Finance: PORTFOLIO MANAGEMENT
FORGET ALL YOU KNOW ABOUT STOCKS
Bob Haugen's recipe may change the way you invest
Looking for the ideal investment? How about a group of stocks significantly more profitable, less risky, and cheaper than the average stock in the Standard & Poor's 500-stock index? Sounds pretty good, except very few stocks have all these characteristics--at least, not enough to fill a portfolio.
No problem, says Robert A. Haugen, a finance professor at the Graduate School of Management of the University of California, Irvine. From a universe of 3,000 ordinary stocks, Haugen has been building portfolios of "Super Stocks" that, taken as a whole, have all the desirable characteristics that normally prove elusive in a single security. In a sense, the whole portfolio becomes greater than the sum of the parts. And because of its special attributes, the portfolio can handily beat the market. "Think about soup," says the 54-year-old professor. "You have lots of ordinary ingredients, which individually you may not even like. But put them together in the right proportions and you can make a wonderful soup."
"CAREER-MAKING?" Haugen's approach fundamentally challenges the received wisdom by which trillions of dollars have been managed for decades. So far, few disinterested experts have had an opportunity to study Super Stock portfolios. But if his system proves out, it could bring major changes in the investment management business. Haugen says the payoff from Super Stock investing is, well, super: an average four percentage points a year better than the S&P 500. Many money managers might beat that over several years, but few have done it over 10- or 15-year periods. "Four percentage points," says Haugen, "is a career-making return."
It hasn't made anybody's career yet, but Haugen is certainly trying. He has been on academic leave for the past semester, working out of a vacation home in Durango, Colo., and traveling extensively in the U.S. and abroad, talking about his ideas and signing up licensees for the system.
Corollaries of Haugen's heretical views extend beyond Super Stocks. An author of seven books and consultant to money managers and several public pension funds, he is regarded as an iconoclast by his peers in academia. In his 1995 book, The New Finance: The Case Against Efficient Markets, Haugen attacked the notion widely held in academia and taught in business schools that markets are fairly efficient and no one can consistently beat the market without taking higher than market risks. That school of thought also teaches that for most investors, the best strategy is to invest in a fund that merely replicates the return of a market index like the S&P 500. "If you believe that," Haugen told a workshop last month at the Charles Schwab Institutional Conference in Orlando, "you are utterly and completely misguided and confused. The market is easy to beat."
So far, Haugen has been beating the market mostly by testing his portfolios with historical data. Though there isn't much real-world experience with the method yet, eight investment firms and pension fund investors have licensed Haugen's program and are collectively managing about $200 million in a Super Stock portfolio. Several more firms plan to start running Super Stock portfolios in January, and a few others are still testing the program.
The oldest live portfolio using the Super Stock approach is a $45 million fund run by Industrifinans Asset Management, an investment management firm in Oslo. The two-year-old Norwegian fund applies Haugen's methods to an international portfolio that invests in the U.S., Britain, France, Germany, and Japan. Arild Orgland, a partner at Industrifinans, says that the fund has delivered the expected four percentage points over its benchmark (before fees).
Most of Haugen's licensees manage institutional accounts, but one tiny U.S. mutual fund is now following his system. The $3 million Analytic Enhanced Equity Portfolio started using Haugen's program in September. It's too soon to tell if the fund will meet its long-range performance goal, but early returns are promising. From Oct. 1 through Dec. 2, Analytic Enhanced Equity earned
an 11.1% return, vs. 10.1% for the
S&P 500. On an annualized basis, the fund is performing above expectations.
From early observations, it's clear the fund doesn't beat the market all the time. "On days the market rockets up, the fund hardly moves at all," says Harindra de Silva, managing director of Analytic TSA Global Asset Management Inc., a Los Angeles investment manager with $2 billion in assets, which runs the small fund. De Silva worked on research with Haugen when he was a PhD candidate and Haugen was his adviser. "Then, over the next few days, the fund moves up. That's because the stocks are not the institutional favorites. You don't get Netscape or Iomega."
MOTLEY CREW. What's unusual about a Super Stock portfolio is that most, if not all, the stocks by themselves hardly seem super. Among those in the Analytic fund are Manpower, Interstate Bakeries, Neiman-Marcus, and U S West. The fund holds 82 stocks, and de Silva says the number will grow as the fund does, but probably will not need more than 100 names to carry the program.
Haugen says the program can be pared down to fewer names as well. Look at Haugen's 16-stock portfolio (table), which delivered a 10.36% return in November vs. 7.55% for the S&P 500. The "hottest" stocks on the list--Abbott Laboratories, Schering-Plough, and Texas Instruments--are all up more than 30% this year. But there's also Micron Technology Inc., which is down about 10% for the year and trades at less than half its 1995 high. Pacific Gas & Electric Co. and Unicom Corp. are also in the red for 1996. The Super Stock system does not put an equal amount in each stock, but rather uses specific weightings.
This motley assemblage has a clear logic. Abbott, Schering, and Texas Instruments give the portfolio its high profitability characteristics. The big oil companies like Amoco, Exxon, and Mobil bring liquidity, cash flow, and dividend yield and also have lower-than-average price volatility, or "beta." The utilities contribute even lower betas and higher yields.
Even with its somewhat clunky companies, the 16-stock portfolio still compares favorably with the S&P 500, according to Haugen (table). For instance, the companies as a whole have less debt and more ability to service it than the average S&P 500 company; they have higher returns on equity and earnings growth, and price-earnings ratios of about half that of the S&P 500. The one drawback, says Haugen, is its heavy weighting in energy and tobacco stocks, leaving it exposed to adverse news in those sectors. That's why portfolios with more stocks are slightly more desirable.
Though Super Stocks are a long-term strategy, no stock is necessarily a long-term holding. Haugen suggests monthly rebalancing, and stocks and weightings can change significantly. Investors can also modify the program to change performance goals or portfolio traits. That way, no two investors should end up with the same buy list.
Should Haugen's ideas behave in practice as he predicts, it could have a seismic impact on investment practices. His "build what you can't buy" approach is vastly different from that of conventional money management. Usually, a manager homes in on stocks for one or two characteristics, such as a certain level of p-e ratio or dividend yield, and builds a portfolio from those that pass that screen. But using Haugen's system, managers can factor in a dozen or so portfolio characteristics.
The Super Stock idea could do away with the longstanding debate about whether to buy "growth" stocks--those with high earnings growth and profitability--or "value" stocks--those that are cheap by statistical measures, like p-e ratings and dividend yields. The market typically swings back and forth between favoring value and growth stocks, so at any one point, the value or growth manager--and his clients--is relegated to underperforming the market. But the Super Stocks method incorporates the best of both investment styles, and those that adopt it might be able to skirt those cyclical swings.
Of course, all of this is contingent on the successful transfer of ideas from paper to practice. Keep an eye on Analytic Enhanced Equity mutual fund or any other investor that adopts the Super Stocks strategy. You just might see Bob Haugen's career being made.By Jeffrey M. Laderman in New YorkReturn to top