/2004), determine the two best performing funds. In the above example, Health Care and Consumer Discretionary come out on top. Purchase an equal amount of the two funds on the next business day (e.g. 1/3/2005).
    3. Hold the two funds for 30 days and then immediately sell the shares if the fund isn't still part of the top two. If it is still in the top two, hold onto the shares.
    4. Repeat forever.
    This strategy is great because of the low cost associated with the frequent trades. Normally, such high frequency trades lead to an accumulation of sizable transaction costs. But, as I said previously, if you trade these funds in a Fidelity brokerage account, there are no transaction or redemption costs as long as you hold the funds for 30 days.

    Now, I must say that this strategy is somewhat counter intuitive to the buy low, sell high mantra. This strategy forces you to buy the "hottest" sector after it's already increased for a month, so you'd potentially expect a pullback. Nonetheless, this strategy is one many investors/traders are interested in, so I used it ignoring the fact that I almost always wait for a slight pullback before pulling the trigger.

    Historical Results

    I analyzed both the growth of an initial $10,000 investment using this strategy (not including reinvested dividends) as well as the month-to-month percent change and cumulative percent change. I used data from 1/1/2005 to the end of June in 2009. I compared these to a buy-and-hold of an S&P 500 index fund, Vanguard 500 (VFINX). Using the Fidelity Sector rotation strategy, you would have experienced a 30.51% increase, while buy-and-hold of the S&P 500 led you to a 24.11% loss. That is an outperformance of nearly 55%! However, note that the sector rotation strategy was actually at +93% (outperforming the S&P by 65%) as of 10/31/2007, so it actually underperformed the S&P by about 10% from 11/1/2007 to 6/30/2009.

    Below is a graph of the growth of $10,000 as well as a cumulative percent change:

    Also note that this isn't a true representation of the return on your investment since I left dividends out. When adjusting for dividends, the buy and hold strategy actually returned -17.43% or nearly 7% better. The dividends for VFINX are distributed monthly while the Fidelity Select funds are quarterly. I didn't want to take the huge effort to look up the yields and distribution dates for each particular fund and adjust the results accordingly since it should ultimately be similar to the S&P 500. However, I'd venture to guess that the dividend aspect of VFINX is slightly more attractive than the sector rotation strategy (perhaps by a percentage point or two; hardly enough for it to catch up in this analysis), so that is also something to consider.

    For a more detailed month-by-month performance analysis and a list of the funds invested in on any given month, feel free to e-mail me at, and I'd be happy to send you a copy. Following is a listing of how many months the funds were held: Energy (26 months), Utilities (14), Materials (14), Technology (12), Telecommunications (10), Health Care (8), Consumer Staples (8), Financials (7), Consumer Discretionary (6), and Industrials (4). Not surprisingly, Energy leads the way with its huge run-up in recent years. However, due to this run-up and others, there were several months using the sector rotation strategy that led to huge losses.

    Analysis and Conclusion

    In general, the sector rotation strategy was far riskier than buy-and-hold with huge fluctuations in return on a monthly basis. See the below graphs for the month-to-month fluctuations in price and notice how the sector rotation strategy is far more volatile than buy-and-hold. Almost without fail, the sector rotation strategy had big gains or big losses every month. I separated them into two graphs since the scales needed to be different in order to more accurately visualize the differences since the past year has been far more volatile in general.

    Unlike Sy Harding's market timing STS, this sector rotation strategy is far more aggressive and riskier than buy-and-hold as seen by the above graphs. Mark Hulbert, editor of The Hulbert Financial Digest, further elaborates on this in his New York Times article about sector rotation, saying that "Between the beginning of 1988 and Nov. 30 [2001], the [sector rotation] portfolio outperformed the Wilshire [5000], 16 percent to 13.7 percent, annualized. At the same time, the portfolio was 73 percent riskier than the Wilshire. As a result, the portfolio's Sharpe Ratio was below that of the Wilshire -- which means that it owes its market-beating performance to its riskiness." Thus, sector rotation is not really for investors at all. Rather, sector rotation might make sense for traders who pay close attention to the markets on a day-to-day basis and can stomach additional risk, with the possibility for increased returns.

    In the end, while this sector rotation strategy worked for this time period with a huge outperformance on the market, it's probably only suitable for a very small percentage of the population: that is, aggressive traders with long-term outlooks who are able to stomach huge losses with increased risk and pay attention to the market on a daily basis.
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