by Archie M. Richards, Jr., CFP^®
January 9, 2005

The Robot Portfolio, fashioned by Bloomberg columnist John Dorfman, has done it again. During the two years the stock selections have been recommended by this column, the total returns, including dividends and appreciation, amounted to 38 percent and 29 percent.

Not only that, the portfolio has beaten the S&P 500 Index in every one of the last seven years! Dorfman reports that, assuming the stocks are replaced with the new list at the turn of the year, the portfolio has gained 727 percent. Over the same period, the S&P 500 gained a lousy 13 percent.

If you acquired the Robot stocks because of this column, your results probably differed from Dorfman's numbers. In the first place, you had to pay commissions and taxes. Secondly, my columns on the subject were published towards the end of January, requiring that you make purchases and sales several weeks after the yearend.

The Robot Portfolio is constructed by computer. Dorfman designed the specifications, but otherwise exercised no judgment - thus the "Robot" name.

All ten stocks are deeply out of favor. If you're a follow-the-crowd kind of person, they're not for you. (Neither are most investments, because time and time again, following the crowd results in losses.)

To select the stocks, Dorfman starts with all U.S. stocks whose market value exceeds $500 million. That's about 2,100 stocks.

To cut risk, he omits:

• Unprofitable companies
• Companies whose debt exceeds equity. (For example, if a corporation has $600 million in assets and $350 million in debt, the difference of $250 million is the equity. With debt exceeding the equity, this company would be excluded.)

Okay, the list is down to 1,400 stocks. From these, the system selects the ten stocks with the lowest price-earnings ratios.

To illustrate what this means, imagine buying a pair of pants or slacks. You know the item's value to you, because you can see it and feel it.

Not so a stock. It represents a corporation whose profitability you can neither see nor feel. How can you estimate its value?

A common method is to determine how much the stock's current price exceeds the company's annual earnings. That's the price-earnings ratio (PE).

For all 500 companies included in the S&P 500 Index, the collective stock prices exceed the earnings by 18.7 times. If the annual earnings stayed the same, 18.7 years would be required for the cumulative earnings to equal the price paid up front.

The PE ratio of a stock reveals how much investors favor the company. The price of Google, for example, is 102 times greater than the annual earnings, a whopping price-earnings ratio of - you guessed it - 102. Needless to say, investors favor Google a whole lot. They expect the earnings to grow rapidly, and the price to rise as well.

John Dorfman takes the opposite tack. His Robot stocks have all suffered misfortunes. They're out of favor, making the PEs low. Investors have turned their attention elsewhere, not expecting the earnings of these companies to grow.

But investors often exaggerate problems, pulling the stock prices down too low. Low expectations are easier to beat than high ones. When conditions turn out better than expected, the stock price rebounds.

Here's the list for 2006:

• Ashland (ASH)
• Fremont General (FMT)
• General Maritime (GMR)
• Gold Kist Inc. (GKIS)
• Hovnanian Enterprises (HOV)
• LandAmerica Financial (LFG)
• M.D.C. Holdings (MDC)
• Overseas Shipholding Group (OSG)
• Schnitzer Steel Industries, Cl. A (SCHN)
• United States Steel Corp. (X)

The average PE ratio for these stocks is only 5.5.

To act on John's recommendations, place an equal amount of money into each stock. Don't get smart and try to guess which ones will outdo the others. Nobody knows. Buy 'em all. It's the system you're acquiring.

Two of the stocks (GMR and LFG) were included in last year's list. If you already own them, adjust the number of shares so that the market value of each equals the value of the other stocks in the new list.

Driven down by bad news, the Robot stocks have remarkably low price-earnings ratios. They're bargains.