Based on the investing criteria of many of the market's most successful investors, John Reese compiles a variety of portfolios for his Validea newsletter. Here, he answers several questions about his strategy, his newsletter and his exchange-traded fund modeled on this approach.

MoneyShow: Your strategy at Validea involves assessing stocks based on the investing criteria of legendary investors. Could you explain this strategy?

John Reese: That’s correct. Since 2003, I have been running models based on legendary investors, including stock selection models using approaches outlined by Ben Graham, Peter Lynch, Martin Zweig, John Neff and a number of other long term, successful investors.

Each model looks at a unique set of fundamental criteria, or factors, and my system scores and ranks over 6,000 stocks based on whether or not they pass all or some of the criteria in each model. Some of the models have a value bias, while some have a growth or momentum tilt.

But all of them use a combination of valuation metrics, financial strength criteria, profitability measures and other factors that are important when assessing the attractiveness of a particular security.

MoneyShow: For two years, you've also applied this guru-based strategy to the Validea Market Legends ETF. Could you explain how this ETF is compiled.

John Reese: The ETF utilizes 10 of these “guru”-based models and we allow each of the ten models to pick the top ten scoring stocks, which translates into a portfolio of 100 stock holdings. The 10 models we select for inclusion in the ETF are picked based on each one’s long term performance and the correlation to each other.

On a monthly basis, we perform a portfolio rebalancing, and on these predetermined dates the underlying models have the ability to remove stocks that have fallen in score and replace those names with better scoring stocks.

As part of the portfolio construction process, we also layer in risk constraints, such as sector limits and stop loss criteria, which is important when implementing these quantitative strategies smartly in an actual portfolio.

MoneyShow: One investment theme that underlies some of your best known experts is value; could you touch on the importance of value investing and highlight some of the gurus that employ this approach?

John Reese: At the heart of value investing is buying stocks that trade a discount based on some type of economic value, whether that be earnings, assets or the intrinsic value of a company.

There are different types of value investing approaches, such as a deep value approach like Ben Graham popularized, or a high quality and value approach, which is mostly what Warren Buffett subscribes to.

In addition to Graham and Buffett, others such as John Neff, David Dreman, Ken Fisher and James O’Shaughnessy have all written about various value stock selection methodologies.

In the markets, you may read and hear a lot about the “value premium”, which the excess performance value stocks tend to deliver over long periods of time.

The data supports this, but the jury is out as to the “why” this excess value stock performance exists. It’s some combination of expected risk, investor behavior and emotions and market expectations that contribute to value stock outperformance.

MoneyShow: You also focus on gurus whose strategies are based on growth as well as income. Could you highlight some of these gurus and explain how you combine value, growth and income together in the portfolio?

John Reese: Let’s take one model as an example — our approach based on Peter Lynch, the great mutual fund manager. The Peter Lynch model is a Growth at a Reasonable Price, also known as GARP, strategy.

The Lynch method, which I base on his book One Up on Wall Street, first segments companies into various categories based on their earnings growth – faster growers, slow growers and stalwarts – and based on this he would apply a different set of investment criteria.

Lynch popularized the PEG ratio, which is the Price-to-Earnings ratio over the Growth rate. If a firm had a P/E of say 15 but an earnings growth rate of 20%, that would be a potential opportunity assuming Lynch’s other criteria were also met.

Similar to Lynch, many of the other growth models I run have a valuation component. Most of these great investors, even in the growth camp, usually paid some attention to valuation.

So to some extent, the combination of various investment styles (i.e. value or growth) can happen within the strategy itself. But, for the purposes of constructing a portfolio I combine models together.

The Validea Market Legends ETF (VALX) utilizes a portfolio that combines ten distinct models each with a different set of investment criteria an there is value growth and momentum within those models. By combining models together, you get a diverse set of strategies all working to find the best ideas.

MoneyShow: Looking at these three fundamental areas — value, growth and income -- could you highlights some stocks in each category that currently meet your criteria for inclusion in the ETF?

John Reese: One of the characteristics of ETF is that all ETF holdings are reported out daily, so someone can go to the Validea Funds site and see our current list of holdings at any time.

You will see a very eclectic mix of small, mid and large cap stocks. All of the holdings in the ETF were selected using the guru-based system discussed earlier.

For example, we own Thor Industries (THO), a $5.8 billion maker of RVs, because of its growth qualities and we own Atwood Oceanics (ATW), a $850 million offshore driller, because it scores highly according to value approaches.

Greenbrier Companies (GBX), a manufacturer of rail freight and other transportation equipment, is a $1.2 billion dollar market cap firm that gets high scores because of its low value and good fundamentals.

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