Introducing the Score Portfolio
posted by The Traveller on Sunday, April 11, 2010
Seven weeks ago I have started an experiment! All the 200+ China Small Caps in our China Tracker are getting a SCORE assigned. The Score is computed automatically and based only on past numbers that were reported by the company in SEC filings. The idea is to track the fundamental strength of a company by assigning it Score Points if it met certain criteria in the always latest quarterly or annual report. Most important for the final Score though are the current growth rates, both sequentially and annually, for revenue and net income, and the current ratios for price-to-earnings, price-to-book and price-to-sales.
There are several problems with that approach which I will cover later in this post, but for now let's picture the ideal company that would get the highest score. It would have a small number of shares outstanding, a good amount of cash on the balance sheet, no problem with collecting receivables, and insignificant long-term debt. Sequential revenue and net income growth would be at least 10% and annual growth greater than 30%. For annual sales and net income I use a projection from the always last two reported quarters to better reflect short-term developments. The ideal company would have a P/E ratio in the single digits and a Price/Sales and Price/Book ratio below 1.25. All the details of how the Score is determined can be found here.
To test the validity of this approach I have started a Score Portfolio on February 19. The theory is that growth stocks with a higher Score will outperform their peers and the general markets. All transactions in the Score Portfolio happen automatically at the close of every trading day. The portfolio started with $100,000 capital and 20 equally weighted positions of $5,000 each.
The biggest changes in a company's Score can happen when a new set of data is added, means when a new quarterly or annual report is filed. Outside reporting season the only thing that moves the Score is price action. When the stock price goes up all of the ratios as P/E or P/B will go up as well which could lead to a lower Score. The Score Portfolio is revised at the end of every trading day. Every stock with a Score of 6 or less at the end of the trading day is automatically removed from the portfolio at the closing price. A new position is added immediately after this if the cash balance of the Score Portfolio is $5,000 or higher and there is at least one stock that has not yet been added with a Score of 8 or higher.
Now after seven weeks we can make a first evaluation of the Score Portfolio. Since February 19 the portfolio value has climbed by 27.86% to $127,868, it has outperformed both the general markets (S&P 500: +7.68%) and the Chinese Small Caps Sector by a wide margin. Further encouraging is that most of the closed positions, stocks that have been automatically sold as their Score dropped due to price appreciation, are now trading significantly lower than when we sold them. All in all this is an excellent start for this experiment.
However, a company's Score does not always accurately reflect fundamental strength. If you would want to make an investment decision solely based on Score then I would strongly encourage you to first look at every individual company in detail. That Score seems to work for a group does not mean it works for every individual stock and here's why:
The Score criteria are the same for every company in every industry, but certain industries are highly seasonal and it is totally normal if sales and earnings do not show sequential growth every quarter. Negative sequential growth will lead to a lower Score even if year-over-year growth is stellar. You should also remember that Score is based only on quarterly and annual reports (6-K, 10-Q, 10-K). It does not reflect any of the following events that might have been announced outside of those filings: dilution (secondary offerings, warrants redemption, debt conversion), announced restatements of past filings, earnings warnings or company guidance, and many more.
Basically all current events that might be highly relevant for the performance of a stock but have not yet been filed in a quarterly or annual report, or that are not reflected in any of the data used for computing the Score, will have no impact on the Score. A good example for this is current Score Portfolio holding Fuqi International (FUQI), which is down 30% since it announced accounting errors and upcoming restatements. FUQI still has a high Score of 11, which might be misleading as there have been no new reports filed with the SEC since the announcement which led to the sell-off.