My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted?? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

You might notice that this time, I have no industries from the red zone.? That is because the market is so high.? I only want to play in cold industries.? They won?t get so badly hit in a decline, and they might have some positive surprises.

If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.? I generally play in the green zone because I hold stocks for 3 years on average.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh? Why change if things are working well? I?m not saying to change if things are working well. I?m saying don?t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some telecom related, some basic materials names, particularly those that are strongly capitalized.

I?m looking for undervalued industries. I?m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive. I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting. The red zone is pretty cyclical at present. I will be very happy hanging out in dull stocks for a while.

That said, some dull companies are fetching some pricey valuations these days, particularly those with above average dividends.? This is an overbought area of the market, and it is just a matter of time before the flight to relative safety reverses.

The Red Zone has a Lot of Financials; be wary of those.? I?m considering paring back my insurers.

What I find fascinating about the red momentum zone now, is that it is loaded with noncyclical companies. That said, it has been recently noted in a few places how cyclicals are trading at a discount to noncyclicals at present.

In the green zone, I picked most of the industries. If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

That said, it is tough when noncyclical companies are relatively expensive to cyclicals in a weak economy. Choose your poison: high valuations, or growth that may disappoint.

But what would the model suggest?

Ah, there I have something for you, and so long as Value Line does not object, I will provide that for you. I looked for companies in the industries listed, but in the top 5 of 9 balance sheet safety categories, an with returns estimated over 15%/year over the next 3-5 years. The latter category does the value/growth tradeoff automatically. I don?t care if returns come from mean reversion or growth.

But anyway, as a bonus here are the names that are candidates for purchase given this screen. Remember, this is a launching pad for due diligence, not hot names to buy.

I’ve loosened my criteria a little because the market is so high, but I figure I will toss out? lot when i do my quarterly evaluation of the companies that I hold for clients and me.

I read a paper today that I thought was pretty interesting — A Consultant?s Perspective on Distinguishing Alpha from Noise. [8 pages PDF]? I have been on both sides of the table in my life.? I have hired managers, and I have tried to sell my equity management services.

In general, managers that thought would offer value would venture off the beaten path.? They might own some well-known names, but they would own far more that would make me say, “Who is that?”? The companies would be less known because they are smaller, foreign, have a control investor, etc.

Those portfolios would look a lot different than an index fund.? They would be more concentrated by sector, industry and company.? They would have a process that analyzes what the market is misvaluing, whether by sector, industry, or company.? They would stick to their discipline through thick and thin, realizing that all anomalies in the market go in and out of favor.

The process would specify what anomalies of the market, or what information advantages the fund would attempt to exploit.? But once you specify that, you stick to that as your strategy.? There is no room for tossing an asset in “because it looks good.”

There is a balance in good strategies that allows for minor modifications around core principles.? All good strategies have to adapt, but there has to be a strategic core from which the strategy will never vary.? Absent that core, the strategy will give in to fear and greed — buying high and selling low.

Quoting from the paper:

I am amazed at all the managers that make an assertion of the type “In the long run X always wins”, where X could be dividend yield, earnings growth, quality of management, a quantitative factor or mix of factors, etc., yet are unable cite a reason why X should be systematically under-priced by the market.

My view is twofold.? There are some ugly situations involving financial stress that most investors don’t want to take on.? There are also less glamorous companies that few want to buy.? Those can be excellent investments.? My second point is tougher to make, but industries go in and out of favor.? So do market factors.? Buy that which is safe, and out-of-favor.

Now, for managers, I would recommend keeping a trading journal, where you record why you think your investment hypothesis will succeed.? If your investments succeed for reasons that you specified in advance, that is an indication of skill.? There is a lot of what is called “luck” in investing.? If you are beating the market, and it is not for reasons that you specified in advance, you do not have skill, you have luck, and luck strongly tends to mean revert.

My view comes down to this: I like to see a long track record of outperformance, an unusual portfolio, and a strategy that convinces me that you have discipline, and a constructive way of finding undervalued assets. ? Absent that, I will probably think that you are a pretender than an outperformer.? There are always some that outperform for a short time, and then underperform as the underlying economics shift.? Markets are volatile enough that there are always some with three-year track records that are stunning, and very lucky.

Separating luck from skill — that is the toughest aspect of investing.? But it is needed because there are so many investment managers touting skill, and what do they really offer?

From a reader:

Hi David,

I’ve been a classic “bottom-up” investment advisor for a few years now, but I agree with your assessment that industries, in general, are under-analyzed by the masses.

What is the best way to learn about a particular industry? Are you aware of any comprehensive publication that sheds light on both the qualitative characteristics of an industry and the appropriate valuation methods?

Thanks!

There are several ways to learn industries.? I’ll try to explain:

1) You can choose a bunch of companies in an industry, email the investor relations area, and ask for packet equivalent to what they send buy-side analysts.? I’ve done that at various points in time for industries I wanted to learn.? Compare and contrast.? Who is doing well, badly and why?? In the mid-90s, I did this for the trucking industry, and learned a ton of information.? I also talked with some trucker friends of mine who gave me on the ground data.

2) You can read industry publications.? When I was a buy-side analyst for the insurance industry, I read those regularly.? They exist for almost every significant industry.

3) You can go to industry meetings.? Almost every industry has meetings where they discuss industry conditions.? Just don’t be too pushy in trying to get information.? Be interested in the industry as a whole, and don’t try to gain material nonpublic information.

4) Value Line & Morningstar both provide industry analyses.? So do most major investment banks.? You can review those and compare and contrast.

5) You can use the quality screen to look at what industries have a rising ratio of gross profits from operations, versus a falling ratio of gross profits from operations.? Here is a chart from the last seven years:

The colored field reading “Chg” is the difference between the average of years 1-3 and years 5-7.? Profits are noisy, that’s why I did an average.

Gross profits from operations as a fraction of assets [GP/A] is a good measure of the quality of an industry, and whether their sustainable competitive advantage is is improving or declining.

Now, when I look at a measure like that, I do one of two things:

1. I buy cheap companies with strong balance sheets among those industries where GP/A has fallen hard, and buy them, knowing that they are survivors, and will rebound.
2. I buy moderately strong companies in industries where GP/A has been improving, and after research, the trend is not well understood.? It helps if the industry is dull, and few people follow it.

That’s what I do.? Whatever you do, size it to your own abilities, or the abilities of your firm.? Beyond that, look at cheapness of a company relative to normalized earnings, i.e., average earnings over a full market cycle.