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The Keystone family of screens is an attractive choice for newcomers to Mechanical Investing. These screens select large cap stocks familiar to most investors, and work best with an annual holding period, which keeps commission costs low. However, the Keystone strategies did not work well prior to 1986.
By Todd Beaird (TMF Synchronicity)
August 24, 2000
If you're a newcomer to Mechanical Investing (or "MI" as we call it here at the Workshop), it's easy to be overwhelmed by the amount of information. You're probably wondering, "Which strategy (or strategies) should I use?"
My first advice to all you beginners out there is "hold your horses." Step back, take a deep breath, and do a little research before plunging into MI. Study some of the resources available for free here at The Motley Fool and at related sites constructed by some of our superb contributors on the boards.
In addition, there are two excellent reports available for sale on Soapbox from two notable contributors on our boards. One is David Trammel's (LAPropDoc) Unofficial Guide for the New Mechanical Investor, and the other is Mike Sellers' (Sux2BeU) comprehensive report on Relative Strength Investing. Both compilations can be very useful to novice and experienced investors alike.
After you've done your research, you can decide on a strategy. Many newcomers choose a member of the Keystone family of strategies as one of their first screens. These strategies are attractive for two reasons. First, they select large-cap stocks that many new investors are familiar with. Second, these screens work best as annual holds. This keeps commission costs low, which is a necessity if you have limited funds to start.
There are three members of the Keystone family. The first is the original Keystone created by Robert Sheard. This screen selects stocks using the following criteria:
- Take all U.S. stocks ranked Timeliness 2 or better by Value Line.
- Rank these stocks by market cap, and keep the top 30.
- Sort these 30 stocks by 26-week total return, and purchase the top stocks.
Many people purchase the top five stocks, and use this screen as part of a mechanical strategy with an annual holding period. The 30-stock cutoff (with only U.S. companies) was chosen to mirror the 30-stock universe of the Dow Dividend strategies, such as the Foolish Four.
A variation on this screen was introduced by Phil Parker (powerphil). Phil found the 30-stock cutoff to be somewhat artificial. Instead, he used the top 100 stocks by market cap, and dropped the requirement that they be U.S. companies. This screen was christened the Keystone 100.
The third member of the family is Keystone EPS. This screen is similar to the original Keystone, but adds an element of earnings growth. The first two steps are identical. The third step ranks the top 10 stocks by 26-week total return, and ranks them from one (highest) to 10 (lowest).
The fourth step is to rank these 10 stocks by earnings growth over the last 12 months, again from one (highest) to 10 (lowest). The values for both the total return and earnings rankings are added together, and the stocks with lowest combined scores are selected first. We can thank Jim Lynn for this strategy.
Below are the average CAGRs and GSDs for each of the three Keystone strategies, from January 1986 thru August 2000, selecting the top five stocks and using annual, semiannual, quarterly, and monthly holding periods. The S&P 500 is included for comparison purposes. Remember that CAGR is the annual rate of return (the higher the better), and GSD is a measure of volatility (the lower the better).
Keystone Annual Semi Quarterly Monthly
CAGR 30.9% 30.4% 29.5% 28.7%
GSD 28.8% 29.1% 38.3% 37.9%
Keystone 100 Annual Semi Quarterly Monthly
CAGR 33.7% 33.4% 36.4% 31.9%
GSD 35.8% 36.6% 44.5% 44.3%
KeyEPS Annual Semi Quarterly Monthly
CAGR 31.2% 30.7% 32.1% 34.5%
GSD 27.9% 28.1% 36.4% 39.9%
S&P500 Annual Semi Quarterly Monthly
CAGR 17.0% 16.6% 16.1% 16.0%
GSD 12.4% 11.3% 11.2% 12.0%
As you can see, the Keystone strategies have similar results, and they all offer the best combination of return vs. volatility as annual holds.
At this point, you might be wondering if there are any drawbacks to the Keystone family of strategies. There is one issue that might be of concern. Thanks to the Herculean efforts of Richard Stein (buckaroobonzai) and many other members of the MI community, we have been able to test the Keystone and Keystone 100 strategies from 1969 to 1985 on quarterly data. The results were not encouraging, as you can see below:
1969 - 1985 Data
Keystone Annual Semi Quarterly
CAGR 10.3% 10.1% 11.0%
GSD 29.9% 30.7% 28.7%
Keystone 100 Annual Semi Quarterly
CAGR 11.8% 19.6% 18.0%
GSD 38.9% 34.9% 39.1%
As you can see, both strategies had much lower returns while remaining highly volatile. The strategies did outperform the S&P 500 during this time (the S&P had a CAGR of 8.89% during this period), but by a lower margin. Also, the strategies did not perform particularly well as annuals.
Does this mean that the Keystone strategies have simply been "lucky" since 1986? Perhaps. Some people on the Workshop board believe the Keystone screen is a great way to invest, while others are discouraged by the data from pre-1986. As always, you have to weigh the pros and cons of any strategy before you put your hard-earned dollars in it. All we can do is inform you as well as possible so you can make an intelligent decision.
Next week we'll take a closer look at the Plowback family of strategies. See you then, same Fool time, same Fool channel!
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