Boost your returns part 4 – the top 20

Boost your returns part 4 – the top 20

So far in our “Boost your Returns” series we have:

1) Introduced the idea of using a pattern recognition technology called a Support Vector Machine (SVM) to help identify listed companies with the potential to perform well/poorly (see part I here);
2) Tested the approach on historical data and found some encouraging results (see part II here); and
3) Listed the bottom 20 investment candidates from the ASX200 Index, as chosen by the machine (see part III here).

In this instalment we will move on to perhaps the most interesting part – identifying the top 20 investment candidates selected by the SVM from today’s ASX200.

Once again it’s important to note that we expect the machine to get many of its selections wrong (as would any human analyst), and the best we can expect is that it will get slightly more right than wrong. Accordingly, companies in the top 20 list should be viewed merely as candidates for further study, rather than anything more concrete.

With that behind us, the top 20 fall into line as follows:

Table 1 – Possible Outperformers

There are some interesting names in there, some of them unsurprising, some of them perhaps a little unexpected.

Pleasingly, the SVM has put forward a relatively high-quality group of companies. Of the top 20, only 3 fall outside the A1-B3 range we require for our investment process, and these 3 are well above the bottom end of the range.  Recall that when we looked at the bottom 20 chosen by the SVM we found most of the companies were outside the A1-B3 range, and many of these were at the dubious end of the scale.

A large percentage of the companies on this list are names that are very familiar to us.  Four of the twenty are companies we currently own in The Montgomery Fund and/or the Montgomery [Private] Fund, and there are a number of others we have owned recently, but sold on valuation grounds, or have recently studied and rejected because of valuation.

And it is here that an interesting point starts to emerge.  While we very much like a number of the companies on this list, in many cases the valuations are difficult to get comfortable with. There is a clear gap between us and the machine, and it is a gap built on investment philosophy.

Regular readers will know that our philosophy is to buy the very highest quality companies when we see them trading at a price below our estimate of their intrinsic value. When we don’t see sufficiently attractive valuations, our inclination is to hold cash and wait for better value to emerge, and that is the position we currently find ourselves in. With the market having risen faster than earnings in recent time, we have been moving more to cash to protect investor capital.

The machine has simply been asked to find the best and worst investment opportunities, regardless of whether the market as a whole represents good, bad or indifferent value, and that is what it has done. In a somewhat expensive market we shouldn’t be surprised to find it suggesting companies that we feel are expensive, notwithstanding their high quality.

In the short term, our desire to protect investor capital by holding cash is likely to hurt us in terms of investment returns.  Indeed, it already has.  However, in terms of long-run risk and reward, we believe it is the right thing to do, and so we let many of these opportunities go through to the keeper for now.

Time will tell if we are being too conservative in doing this.  It will be interesting to keep track of the top 20 and bottom 20 companies over the next 12 months to get a sense of how the machine portfolios have performed.  Of course, as with all of these sorts of exercises, we need to be careful not to read too much from a small sample size and limited time frame.

MORE BY TimINVEST WITH MONTGOMERY

Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

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