Mike Mara's Model Methods

The manager of the Penn Street Fund Sector Rotational Portfolio explains how his approach generates healthy performance

Thanks to tax cuts and sustained consumer spending, the markets can drive higher in the next six months, says Mike Mara, president of Penn Street Funds. He reasons that cash is sitting on the sidelines in money-market funds, and the economy is expanding. "If we see new jobs being created beginning in 2004, this expansion could continue well beyond June," he notes.

Mara manages the Penn Street Fund Sector Rotational Portfolio (PSRPX ), which uses various valuation metrics such as price-to-book and price-to-earnings ratios and a company's growth reliability to screen for sectors and companies. Using his quantitative model, he ranks securities every week and rebalances the portfolio once a month.

His strategy has proved successful, even when the market dropped. In 2003, the portfolio rose about 37%, vs. a 29.8% gain for the Russell 1000-stock index. For the last three years, it was up 3.75% on average per year, compared with a 3.78% decline in the Russell 1000.

Mara recently sat down with BW Online's Karyn McCormack to discuss the market and his investing strategy. Here are edited excerpts from their conversation:

Q: Your three-year performance looks impressive. How did you do it?

A:

I think the majority of the return comes from the process that we developed where we're not fundamental analysts looking for the particular stocks to buy. We have built a quantitative model that determines what sectors we underweight and what sectors we overweight.

Q: As of Dec. 31, where were you overweight?

A:

Our overweight for the last three years -- again, it wasn't a macroeconomic analysis, it was something that was determined by the model -- have been the financial sectors and consumer cyclicals. Those have been our extreme overweights.

In underweight, we benefited from an underweight in technology for two years. Last year, again, the model told us to underweight. We were down to about 4% of the portfolio and turned it, according to the model, up to about 8% in technology. So, we're seeing more of an overweight, relative to what we've been in the past, but still underweighted relative to the market.

That was not the most advantageous, in that the technology sector did extraordinarily well, but our vast overweight with financials and consumer cyclicals offset the underweight that we continue to have in technology. The tech stocks that are popping up in the model today are more of the high-level technology stocks -- those with earnings that we recognize, like Intel (INTC ) and Symantec (SYMC ).

Q: Tell us about your screening process.

A:

We put 33% growth factors, 33% value factors, and 33% momentum factors [into the model]. We run the top 1,250 U.S. equities by capitalization through this model and then rank them from 1 to 1,250. We'll then take the top decile -- the top 125 -- and by pure count, see what sectors they fall into, whether that be financial, health care, basic industry. And that will give us our target sector weightings.

Within the 11 sectors that we identify, if any particular sector makes up less than 5% of the top 125, we can eliminate it. We'll never be more than 200% of the market weighting in any particular sector, however. Even if financials came in at 60%, we'd never be more than 200% of the actual market weighting. So we're not making huge sector bets. We're just making sector overweights and underweights, relative to their market standing.

That way, we're able to achieve protection and diversification on the downside, as well as performance on the upside. We'll then take a look at the actual weightings that the [model's] target gives us and select the securities to fill in those target weightings.

Q: How long do you typically hold a stock?

A:

Right now, the portfolio turns over at a rate of about 70% in a year. We're actually not going in and out of sectors. We try to buy and hold. The momentum factors would have to turn extraordinarily negative for us to throw something out.

Q: What do you think about the market now that we've hit new two-year highs on the Dow, and the Nasdaq ran up 50% last year?

A:

Well, even in the depths of the recent market decline, I was forever the optimist.... I fundamentally believe that the U.S. will remain an economic power for my lifetime. So for the long-term investor, I think we have a financial system that will continue to develop growth and entrepreneurialism, and continue to expand economically. And the equity markets will reflect that.

In 2004, we fortunately are heading into a year in which the U.S. economic engine is moving in the right direction. We have good economic indicators right now. We still have inflation very low and productivity still relatively high. We have consumer sentiment still high. We're starting to see some business investment, which we hadn't seen in the last couple of years. And to some extent, we've always seen some pump priming from the federal government during election years.

That said, what we're seeing is the tax cuts of 2003. People are starting to file their tax returns, and they'll probably see an additional $55 billion dollars in their hands during the first quarter of 2004, as a result of the tax cuts. And we'll see accelerated depreciation on certain investments by businesses, which will again give them additional impetus for more business investment in 2004.

I and our team think that we'll have a pretty good economic year in the market -- probably a more realistic 15% growth in the U.S. equity markets in 2004.

Q: What sectors will benefit?

A:

Our consumer cyclicals, we believe, will continue to do well. On the technology side, it's the larger technology companies with actual earnings and products that will do well in 2004. And we'll probably see a little bit of a change in the growth of the U.S. equity markets, going from the small-cap toward the large-cap companies in 2004.

Although we believe that the financial sector hasn't seen its heyday completely, I'd be careful. I recommend that you be a little bit wary of those financials that have been driven by the mortgage industries. The financials that may be driven by commercial banking or M&A activity could do very well in 2004, such as Bear Stearns (BSC ). One that still ranks really high is H&R Block (HRB ), which is kind of interesting. And a new holding is City National (CYN ), a regional bank.

Q: In technology, what are some stocks you like?

A:

The technology companies we currently hold that rank fairly high in the model are National Semiconductor (NSM ) and Symantec. We like Symantec for a number of different reasons. One is that they have a product that goes across business utilization, regardless of whether or not there's a continued investment in technology. Intel is one that ranks real high, and another one is FactSet (FDS ), which is more in the data-processing area.

Q: What about consumer cyclicals?

A:

It's across the board, which is quite interesting to us. On the retail side, we like Footlocker (FL ) and Urban Outfitters (URBN ), as well as Nordstrom (JWN ), a high-end retailer.

A couple of interesting ones that have come up on the model recently have been auto manufacturers, like General Motors (GM ) and Honda (HMC ). They score very high in our model currently. And one that's a little interesting, it's leisure recreational: Harley Davidson (HDI ). Plus, two homebuilders: We were very surprised that they continue to have the strength that they do, but quantitatively KB Homes (KBH ) is still looking very good for us. And we've have done extraordinarily well with it.

Q: What's the one most important thing investors should be thinking about?

A:

We believe that asset-allocation is the greatest driver of long-term performance for an individual investor. You should ensure that you have the proper balance, based upon your risk tolerance, along with your financial means and resources and need for liquidity, between stocks, bonds, and cash.

In your equity portfolio, [find an appropriate balance] between large-cap, mid-cap, and small-cap growth and value-type stocks or funds. Make sure that you're not chasing the hot sector or the hot style at any given time but participate in all styles and sectors because easily various sectors go from worst to first in one particular year. You don't want to be chasing them and sectors at any given time.

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