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As I stated in a previous post, selecting stocks using ROA and P/E did not work out based on the stock portfolios I was tracking. After a couple of tranches I settled on the following criteria for screening: 1) market cap > $250M, 2) ROA > 15%, 3) P/E > 2. Holdings were kept at 30 stocks per the book. So you can see that I did not follow the screening steps exactly. This was due primarily to the desire to simplify the process by creating one portfolio for the year to eliminate the need to run screens every couple of months. Otherwise I’d have to ‘actively’ manage a tracking portfolio. Secondly, using a ROA cut-off greater than 25% reduced the stock list down to roughly 40 stocks or less in most years. These stocks had P/E ratios that generally averaged about 18 as a group, and went as high as 70. The high ROA gets the “good” company part of the screen, but to me that didn’t capture much “cheapness”. I figured it is a ranking system so even using a cut-off of ROA > 15% the best stocks with the highest ROA should still end up ranking highly on a list of stocks to buy. In retrospect it is obvious that this plan was seriously mistaken and using possibly flawed logic.

During the existence of the tracking portfolios I was regularly struck by the lack of overlap between the selected companies and those on the official MFI list. I never researched it once I’d started the portfolio, just to be consistent. One additional item that I thought could be used to double-check or verify validity of the stock selections was to pull the real list from the MFI website and then compare to the ROA and P/E for those exact stocks. I did that recently. To put it mildly, I’m astounded. The results are not even close to what I’d expect! Pulling the top 50 list of MFI stocks over $50M and then checking the ROA and P/E shows the majority of those stocks wouldn’t be on the manual screen. The MFI screen also includes MSB, which operates as a royalty trust. Eliminating the trust and two stocks that seem to have negative earnings I came up with the following information.

set stocks median std dev. median std dev.
ROA>25 10 34.4 13.4 10.6 4.0
ROA<25 37 9.9 5.6 15.3 13.4

Those remaining 37 stocks with ROA<25 strike me as not that ‘good’, and only a little bit on the cheap side compared to the P/E of the Russell 3000 index (18.7).

I do still intend to go with the ROA + P/E portfolio since it was suggested as an alternative in the book. My intention is to follow the recommendations in the book much more closely with the future portfolio. The only deviation that I can think of at the moment is that because this strategy works “on average” I will increase the number of stocks to between 30 and 40 based on number of stocks that have a ROA greater than 25. I will also stagger the timing of purchases on a quarterly basis (similar to my real MFI portfolio) that may eliminate possible seasonality. This could eventually lead to unequal weightings in the portfolio.

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When Life Gives You Lemons
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