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Wall Street rose on Monday, with the Dow touching highs not seen since July, while investors braced for a flurry of quarterly earnings reports through the week.

A recent rebound in oil and signs that the U.S. economy was recovering have helped stocks rally from a steep selloff earlier this year that had pushed the S&P 500 down as much as 10.5 percent.

The index is now up 2.3 percent in 2016 and only about 2 percent short of its all-time high, while the Dow breached 18,000 for the first time since July 21.

That came despite bleak expectations for first-quarter earnings reports, many of which flow in this week. Earnings of S&P 500 companies are seen falling 7.7 percent on average, with the energy sector weighing heavily, according to Thomson Reuters I/B/E/S.

Source: Dow reclaims 18,000 as quarterly reports begin to flow | Reuters

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I have often contended that share buy-backs are not a great thing. I suggest that companies should focus on growing their top line revenue number with appropriate attention to the bottom line number. Focusing on number of shares as a way to control EPS is very expensive.

This article from the WSJ, tends to agree with my premise.

Citigroup analysts found 38 of the 50 retail and apparel companies they cover repurchased shares in fiscal 2015. The bank set out to determine how bullish that is for future performance, looking at buybacks across the group since 2011. It focused on instances of companies repurchasing 5% or more of their outstanding shares within a year.

Out of 71 such instances, on average, the stocks underperformed the S&P Retail Index by more than 10 percentage points in the year following the repurchase, Citigroup found. The companies’ stocks underperformed the index in the year following the repurchases in 44 of 71 instances, outperforming only 27 times.

That suggests companies may be buying back stock to cushion earnings per share the following year. Instead of applauding buybacks, investors might be better off questioning their motives.

Source: Retailers: What Happens When They Buy Back Their Shares

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rating photoA balanced portfolio should include great companies and mutual fund stock indexes. In order to effectively buy a mutual fund, you should evaluate its performance using one of the mutual fund rating systems. Both the Morningstar and Lipper mutual fund rating systems provide comparative ranking of fund performance ranging from 1 year to 10 years. The primary difference lies in the metrics used to determine which funds rank highest to lowest in a category (i.e. peer group).

Morningstar mutual fund rating system overview

The Morningstar system relies on a single metric: a calculation of risk-adjusted return. The risk adjustment incorporates a utility function to reflect how investors’ trade-off return and risk for factors such as loss aversion. Also, Morningstar will adjust for taxes in its risk-adjusted return calculation if most investors in that fund qualify for the same tax treatment. The resulting risk-adjusted returns are segmented into five categories (1 to 5 stars) based on a bell-shaped (i.e. normal) distribution.

Lipper mutual fund rating system overview

The Lipper system evaluates fund performance using metrics which determine the overall ranking for a fund. These five metrics are

  1. Total return (not risk-adjusted)
  2. Consistency of Return
  3. Preservation of Capital
  4. Fund Expense
  5. Tax Efficiency

One advantage of the Lipper system is that investors can dig into an overall Lipper ranking to determine which of these five metrics played a crucial role. Funds within the same peer group are ranked into one of five categories numbered 1 to 5 (best to worst) using a flat distribution of 20% each so that an equal number of funds are assigned to each performance category. Lipper also provides an overall fund rating based on total return with capital gains and dividends re-invested.

Morningstar Mutual Fund Rating System Methodology

Morningstar Ratings has the following characteristics:

  • Mutual funds are evaluated against a peer group
  • Ratings are based on the funds’ risk-adjusted returns

Within each Morningstar Category, the top 10% of funds receive five stars, and the bottom 10% receives one star. The 4-star category encompasses 22.5% of the peer group as does the 2-star category (immediately above the 1-star category). The middle category (3 stars) contains the remaining 35% of funds.

Funds are rated for up to three time-periods:three-, five-, and 10-years. These multi-year ratings are combined to produce an overall score.

Ratings are objective, based entirely on a mathematical evaluation of risk-adjusted past performance. They’re a useful tool for identifying funds worthy of further research, but shouldn’t be considered buy or sell signals.

Lipper Mutual Fund Rating System Methodology

Lipper ranks mutual funds according to a peer-based performance system which measures returns according to specific time frames and fund classifications (small, mid, multi and large-cap). Mutual fund returns are assigned a rank that places each fund within a group – the lower the number rank, the better the fund performed compared to other funds in the classification group. For example, a rank of 24 indicates that the fund has the 24th best rate of return in its category. In effect, Lipper ranking reflects how well the fund performed compared to its peers for a given period. Because the number of mutual funds in a classification group can vary widely, Lipper also calculates a percentile measure for each fund.

Lipper ratings are derived from formulas that analyze funds against clearly defined criteria. Funds are ranked against their peers on each of five measures:

  1. Total Return
  2. Consistent Return
  3. Preservation
  4. Expense
  5. Tax Efficiency

Each of these criteria is defined below:
Scores are subject to change every month and are calculated for the following periods: 3-year, 5-year, 10-year, and overall. The overall calculation is based on an equal-weighted average of percentile ranks for each measure over 3-year, 5-year, and 10-year periods (if applicable). For each measure, the highest 20% of funds in each peer group are named Lipper Leaders. The next 20% receive a rating of 2; the middle 20% are rated 3; the next 20% are rated 4, and the lowest 20% are rated 5.

  1. Total Return – A Lipper Leader for Total Return is a fund that has provided superior total returns when compared to a group of similar funds.
  2. Consistent Return – A Lipper Leader for Consistent Return is a fund that has provided superior consistency and risk-adjusted returns when compared to a group of similar funds.
  3. Preservation – A Lipper Leader for Preservation is a fund that has demonstrated a superior ability to preserve capital in a variety of markets when compared with its peers.
  4. Expense – Lipper Leaders for Expense are funds that have successfully managed to keep its expenses low relative to its peers and within its load structure.
  5. Tax Efficiency – A Lipper Leader for Tax Efficiency is a fund that has been successful at postponing taxes over the measurement period relative to similar funds.

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Picking stocks has become so hard that some mutual fund stock pickers have given up pretending to try.

Pry open the hood of a mutual fund, and you might be startled by what you find. In the past, you would have seen roughly 100 stocks, each painstakingly selected by a portfolio manager passionate about beating the market. Today, you’re increasingly likely to find a few handfuls of exchange-traded funds — those autopilot portfolios that seek to mimic the market rather than beat it.

This evolution in how mutual funds are being run changes the relationship between funds and their investors. Some folks might respect the intellectual honesty of a money manager who has climbed off the hamster wheel of trying to beat the market. Other investors might feel they aren’t getting their money’s worth if they’re paying for active management but their fund manager largely picks other funds instead of individual stocks.

This lack of expertise by fund manager’s is even worse when you look at the success of mutual funds. I have often advised that index funds are better than actively managed funds. This advice is even more prudent if the actively managed fund is really an index fund in sheep’s clothing.

SPIVA tries to compare actively managed funds compared to their benchmark such as large company actively managed funds compared to large company index funds. The mid-year 2015 results showed little improvement in actively managed funds. For instance:

  • The first half of 2015 witnessed modest fluctuations in the domestic equity market. Based on the June 30, 2015, SPIVA U.S. Scorecard data, 65.34% of
    large-cap managers underperformed the benchmark (S&P 500, 7.42%) during the past one-year period. The figure is equally unfavorable when viewed over longer-term investment horizons. Over the five- and 10-year investment horizons, 80.8% and 79.59% of large-cap managers, respectively, failed to deliver incremental returns over the benchmark.
  • The investment landscape improved modestly for mid-cap managers, with roughly 48.21% failing to beat the S&P MidCap 400 over the one-year period. Despite a modest decrease in the percentage of small-cap managers underperforming the benchmark, 58.52% of active small-cap funds still lagged the benchmark.
  • However, over the longer-term horizons, such as the five- and 10-year periods, an overwhelming majority of actively managed mid- and small-cap funds underperformed their respective benchmarks.
  • It is commonly believed that active management works best in inefficient markets, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA mid-year 2015 report. The majority of small-cap active managers consistently underperformed the benchmark in both the 10-year period and each rolling five-year period since 2002.

While I believe that an individual investor can pick great companies to invest in. I do not believe that their portfolio should be assisted with actively managed funds. Instead simply pay the lower cost of an index fund and diversify about 35-40% of your portfolio evenly between large cap, small cap, international and bond index funds. The remaining 60-65% of your portfolio should be targeted at high quality growth companies like those I list on my Watch List. Those high quality growth companies should then be invested in with the techniques that I teach in my book, The Confident Investor. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in e-book formats for Nook, Kindle, and iPad.

Further reading: When Stock Pickers Stop Picking Stocks – MoneyBeat – WSJ

Also, check out this video explaining SPIVA:

https://www.youtube.com/watch?v=llGiz8t_f5U