THE INDOMITABLE ROBOT
An incredibly simple stock-picking
method nets a 267 percent gain
B Y J O H N D O R F M A N
I created a stock-picking robot. Now I feel like a parent
whose child is outdoing himâproud but a trifle annoyed. The
robot, which lives in my basement and uses Bloombergâs equities
database, compiles its official Robot Portfolio at the start
of each year, though Iâve updated it to April 1 for this story. It
assembles a 10-stock portfolio using a method that is simplicity
itself. It begins with all the U.S. stocks having more
than $500 million in market capitalizationâabout 1,800 candidates.
Then it discards those that have total debt greater
than common equity, lopping off 600 issues or so. From the remaining 1,200 stocks, the robot selects the 10 with the lowest
price-to-earnings ratios. (The P/E is the stock price divided by
the past four quartersâ per-share earnings.) Thatâs it. Any graduate student in finance could design a more sophisticated
stock-picking model. Even a bright high school student could
create something less naive. But look at the robotâs results.
In 1999, when the S&P 500 Index rose 19.5 percent, therobotâs picks advanced 40.3 percent. I smiled and was pleased.
In 2000, when the S&P 500 declined 9.1 percent, the robot
surged 67.7 percent. I was delighted, but a bit discomfited. I
had been very proud of the 30.9 percent gain I obtained for
my clients that year, yet the robot had done much better.
In 2001, the S&P 500 had an even worse year, falling 11.9
percent. The Robot Portfolio bucked the trend again, rising
23.8 percent. In March of that year, this magazine featured the
robot in a cover story. Now things were getting a little ticklish.
A few clients suggested that I give the robot the reins.
At the start of 2002, the robot picked a portfolio heavy in
out-of-favor energy stocks. (I heartily agreed.) It also included
Providian Financial (PVN), which extends credit to people
with short or weak credit histories. I have never been a fan of
that business, and I thought a recession was a terrible time
for it. Lo and behold, through the end of the first quarter, Providian was up 113 percent. The Robot Portfolio as a whole had
gained 26 percent, against a 0.3 percent gain (including dividends) for the S&P 500. From January 1, 1999, through April
1, 2002, a $1,000 investment in the robot would have grown
to $3,674.
Why does such a simplistic model do so well? There are
several explanations. A statistician might point out that the
sample size in the robot experiment (three years and a quarter,
only 10 stocks a year) is statistically insignificant. A value
investor like me might say the robot does well because it is a
at the beginning of 1999,
V A L U E I N V E S T I N G
pure embodiment of value investing, searching for bargains
among ugly-duckling stocks. A psychologist could argue that
the robot does well because it is emotionless and has no fear
of embarrassment when it recommends stocks that âeveryone
knowsâ are no good. Certainly, Providian is a good example
of that. In past years, so were such beaten-down shares as
Ensco International (up 114 percent in 1999), HealthSouth
(up 204 percent in 2000), and Navistar (up 51 percent in 2001).
But enough theory. Letâs talk stocks. In January of this year,
6 of the robotâs 10 picks were in the energy sector: Amerada
Hess (AHC), Devon Energy (DVN), Sunoco (SUN), Tesoro
Petroleum (TSO), Valero Energy, and Vintage Petroleum
(VPI). Today, those same stocks have gained between 1 and 30
percent, though most are still not expensive. The United
States will likely experience spot shortages of energy during
the next five years, so I believe the long-term prospects for
these companies are excellent.
Two more of the robotâs official 2002 selections were home
buildersâStandard Pacific (SPF) and MDC Holdings. The
risk here is that as the economy recovers, interest rates will
rise, choking off home buying and hence home building.
Already, the Federal Reserve has signaled that it is probably
finished with its regimen of rate cuts. However, my feeling is
that it will likely be 2003 at the earliest before higher rates
begin to pinch home purchases. Meanwhile, housing stocks
are quite cheap.
The robot filled the remaining two slots with Providian
Financial and SureWest Communications (SURW). I was a
fan of neither; both have done well. But in my judgment,
SureWest made the list by dint of extraordinary earnings,
while Providian still looks risky.
When I set the robot in motion again in early April, it
picked only 2 of the original 10âValero Energy and MDC
Holdings. The other eight are newcomers, mostly because the stocks in the initial group have appreciated in price.
Still, the robot continues to love the energy sector. Its latest selections include Houston Exploration, Marathon
Oil, Occidental Petroleum, and refiner
Ashland. I like these for the same reasons
I liked the other energy companies
mentioned above. Iâm especially
keen on Marathon Oil, now independent
of U.S. Steel for the first time in 20
years. I believe that subsidiaries often
show better performance once they are
cut loose.
Iâm also a fan of Occidental Petroleum,
a Los Angeles-based international
producer of oil, natural gas, and
chemicals that had revenue of close to
$14 billion last year. I think its CEO, Ray Irani, is being more
candid and complete in talking with investors than his predecessor,
Armand Hammer, was. Occidental sells for only
eight times earnings and offers a 3.4 percent dividend yield. I
own the stock for most of my clients. The shares, at around
$29, are trading close to their 52-week high of $31, but from a
valuation standpoint, they appear to have room to grow.
PNM Resources of New Mexico produces and sells electricity
and natural gas. The stock is cheap because earnings
have fallen on thinner profit margins in wholesale power, from
$4.52 cents a share in 2001 to an estimated $2.85 this year.
A pair of title insurance companies, Fidelity National Financial
and LandAmerica Financial Group, made the April
list, each with a P/E ratio of 7. The peril for these firms, like
the housing stocks, is that if interest rates rise, fewer people
may buy homes, and there will be less need for title insurance.
But here again, the stocksâ low prices probably discount the
risk, and then some.
Rounding out the robotâs latest selections is Alexander &
Baldwin, a shipping and real estate company that carries
goods to and from Hawaii and owns land there. Hawaii has
been in a prolonged economic slump as a result of the chronic
Japanese recession and the decline in U.S. travel after the September
terrorist attacks. At 8 times earnings and 1.6 times
book value (corporate net worth per share), this stock strikes
me as a bargain.
A few of my clients have the entire Robot Portfolio incorporated
into their holdings. Such has been the power of the
tin man. Letâs see if his good fortune continues. ∂
John Dorfman, president of Dorfman Investments in Boston, is a
columnist for Bloomberg News. The opinions expressed are his own.
His firm or its clients may own or trade investments mentioned.
T I N M A N â S N E W P I C K S
The Robot Portfolio contains stocks with at least $500 million in market capitalization that
have rock-bottom P/Es. This year, the roster is dominated by beaten-down energy stocks.
P/E RATIO YTD RETURN
ALEX Alexander & Baldwin shipping and real estate 8 4%
ASH Ashland refining 8 â2
FNF Fidelity National Financial title insurance 7 7
THX Houston Exploration oil and natural gas 7 â8
LFG LandAmerica Financial Group title insurance 7 19
MRO Marathon Oil oil and natural gas 6 â3
MDC MDC Holdings home building 7 13
OXY Occidental Petroleum oil and natural gas 8 13
PNM PNM Resources electric and gas utility 7 9
VLO Valero Energy refining 6 29
All data as of 4/1/02. SOURCE: Bloomberg.
