Rites of Spring

Cover Story, by Cy Lynch, Chief Education Officer March 1st, 2007

Early spring and another baseball season reminds us that investing results, like baseball, can be improved with effective practice and discipline.

Attention to Detail

Spring is definitely in the air. Groundhogs have spoken and even better, baseball players have returned from their winter break to Arizona or Florida for Spring Training. I am eager to launch my annual trek to watch my beloved Braves play in the Florida sun in a few weeks.

Derek Jeter’s (2) play kept the Yankee dynasty alive in 2001. Many veteran sportswriters regard this play as the most “heads up” play they’ve ever seen. Note that Jeter is behind home plate as he follows through. It was impossible, picture perfect and simply unforgettable. Giambi (7) was tagged out inches from home plate. Source: www.espn.com

For the players, Spring Training is far from glamorous. It’s an often monotonous, even grueling time. Fielders take ground ball after ground ball practicing so that they are in the right place when it counts. Pitchers, not known for, or relied on for their hitting ability, practice bunting over and over so that it becomes second nature. Attention to detail. Routine. Second nature.

For a spring training drill, Yogi Berra instructed his players to “Pair off in threes.”

Seriously, it’s the spectacularly routine things that matter most.

I am reminded of one of the most spectacular and amazing plays of all time. It happened in the third game of the 2001 American League Division Series when the Yankees were playing the Oakland A’s. The Yankees were barely ahead, 1-0, when Yankee shortstop Derek Jeter made a play that likely saved that game and the season for the team.

The A’s had a runner, Jason Giambi, on first when the batter hit a long drive down the right field line. It looked like Giambi could score the tying run as the third base coach waved him home. The Yankee right fielder’s throw soared over the head of the two relay men and dribbled toward the Yankee dugout. Suddenly Jeter appeared, seemingly out of nowhere, to grab the ball and shoveled it backhanded to the catcher, Jorge Posada, who tagged Giambi out at the plate. There would be no more scoring. Yankees 1, A’s 0.

While the fact that Jeter even got the ball to the catcher in such unorthodox fashion was astounding, even more incredible was the fact that he was there to catch the ball at all. He was in a place no one expected him to be, well over 100 feet from his regular shortstop position. Jeter’s focus on baseball fundamentals meant he was exactly in the right place — ready, vigilant and poised near the pitcher’s mound. His attention to details, carefully watching the trajectory of the throw enabled him to react when the throw unexpectedly sailed over the heads of its intended targets. Unexpected? Not to Jeter. He was prepared.

But appearances of miracles aside, that play didn’t just happen, the foundation was laid back in spring training, with repeated focus on the fundamentals, practice and attention to detail. That focus resulted in Jeter’s remarkable ability to adapt and respond effectively when the unexpected happened. What can investors learn from this example?

Keep It Simple

At its core, baseball is a simple game: Score runs to get ahead and then protect that lead by keeping the other team from scoring. Despite the game’s basic simplicity, it’s also a game of numbers. Rabid fans often obsess over the numbers, watching batting averages, earned run averages and the like. This obsession may become so great that simple beauties are overlooked, like Jeter doing something very simple, reversing a mistake to protect a lead, albeit done in remarkable fashion.

Investing is a game of numbers, too. We are bombarded with information: a plethora of data available on the Internet; commentary by pundits galore on CNBC. Like rabid baseball fans, it’s easy for us to become so obsessed over the numbers and “noise” that we miss the simple beauty of our goal — obtaining sufficient returns to realize our life objectives. Like baseball, investing is simple at its core, score by realizing returns and protecting those returns by keeping the quality high. At MANIFEST, we keep investing simple by focusing on the two fundamentals that will assure that we are winners at the end: Expected Returns on our investments and the Quality of those investments.

It’s a Team Effort

Like baseball, investing is a team sport. Just as a ball team is evaluated based on the wins it achieves as a whole, it’s the overall performance of our total portfolio team that matters to us. Consequently, MANIFEST methodology entails looking not just at each security in isolation, but rather focusing on the impact that each security has on our overall portfolio team — Portfolio Centered Decision Making.

Cy Lynch’s Dashboards become Lineup Cards. Enough portfolio PAR? Check the green circle to see if the PAR number is green. Quality? Check the cyan area shown here for all “blues” and “greens” Is the blue circled item coded in blue? If the overall portfolio quality is greater than 65, it is. Enough growth? Is the highlighted field on the bottom line greater than 10%? These “check points” are a quick and easy way to see if the portfolio has the “right players on the field.”

That’s where dashboards come in. At a glance, they let us easily assess the strengths, weaknesses and potential of each security in our portfolio, along with the overall strength, weakness and potential of our portfolio as a whole. We put dashboards into action by focusing first on the fundamentals, Quality and Projected Annual Return (PAR), and then by being attentive to more details, Financial Strength, Growth and EPS Stability.

Focus on Fundamentals

Quality boils down to management’s consistency in capitalizing on business opportunities and competitiveness in doing it better than its peers. MANIFEST’s Quality Rating (QR) quantifies and measures those intangibles by numerically ranking four factors: relative growth, relative profitability, financial strength and EPS Stability. Our focus on this fundamental (Quality) generally guides us to limit our holdings (and thus our “shopping” for new stocks) to those in the top 40% with QRs of 55 (good) or greater. Use your dashboard to do this at a glance, just look for all green and blue numbers in the QR column.

Some members of our team will be higher in quality than others, offsetting potential shortcomings of some of the weaker quality holdings. I suggest keeping an overall portfolio QR of 65 or greater (excellent), although some individual holdings may fall in the “good” range from 55 to 65. This is easily done by glancing at the last line of the QR column to be sure that it’s blue.

Turning to focus on the second fundamental (PAR) our MANIFEST methodology is based on seeking portfolio returns greater than those expected for the broad stock market as a whole. We use PAR to measure the expected return of each individual security and the median PAR of all stocks in the MANIFEST Solomon database (MIPAR) to measure the expected return for the market as a whole.

Just as some ball players are power hitters with the potential to hit many home runs, some stocks in our portfolio may have high PARs — the potential to hit investing home runs. A baseball team can win more games than the competition with a blend of hitting home runs and singles or doubles; our investing team can win with a blend of holdings with relatively high PARs (home run potential) and those with lower PARs (single and double potential). What matters is that the overall portfolio PAR (run producing potential) for our “team” is sufficiently above that of the market as a whole.

Like Jeter did, we recognize that things change. Prices fluctuate, period. As a result, returns fluctuate too, both for individual stocks and the market as a whole. MANIFEST suggests remaining flexible in setting goals for expected returns. Aim not for a static goal, but rather seek to maintain a cushion (we call it advantage threshold) between the average PAR for our portfolio over MIPAR for the overall market. While that cushion may vary from individual to individual, we believe that an advantage threshold of at least five percentage points over MIPAR is appropriate for most investors.

As is the case with QR, our focus is on maintaining our advantage threshold of five points over MIPAR for our portfolio team as a whole, not for each individual player stock. Again, this is easy to check. Just look at the last line of the PAR column on your dashboard to assure that it’s green.

Attention to Detail

Focusing on just the two fundamentals of maintaining portfolio average QR of 65 or greater and average PAR of MIPAR + 5 points or greater is a great beginning, and is likely all by itself to provide you with above market returns. But just as ball players strive to be better than just good; many investors strive for more as well. Attention to detail leads us to probe deeper into our holdings, looking at characteristics beyond just QR and PAR.

Financial Strength helps us assure that each holding on our team is sufficiently strong to withstand economic and stock market downturns. Generally we look for companies with a Financial Strength of 70 or greater, being even more selective (raising the minimum to 80) when the markets are generally overbought (indicated by relatively low MIPAR of 10% or less). Recognize that some “team members” may fall a little short with lower financial strength indices, but we keep our overall team strong by maintaining an overall average financial strength of 80 (or more) for the total portfolio.

Portfolio average growth (forecasted sales growth) is another detail worthy of attention. Over the long haul, it’s primarily growth in a company’s sales that drives its earnings, which in turn drive the stock price. Because we’re attentive to detail, we seek to maintain overall portfolio growth of at least 10%.

Consistency is another detail that matters, too. While volatility in EPS can lead to opportunity, we seek to balance more volatile companies with lower EPS Stability ratings with “stalwarts” with high EPS Stability ratings. (We covered this aspect of correction/recession resistant stocks in Unlocking The EPS Stability Code, June 2006.) A nice rule of thumb for conservative investors would be to maintain overall EPS Stability at 80 or above. More aggressive investors may be willing to accept more volatility in EPS, but they should be certain to select stocks with higher PARs (a larger advantage threshold) as compensation for said volatility with particularly strong QR and financial strength. In other words, expect to be rewarded with higher returns when investing in smaller but promising companies with higher growth rates.

StockSearch as your “Scout.” Your portfolio PAR is a little lower than you’d like. You have this good company with a PAR of 4% and a quality rating of 70. By seeking replacement candidates with a PAR between 15-22%, a quality rating of 70 and a financial strength of 80 — you’re assured that the shopping list will be pretty good. But with recent corrections, you want stability — so you ask for only those stocks with EPS Stability greater than 90. The search results deliver: Microsoft, General Electric, Walgreen, Lowe’s, United Parcel Service, Sysco Foods and Bed Bath & Beyond. Go ahead. Take a swing at the best pitch as you study a few of these.

Adaptability

Things change in baseball and investing. Adapting to change is one reason why baseball teams trade players throughout the year. A manager may also decide to play a particularly “hot” player more than another to improve his team’s performance.

We do the same with our portfolios. Generally, we accumulate more of current holdings with the highest PAR with new cash. When our portfolio average PAR slips “out of the green,” below our goal of MIPAR plus five points, we challenge the holding with the lowest PAR to see whether we can exchange it for one with more PAR without compromising overall portfolio quality.

MANIFEST’s StockSearch makes that easy, just do a screen setting your minimum PAR criterion at MIPAR + 5, minimum QR at the same as the stock being challenged and minimum financial strength of 70 or 80 as appropriate. If that doesn’t provide a sufficient shopping list, consider relaxing the QR to 65. StockSearch can be a very reliable scouting system.

Similarly, QRs change as well. If a holding slips below our minimum of 55, seek a replacement with a QR of 65 or better, financial strength of at least 70 or 80 as appropriate and minimum PAR equal to that of the stock being challenged. If that doesn’t provide enough purchase candidates, then consider relaxing the minimum PAR criterion to MIPAR + 5. You could potentially relax it slightly more if your overall portfolio PAR is sufficiently high compared to your goal.

Spring Training prepares baseball players for an effective, safe and enjoyable regular season. This is done by practicing routines and building habits that become second nature.

Investing can be equally fun and effective. The tools and resources at MANIFEST provide a strong foundation for making routine decisions. Keep it simple by filtering out the noise and not bogging down in too many numbers. Instead focus on the fundamentals of effective portfolio management by using your dashboards to choose the best “players” and hold the strongest lineup cards. With a little focused effort, preparation and practice, you and Derek Jeter will be ready for whatever the market throws at you. Play ball!