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Guru Investor / John Reese8/4/2008 12:01 AM ET

Going all in, guided by 5 gurus

A bearish market has its share of risks, but plenty of opportunities, too. This 20-stock buy is based on strategies devised by the masters of the market.

Strategy Lab is MSN Money's stock-picking challenge. To learn more about the game and the contenders, click here.

As we head into this new round of Strategy Lab, the economic landscape isn't pretty. Home prices keep cascading lower even as foreclosure rates push higher; gasoline remains around $4 a gallon; and the financial sector is still loaded with uncertainty, with several banks recently failing. And, don't forget those disappointing recent unemployment figures.

Of course, there are some good signs, too. Earnings season has had plenty of pleasant surprises, for example, while oil prices have come down significantly in recent weeks.

The combination of mixed signals has made for some major volatility in the stock market lately, creating the type of environment that can flummox many investors -- particularly those who try to time the market's unpredictable short-term swings. This was the main theme in my first Strategy Lab article a few days ago.

But while a lot of stock investors remain on the sidelines, I'm heading all in today, splitting up my $100,000 equally among 20 stocks.

The best strategists on my side

And a big part of the reason is that I've got some of the greatest stock strategists in history on my side. The "Guru Strategy" computer models I'm using for this competition (and which I developed and use in my professional and personal investing endeavors) are based on the published quantitative strategies of Wall Street greats.

While I've developed about a dozen of these strategies, for this contest I'm focusing on five. I've based them on the approaches of Warren Buffett, Benjamin Graham, Martin Zweig, David Dreman and James O'Shaughnessy.

Each of these gurus has a verified track record of beating the market over the long haul, and each did it with a disciplined, mostly or completely quantitative approach to picking stocks. And one critical thing to note: For the most part, they didn't shy away from investing during bear markets. In fact, several of them believed bear markets were a great chance to pick up good stocks that had been beaten down unfairly because of the environment of fear and anxiety.

Throughout this contest, I'll rebalance my portfolio each month, taking the four best-scoring stocks from each of these five gurus. Let's take a quick look at them, and how they made their fortunes:

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

  • Graham: 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.

  • Dreman: A contrarian, Dreman focused on the least popular stocks -- those that had been shunned because they're in a troubled industry or because of investor apathy -- finding companies 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 3,175 funds in Lipper Analytical Service's database.

  • Zweig: During the 15 years that it was monitored, 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.

  • O'Shaughnessy: 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 -- made a couple of surprising findings, including that price-to-earnings 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 this contest, I'll be using his growth strategy, which produced the higher absolute returns in his study.

An intense focus on the numbers

While these gurus differ greatly in their approaches to picking stocks, they are similar in one important way: Each focused mainly or completely 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.

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

After today's purchases, here is the breakdown of which of my Guru Strategies picked which stocks in my portfolio:

By picking these 20 stocks at a time when the market is volatile, it may seem like I'm taking a risk. But to me, the real risk is staying out of the market. Over the long term, the stock market produces returns unparalleled by any other investment vehicle.

The catch: You have to stick with it over the long haul to realize those great returns.

Those who try to jump in and out of the market to catch the upswings and avoid the downswings almost always fail, as they end up buying high and selling low.

Remember: When the market turns around, it often does so very, very quickly. If you wait to make sure the next upturn is the real start of a bull market, you could miss out on those early turnaround gains.

So, wherever the market goes in the coming months, I'll stick to my strategies. They worked for some of the greatest investors of all time, and they've worked for me for several years. I expect they'll keep doing so for the long haul.

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

At the time of publication, John Reese and his clients at Validea Capital Management were long all of the stocks mentioned in this article expect NetGear.

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