Validea Market ETF: Legendary Investing

01/28/2015 10:00 am EST

Focus: ETFs

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese has taken strategy used in his Validea newsletter—assessing stocks based on the investing criteria of legendary investors—and applied that approach to a newly-launched ETF.

Steven Halpern: Our guest today is John Reese, editor of the industry leading newsletter Validea and now manager of a new exchange traded fund, Validea Market Legends (VALX). How are you doing today, John?

John Reese:  Great, thank you Steve and looking forward to a little ski trip up to Mont-Tremblant, Canada.

Steven Halpern: Oh, great.  Many of our listeners are familiar with your underlying strategy, by which you assess stocks based on the investment strategies of many of the markets’ most well-known and successful investors.  

Now your strategy is being applied to this new ETF.  Could you tell our listeners about this?

John Reese:  Sure.  At the core of our investment strategy—as a stock selection system that utilizes the methods of great investors with proven long-term records of successful and market outperformance—we studied the stock picking techniques of these individuals, who include investing legends like Warren Buffett, Benjamin Graham, John Ness, and many others.  

And we captured their fundamental strategies that they published in computer models that we run.  In total, we have 22 unique strategies that we run and we have been running most of them since 2003.  

The Validea Market Legends ETF utilizes a blended approach combining ten unique models with approaches ranging from value to growth to income base, with each model selecting ten stocks to be part of the ETF portfolio.

The result is a 100 stock active equity strategy that looks very different from the major indices and has an objective of outperforming the market over the long-term, by focusing on fundamental and systematic stock selection.  

Steven Halpern: Now, many of the gurus that you follow place an emphasis on investor psychology, and likewise, your buy and sell strategy is in part designed to eliminate the role of emotions in the investing process.  Could you explain that step?

John Reese:  One of the most common characteristics of the gurus I follow is their emphasis on following a disciplined investment approach and not letting emotions influence the decision to buy or to sell a specific stock.  

I think the approach utilized in the Validea Market Legends ETF takes us to the next level, because I will never buy or sell a security based on a hunch, or a feeling, or what I read in a newspaper or in an analysis report.  

The buy and the sell decisions are always based on how a particular stock scores according to specific fundamental proven long-term strategy and how that score basically stacks up relative to all the other opportunities in the market at that moment.  

That makes the Validea Market Legends ETF unique in that the process we built is free of emotion and biases and will always be selecting stocks based on the underlying financial evaluation and growth metrics that each of the strategies analyze.  

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The other thing that we do, and have been doing for 12 years now, is to follow a monthly portfolio review process, so once every 28 days, or 13 times a year, we re-analyze the stocks and the portfolio and when we sell lower scoring stocks and replace those names with higher scoring stocks.  

We found that there is an opportunity cost of not holding the top scoring securities, and over time, the good investment management process needs a set portfolio review frequency so the stocks can be removed and replaced with better scoring stocks.

Steven Halpern: Perhaps you could walk us through some of the specific steps that you use in managing the ETF, such as how you narrowed down the possible number of stocks you consider and how you score these ideas relative to each other.

John Reese:  Yes. Our investment approach starts by scoring approximately 2500 to 3000 stocks using each of our model’s fundamental criteria.  The criteria includes quantitative metrics like return on equity and capital and debt metrics like long-term debt versus assets and valuation metrics that many people are familiar with like price to sales and price to earnings ratios.  

Stocks then get a score from zero to 100% with 100% being the best and we then combine the top 10 performing models together which effectively creates a 100 stock portfolio made up of the 10 highest scoring stocks from each of the 10 strategies.  

Then, there are multiple risk controls layered onto that portfolio management process including dynamic stop losses and sector limits and equal weighting of position.

Steven Halpern: Now interestingly, as you alluded to earlier, there is not a lot of overlap between the stocks that will make up your portfolio and the S&P 500. Could you explain that?

John Reese:  We allow each of the ten underlying strategies to roam the entire market looking for the best opportunities. Of our universe of close to 3000 stocks, approximately 80% of those names are small- and mid-cap that meet our liquidity requirements.  The remaining 20% are large- and mega-cap stocks.  

Given that breakdown, it’s not surprising that the makeup of the portfolio and the Validea Market Legends ETF is not weighted towards the large-caps.  We actually think that that attribute is a long-term positive for the strategy, as there are many great opportunities in lesser-known small names that aren’t as widely followed by the market.  

I think you know that most large-cap managers are all chasing the same 500-600 stocks, but we want our models to guide the portfolio to the best opportunities regardless of whether the company is a small, medium, or large market cap stock.

Steven Halpern: Finally, in terms of risk and investor time horizon, what type of investors do you think would be best served by this type of ETF?

John Reese:  Any investor that looks to make an allocation to the ETF should have a time horizon of at least three years, but preferably five+ years and they should have a reasonably high risk tolerance.  

Anytime you invest in the market as an active strategy like the one used in the Validea Market Legends ETF, you should give the strategy as long as possible to effectively judge it and to give the investment opportunity to work over a full bull-bear market cycle.

Steven Halpern: Well, congratulations again on the launch of the new ETF and we really appreciate you joining us today.

John Reese:  Thank you very much, Steven.  

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