Is mechanical investing a form of index investing?

Benjamin Graham is considered the father of value investing. He is also teacher and mentor to Warren Buffett, widely considered to be the best investor of all time. Little is known that Graham ran Graham-Newman Corporation and achieved stellar returns of 17% annually. Even lesser know is that Graham picked stocks using a checklist.

In The Snowball, Alice Schroeder writes:

[Warren Buffett] and Walter [Schloss] collected numbers from the Moody’s manuals and filled out hundreds of the simple forms that Graham-Newman used to make decisions.

Did Graham practice mechanical investing?

Take a look at his checklist from the Graham-Newman Corporation:

1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value (NCAV)
6. Total debt less than book value
7. Current ratio great than 2
8. Total debt less than 2 times Net Current Asset Value (NCAV)
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible

As long as stocks met the criteria, they would be selected and invested. This does seem exactly what mechanical investing is about.

What is mechanical investing?

By having a checklist ready, any stock that matches the checklist will be added to the portfolio. Standard rules for selling also apply, such as upon reaching the net-asset-value or after 2 years, whichever is earlier.

Mechanical investors do not care about the industry, news and anything outside the factors listed. As long as it meets the criteria, they buy it.

What has it got to do with index investing?

Take a look at the indices you heard of: S&P500, DJIA, STI, and so on. What are these indices?

The S&P500 is basically the largest 500 stocks in the US stock market by market capitalisation, the DJIA is the top 30 largest companies, which the STI is the top 30 companies by market size and a few other qualitative factors.

When academics talk about most active funds not being to beat the market, they seem to talk about these broad indices. However, we could go one step further by creating our own index, which might or might not beat the broad index over time.

This is where it gets interesting, because such mechanical investing approaches have been actually proven to beat the market over the long run.

Meet the mechanical investors

Walter Schloss
Walter Schloss actually studied under and worked for Benjamin Graham. He had never gone to school, but amassed such an incredible track record that he is doubted a super-investor.

He was so firm in his methodology and Buffett said:

He knows how to identify securities that sell at considerably less than their value to a private owner… He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do – and is far less interested in the underlying nature of the business; I don't seem to have very much influence on Walter. That's one of his strengths; no one has much influence on him.

Joel Greenblatt

Perhaps the most well-known is Joel Greenblatt. In 2005, he published a book titled "The little book that beats the market", laying out a formula for identifying a portfolio of stocks that beat the market. The revised version in 2010 showed that he achieved an annual return of 23.76% from 1988 to 2009.

You can check out this Magic Formula through Wikipedia but the two key criteria are earnings yield and return on invested capital. You can even find the stocks directly using his website.

James O'Shaughnessy

James is what you will call a quant investor, using formulas and simple criteria to make buying and selling decisions. His book "What works on Wall Street" can be deemed as the longest ever study on stocks.

In his study, he found that value and momentum stocks make good picks and combining them both gives devastating effects. Particularly, a combination of stocks ranked by having the highest 1-year price growth whilst having a price-to-revenue ratio of less than 1 gives an annual compounded return of at least 18% over the past 50 years.

Joseph Piotroski

A finance professor, he published a seminal paper "Value investing: the use of financial statements to separate winners from losers". In it, he came up with 9 factors to assess the stronger companies amidst a group of low price-to-book stocks.

These 9 factors came to be known as the Piotroski F Score, whereas a score of 8 or 9 implies a quality company. Similarly, these showed a market beating return.

How can we use this to our advantage?

The reason we adopt index investing is because we want to take our emotions out of the game, and stick to a proven strategy that has worked over time. More to the tune of "if you can't beat them, join them" since most actively managed funds don't beat the market over time.

With mechanical investing, it is a form of index investing, since it takes the emotions out and saves us time to research each individual company. The key is to stick with the strategy, and not waver or change even though it might not beat the market from time to time.

Some ways to get started

This is by far the best way of trying out different strategies: Uncle Stock. I used it and bought the stocks it came up on the Singapore screener. Backtested results: 27% annually over the past 5 years.

If you are thinking that such strategies don't work, because there's always a way to sieve the stocks out through hindsight, then let me offer an alternative thought. Why do value stocks and quality stocks outperform all other stocks? There has got to be an underlying reason.

So, if we build our criteria based on sound logic and then arrive at a reasonable result through backtesting, this lends integrity to the selection criteria than through reverse engineering.

Have a look at the Singapore screener that focuses on safe, conservatively financed, and cheap stocks:

1. Price-to-earnings ratio must be less than 10
2. Working capital (net current assets) must be more than long term debt
3. Dividend yield of more than 5%
4. Return of assts of more than 5%
5. Rank stocks based on price-to-revenue ratio (lowest on top)

Currently, this portfolio selection is giving me a 4.31% return since May this year. You can test out other strategies through the website too. I'm looking at this selection criteria which gives a set of quality stocks which have just begun to realise their value but have not yet become too expensive:

1. Price-to-revenue ratio must be less than 1
2. Piotroski score of 8 and above
3. Rank stocks based on 1-year price growth (highest on top)

Conclusion

Mechanical investing can be seen as a refined way of index investing and might breed better returns than just simply buying a portfolio of broad based market indices.

Do take heart that at some times, the mechanical approach might underperform the market but the key is to stick with it. If you think you can't withstand the emotional aspects of underperforming the market for some time periods, then sticking to a pure index strategy might be better.

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