Investing Process Active management consists of selecting strategies or screens for a group of stocks, selling the group or individual positions when they appear vulnerable, and then using the cash generated from the sale to reinvest and continually balance the portfolio. The goal of active management is to achieve significantly better returns than the market; my task is to make the chart lines go up. Every position is purchased within the context of a specific strategy and set of criteria. Almost always stocks are purchased in a set or to maintain a set of between seven and twelve positions to execute a specific strategy and portfolio within a specific account. For diversification, my client and I prefer at least three such portfolios. Some households have up to a dozen strategies with seven to twelve positions in each strategy. Passive management at Wenzel Analytics is a strategy to buy exchange traded funds and occasionally mutual funds for smaller accounts or sometimes for a minor portion of larger accounts. The goal of passive management is to achieve diversification with minimal risk of underperforming the market. For active or passive management, the process is to buy, review, sell and buy again. Turnover is greater with active management. Timing strategies are deployed cautiously at the point of suspected major market turns or as an influence upon the exact timing of a purchase or sale planned for other reasons. This report is a fairly detailed snapshot of the processes for buying and managing investments; the processes will continue to change and evolve. Buying To start with the buying process, every position fits within one of three different strategies. Some strategies come from an outside tested source with data making it credible and promising. Some strategies are derived from my statistical and data mining work. And some strategies come from a rationale or logic that seems to make enough sense to put money on it. Sources Tested Source Strategies Tested source strategies derive from a variety of sources. Some have come from investment newsletters with strong long-term returns according to Hulbert’s Financial Digest which independently tracks about four hundred such newsletters. Sometimes I will take a mutual fund that has exceptional and stable returns with low turnover. Mairs and Power Growth Fund is an example that has only about thirty-five positions. I pick and choose from the stocks it holds, paying attention to the mutual fund's report each quarter as to what they are buying and selling. Data Mining Strategies Data mining screens are the result of my ongoing statistical work. Some of these start strictly from weekly or monthly database, and some are refinements of AAII screens. As introduction, let me give a brief description of data mining. In traditional scientific and academic research, the researcher begins with the hypothesis and then assembles data to prove that the hypothesis cannot be false and therefore must be true. In stock selection, the typical format is to take a logical selection of criteria such as certain values for price/earnings (PE), growth (PEG), debt, revenue, etc. and then back-test the screen to see if it worked in the past. With data mining software one searches through thousands of variable combinations and their respective values looking for statistical significance. The researcher does not ask the specific hypothesis before scanning for relationships. After strong relationships are discovered, the screen of variable combinations may or may not make sense. Those with some kind of logical explanation are more likely to persist than those which are accidental or “trained”, but not necessarily so. I typically work with about eighty variables taken from ten or more years of monthly data comprised of about four thousand stocks each month, yielding a database of if 500,000 records or more. Sometimes the relationships are linear, meaning the higher returns correspond with variables going up or down. Often the highest returns are at both extremes of a variable, and sometimes are true only for a specific midrange. Typically four to six variables are found to best define a productive screen. For data mining software, I have been using KnowledgeSEEKER for over twenty years. The Shadow strategy started with the variables and respective values for a screen of that name which is frequently published in the AAII Journal by James Cloonan, chairman of AAII. Using the data mining process, I refined the screen, dropping some variables, changing the screening values of others, and adding still others according to my findings. Similarly, the Piotroski Relative Strength strategy uses a Piotroski scale published by AAII for the Piotroski screen, but uses different values on the scale and combines the scale with variables other than called for by the AAII Piotroski screen. The latest statistically derived screen is called Playing Defense. It was created from data in down-trending markets, and thus has better resilience in down markets. The number of stocks meeting the criteria in any given month is incredibly predictive of future returns one year later. Strong Rationale Strategies The final source category is those strategies with a strong rationale or logic, but not necessarily an easily verifiable history. The High Income strategy has had extraordinary returns for several years. The Resource Scarcity strategy consists of stocks selected on the assumption that energy, metals, timber, water and other resources are going to be in increasing short supply and their price will go up. Some of the stocks are major holders of such resources, and some stand to benefit by providing specialty services in response to increased demand. There are occasions when I will break the rules and buy a single position on a tip or other reason. Usually these are in my personal account unless a client requests buying a specific position. Our overall performance for each of these strategies, both recently and since inception, can be found under the Stock Performance heading in the navigation panel. Strategy Selection Review If the potential strategy comes from a trusted source or from data mining, rather than merely a strong rationale, the next step is to subject the strategy or screen to a rigorous analytical and quantitative review. The first test is to see if the criteria consistently produce an adequate number of stocks. Screening criteria that produce five stocks one month and a hundred and five another month are hard to implement. The next review is consistently high rates of return. Screens are dropped if the returns vary considerably, show a pattern of exaggerating market down trends, or if the average high returns are because of a small number of stocks within the screen rather than dispersed throughout all selected stocks. Since a higher return will necessarily create a higher standard deviation, screens are compared using a coefficient of variation obtained by dividing the standard deviation by the average return. Returns rates going forward from the date of the data are compared for four weeks, thirteen weeks, twenty six weeks and fifty two weeks, plus using the average of these time periods. Returns are often compared going back a longer time period, such as four years, then for the last year and sometimes for the last quarter using weekly data. A major change in market direction will often change the performance dynamics of how well a screen works, prompting new data mining research and new average return comparisons for selecting screen strategies. Sometimes a pattern will work for forty-five years, and suddenly not work. It may resume working at some point, or it may not. Please ask if in the process of selecting a strategy for your account you are interested in the coefficient of variation or other comparison numbers. Technical Analysis to Select Individual Positions Once a screen has been selected using historical data and the steps described, the filters for the strategy are run on a current stock database. The thirty or so candidates are imported into Worden’s TeleChart software and each position is given a technical rating. Some are a "buy now" and some are "interesting, but not right now." Some stocks are excluded on principle, such as tobacco and gaming stocks. The technical analysis is a study of the balance of supply and demand for a security, charting price and volume for various time periods. Like in real estate, a stock is worth today what a buyer will pay for it, and worth tomorrow what a buyer will pay for it. As explained and illustrated below in the section on selling, I mostly use trend lines and horizontal shelf lines of previous resistance or support, looking at daily charts and then multiple time frames usually going back ten or fifteen years. I also review the preponderance of evidence from several other indicators. I tighten or loosen my judgment until I get a list of ten or so stocks from diverse industries. Occasionally I do a blind test on technical analysis predictability by taking from fifty to a hundred stocks and, not showing the later history, make my selections. I then unfold the history and evaluate my choices. Sometimes I’m able to do much better than a random selection, and sometimes the results are not significantly different from a random selection. It depends on the market and on the screen. Some screens will get high returns from stocks that technically look very scary. At any rate, the process does not do worse than a random selection, and provides a way to winnow a screen down from thirty to ten. The whole selection process is a way of implementing the laws of large numbers such as used by an actuary. An actuary can predict fairly precisely what the death rate will be for 100,000 people sharing common characteristics, but cannot predict who will die next year. To benefit from the predictability offered by the laws of large numbers, implementing a strategy needs to include enough stocks to represent the whole but few enough to minimize trading costs and management complexities. Trading Desk Once I have ten or so stocks current for a given strategy, I paste the list into my list of buys for all current strategies. When to actually buy stocks depends upon what the market is doing. If the market is heading down, I will wait until it turns up. (All purchases are long; I do not buy short. Most accounts are in IRAs which do not permit shorting. A minimum amount of margin may be used temporarily in non-IRA accounts.) When I’m ready to fill a strategy for one or more accounts, I review intraday charts for each position and determine a likely price and whether based on trading volume it will be a market or a limit order. I then paste the buying list for the screen into the Excel database that is used as a trading desk tool as well as for various filtering and for creating a pivot table. Once in the database, I paste from a previous row to the current entries about five fields identifying the account, and then divide the amount of money available in this account for investment in this strategy between the different positions such that there are roughly equal dollars in each position, rounding out lots when possible. I then upload orders to Scottrade. After each transaction executes, price and cost are entered back into the Excel database. The next morning when the brokerage has updated their records, the transaction data are retrieved into Fund Manager (www.FundManagerSoftware.com), the portfolio management program used for performance calculations and performance charts. Review and Management While a chart for each position in each account is maintained on Fund Manager, usually my regular reviews are done on TeleChart which has watchlists of all unique positions in each strategy. Stocks that are precarious are kept on a separate list and reviewed more often. The TeleChart watchlists are imported from pivot table unduplicated lists of positions in each strategy. Almost all selling is based on a technical chart review. Stocks are harvested when they become parabolic, meaning that the prices on a logarithmic chart are going up steeper and steeper, and volume or other indicators are pulling back. I will get out if there is a frenzy and most of the float is trading in a short period of time. Stocks are also harvested when the chart lines are rolling over and breaking through an upward trendline. Sometimes I will replace stocks after a prescribed period such as a year if the supporting research was based on that timeframe. The best time to buy a stock is when it is priced higher than it was, and the best time to sell a stock is when it is priced lower than it was. To buy at the absolute low or sell at the absolute high is unrealistic and usually means one is buying as it continues to fall or selling as it continues to rise. Instead of stop orders or goal prices, I prefer to place expectation trend lines on each chart. I do not believe in selling when a stock goes down a given percent from the purchase price. Contrary to popular belief, what we paid for a stock has nothing to do with whether a stock will go up or down. The reasons to sell a stock are if it threatens to go down, regardless of the purchase price, or does not continue up at a satisfactory rate. Maintaining account value and avoiding losses are important at the account level, but not a major consideration for each position. Occasionally I or a client will want to move from one strategy to another or into cash. Even if I decide to abandon a portfolio, the selling process is usually over time and is based on a more aggressive stance towards selling individual positions and not replenishing with new purchases. Rarely will a position be sold merely because it is no longer a buy on the source screen. If the market as a whole drops below key support lines, I will become more aggressive in selling positions and accumulating cash. Any passive investments (exchange traded funds) are the first to be sold in a dropping market. As cash accumulates from the sale of positions, and if the market appears strong, I then buy more positions. This requires a pivot table review of the strategy allocation for each household, which may apply to multiple accounts if each spouse has an IRA, a Roth IRA, and they jointly have an after-tax account. If a household has thirty or forty thousand dollars in cash, I consider adding a new portfolio and may call to review it with the client depending upon our understanding. Or I may replenish an existing portfolio using the most promising stocks from the current buy list. So, Continuous Improvement The most tedious parts of the investment process are in transferring and cleaning the research data, and in keeping records on Excel and Fund Manager reconciled with the official brokerage records. The transferring and cleaning process involves downloading the research data, setting up return calculations for different time periods, and accommodating stocks that had splits, dividends, were acquired, had symbol changes or went out of business. Stocks are deleted if priced less than one dollar and trading fewer than five thousand shares a day over the last ten days. Outliers with exceptionally high or low returns are sometimes either deleted or the returns limited to a maximum or minimum amount so as to not overly distort the findings. The availability of cheap external storage has enabled storing Stock Investor Pro data for each month just as it was originally published. This has made historical data more accessible. Scottrade and the Fund Manager portfolio management software continue to improve their interfaces and the capabilities for retrieving data and easily reconciling records. I continue to work with them to assist them in design that facilitates my business processes. The more investors and businesses there are that have the same needs as Wenzel Analytics, and the more assertive and transparent we are as to what we need, the more accommodating will be the software. Conclusion So there you have the investment process in more detail than any sane person would probably want to know, unless you are interested in starting a similar business, or would want to use the process for your private investing. In either case, I would be happy to answer questions and share my experience. When I take my car to a mechanic, I don’t want to know the details of what he or she knows, I just want to know that he or she can fix it. The detail is here in case you think your investments are worth more than my car — which I hope they are — and deserve a thorough review of how they will be selected and managed. | 
