In tough times, follow the smartest money

As I write this two weeks into the New Year and the Dow Jones Industrial Average ($INDU) and S&P 500 ($INX) are both already taking a beating, while the Nasdaq ($COMPX) has fallen even further. High-end merchants and bargain chains alike are reporting ugly holiday sales. Housing sales and values keep dropping, the dollar continues to weaken, and many of the big banks aren't done writing off billions of dollars in subprime-mortgage-related debt.

Sound bad? Well, on top of all that, add this to the Strategy Lab equation: I am not a great stock picker. In fact, my own record of handpicking stocks is pretty pedestrian, and if I had to find value in this market on my own, I'm not sure that I could.

But here's the thing: I know who can. Over the last 12 years, I have done extensive research into the strategies used by some of the most accomplished investors of all time, people like Warren Buffett, Peter Lynch, Benjamin Graham, Martin Zweig, and David Dreman, to name just a few. These "gurus" have compiled some of the most impressive track records of outperforming the market over the long term, and they've all done it by sticking with proven strategies through good times and bad.

Computerizing the gurus

What's more, these Wall Street greats have either written or been the subject of books that explain, step by step, the methodologies they used to beat the market. Because many of their approaches are based, to a large extent, on quantitative measures, I have been able to develop a computerized stock selection model based on each of their strategies.

I've detailed these strategies in my book, "The Market Gurus," and on my Web site, Validea.com, and for this contest I'll be using a blend of five guru-based models to assemble my portfolio. They include those that I base on the approaches of:

• Warren Buffett, based on the book, "Buffettology"

Perhaps the most famous -- and greatest -- investor of all-time, Buffett's Berkshire Hathaway (BRK.A, news, msgs) averaged a 24% annual return over a 32-year period. Buffett is known for his patient, highly selective, long-term investment style.

• Benjamin Graham, based on the book "The Intelligent Investor"

Widely considered the father of value investing, Graham -- Buffett's mentor -- used a highly conservative approach to average a 20% annual return from 1936 to 1956. He focused on the underlying value of a company, and bought stocks whose market values were low compared to that underlying value.

• David Dreman, based on the book "Contrarian Investment Strategies: The Next Generation"

Dreman is a contrarian. He focused on the least popular stocks -- those that have been shunned because they're in a troubled industry or because of investor apathy, and found stocks within that group that have strong underlying financials. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever. At the time he published "Contrarian Investment Strategies: The Next Generation," the fund had been ranked No. 1 in more time periods than any of the other 3,175 funds in Lipper Analytical Service's database.

• Martin Zweig, based on the book "Winning on Wall Street."

During the 15 years that it was tracked, Zweig's stock recommendation newsletter returned an average of 15.9% per year and was ranked No. 1 based on risk-adjusted returns by Hulbert Financial Digest, a publication that tracks the records of investment newsletters. Zweig looks for growth stocks, and his methodology is highly selective.

• James O'Shaughnessy, based on the book "What Works on Wall Street."

O'Shaughnessy's "What Works on Wall Street" -- in which he detailed what he learned from back-testing 44 years worth of the stock market -- included a couple of surprising findings, including that P/E ratios aren't the best criteria for selecting stocks. He developed two models, one targeting larger value-oriented stocks and the other targeting growth stocks. His back-tested results averaged 22% per year over those 44 years. For Strategy Lab, I'll be using his growth strategy, which produced the highest absolute returns in his study.

Sticking to the numbers

While these gurus differ greatly in their approaches to picking stocks, they are similar in one important way: Each focused on quantitative measures when investing in stocks. They stuck to the numbers, seeking out financially sound companies and making sure that emotion -- which can lead even the best investors astray -- didn't play a part in their decisions to buy or sell. My models rely completely on the quantitative criteria they've laid out; there's no emotion, no hunch-playing.

According to my testing, a simulated portfolio taking the top 10 stocks based on each of these five strategies would have produced a return of more than 2.5 times the market's returns since mid-2003. The portfolio I have developed for Strategy Lab is a more focused model (taking four of the best stocks from each strategy).

By developing a portfolio of stocks using these diverse methods, I'll be making sure that the stocks I buy pass the rigid financial requirements of each strategy. In addition, because each method looks at different fundamental characteristics, I'll be limiting the risk I'd face if one approach goes out of style for a period.

Undaunted by a down market

One reason that I'm confident my models will find value in the market over the next six months -- regardless of where the economy heads -- is that the gurus upon whom they're based have often outperformed the market during down times. In fact, while their strategies differ, one similarity almost all of these gurus share is that they saw downturns not as problems but as opportunities.

After all, it's easy to make money in a bull market. The investors who can stand their ground in the tough times -- and even profit from them -- separate themselves from the pack.

Another reason I feel optimistic is that the current economic environment, while challenging, is by no means a disaster. For example, while increased unemployment figures in December sent a small panic through Wall Street, unemployment overall remains relatively low at 5%. And the National Association of Realtors is saying that we may reach the bottom of the housing decline as early as this spring, followed by an upturn.

And as for the dreaded R-word, consider this: According to a recent Wall Street Journal piece, recessions don't always bring bear markets -- or even declining returns, for that matter. In the recessions of 1980, 1981-82, 1990-91, and 2001, the market performed better during the recessions than it did in the six months leading up to them.

And in the first three of those examples, stocks actually gained ground during the recession, increases that were then parlayed into runaway gains over the next year. As I write this article, the Russell 2000 is down almost 19% from its high in July, while the S&P is officially in a correction and down 10.4% in the last 13 weeks. While economic uncertainties remain, the recent drop in stocks has the contrarian in me thinking that this is a great time to be starting a new round of Strategy Lab.

There are always going to be crises, worries and fears of one sort or another when it comes to the stock market. If you wait until conditions are perfect to invest, you're going to wait a long, long time.

Always think long term

In the end, I don't have a concrete prediction on where the stock market and the economy are going over the next six months of Strategy Lab, and anyone who says they know is probably trying to sell you something. The economy and the market are far too complex and changeable for anyone to be able to gauge with certainty what direction they'll head.

Rather than focus on where oil prices will head, who will win the presidential nominations or when the subprime crisis will end, I think it is more important to focus on selecting fundamentally sound stocks that exhibit elements of both value and growth, and I'll do that throughout this contest using my guru-based models. And, because of their diversity and track records, I believe these models will find good values in the market.

Still, don't forget: Investing is a long-term discipline, and it can take time to reap the benefits of a disciplined system. Sometimes, it can take a couple of years for the market to really catch on to an undervalued stock that you've been wise enough to pick up at a low price. In fact, the great mutual fund manager Peter Lynch, another guru I follow, has said that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. . . . What the market's going to do in one or two years, you don't know."

Because of that, I think it will be important to take the next six months not only to tell you about how I'm handling my stock picks, but also to explain more broadly how and why these guru-based strategies work over the long term. (And remember, over the long term no investment vehicle has been as successful as the stock market.)

By doing so, I hope to give you an understanding of the methods used by some of the most successful investors in history. Their methodologies have been invaluable over the years, and, regardless of what happens in the coming months, I hope you'll be able to learn from them and use them to your long-term benefit, too.

If you have questions or comments please feel free to e-mail me at johnreese@validea.com.