The Barron’s 400

Barron’s unveiled the Barron’s 400, or B400, a new index of 400 companies deemed to offer the best growth at a reasonable price.

In partnership with MarketGrader in Miami, Barron’s selects from the Dow Jones Wilshire 5000 with a formula that looks at growth, value, profitability, and cash flow. The growth category examines the surprise record, revenue-growth rate, short- and long-term sales and earnings-growth rates, and relative strength. Earnings momentum is defined as a stock’s reaction to its earnings reports, a new twist. The value category looks at the usual ratios such as debt-to-equity, price-to-book, price-to-cash-flow, and such.

Then, according to last weekend’s Barron’s:

Once all the stocks in the DJ Wilshire 5000 have their grades, they are ranked. Then a series of screens is applied. Real-estate investment trusts are eliminated. The number of entries from any one industry is capped at 20%, or 80 companies out of the 400. Any company without officially reported financials in the past six months is booted.

To ensure sufficient stock liquidity, each selection must have a minimum three-month average daily dollar-trading volume of $2 million. The minimum market-capitalization of all components is $250 million, and at least 25% of the components must have a market value of at least $3 billion.

Once all those tests are satisfied, the highest-ranking 400 stocks become the Barron’s 400. Importantly, each stock is initially weighted equally in the index. This prevents a small minority of huge companies from steering the index. Research shows that equally weighted indexes tend to outperform market-cap weighted ones over market cycles. The B400, which was indexed to 100 as of Dec. 31, 1997, is currently at 321.04.

Every six months, on the third Friday of March and September, the whole process is rerun to incorporate more-recent financial results and market action, and the index is revised accordingly based on the fresh rankings.

It will be fun to watch the B400, but I do so with low expectations. It’s not that Barron’s is unworthy or the process flawed, just that almost all new twists on indexing in the past ten years or so have been run in similar ways. Indexes are just screens, after all, and some pretty good ones have existed for longer than any of us have been alive.

Here at The Kelly Letter, we’re big believers in indexes as the foundation of our permanent portfolios. What I’ve found every time I’ve followed new indexes, such as those at PowerShares, is that they’re not enough better than the old tried and true indexes to make it worth switching over. Usually, they’re not better at all.

For instance, the PowerShares Dynamic Mid Cap Portfolio (PJG) is, according to PowerShares, “based on the Dynamic Mid Cap Intellidex Index. The Index is designed to objectively identify those stocks within a particular market segment that have the greatest potential for capital appreciation. Intellidex methodology thoroughly evaluates the investment merit of the 2,000 largest U.S. companies by analyzing numerous unique financial characteristics from four broad financial perspectives: fundamental, valuation, timeliness, and risk.”

That should sound familiar: another stock screen. It’s supposed to produce an index better than the S&P; MidCap 400, the proxy for our Maximum Midcap strategy.

Since its inception a year ago, PJG has failed to keep up with the S&P; MidCap 400 and has been a miserable failure compared with Maximum Midcap, even after the summer correction to Max Midcap’s price.

One day I may develop an indexing methodology that I tie to a leveraged product like what we use in our permanent portfolios, but I would start with the work done by James O’Shaughnessy, author of What Works On Wall Street. In the 2008 edition of my stock book, I look at his latest information and present it in short, formula form. I consider that to be more compelling than MarketGrader’s work.

Regarding MarketGrader, the system might be exciting — if only it worked. Try using it for your investment timing decisions and you’ll be broke in no time.

Consider, for instance, how it guided investors on The Kelly Letter’s AMD holding.

When AMD traded at $34 in spring 2006, MarketGrader’s StockGrader assigned it a Buy rating. The stock had to drop to $25 before it changed that to Sell, but it then upped it to Hold when it poked up above $25 again a year ago.

We had been watching all that time from the low $30s with an initial target price of $20, which we then lowered dollar by dollar until finally buying the stock below $14 earlier this year. StockGrader didn’t wise up to the short-term damage ahead for AMD until October 2006, when the stock again fell through $25 on its way to the teens.

This brilliant system that told us to buy AMD back at $34 when we later had the chance to buy it at $14, is the one Barron’s is relying on to put together the B400.

Now, just by virtue of the index being a group of stocks, it will probably do pretty well. The problem is, that’s not revolutionary, or even new. Charles Dow had that idea over a hundred years ago, and his humble little average is still one of the best for tracking large company stocks — with a mere 30 components.

I’ll keep an eye on the B400 in case they’re on to something, but my hopes aren’t high. So far this year, for instance, the B400 is up 5.4% compared to 11.6% for Double The Dow and 10.2% for Maximum Midcap.

When the sustained end-of-year recovery takes hold, watch our doubling strategies soar yet again past all comers, as they always have to date and look set to continue doing.