Testing An Aggressive Investment Strategy Using Value Line Ranks: A Comment

Abstract

RECENTLY IN THIS JOURNAL, Clark Holloway employed a novel and interesting approach to testing for superior performance [1]. However, there appear to be errors in his methodology and in inferences he draws from his evidence. Holloway holds that a Buy-and-Hold policy based on Value Line (VL) recommendations yields abnormal returns even when transaction costs are considered. He calculates that annual compound rate of return of VL Rank-I stocks was 11.3 for 1965-78 period. And indeed this is result reported by VL when dividends are not included. Holloway then applies a 2 one-way commission up to May 1975 and 1.25 thereafter. He reports that the annual abnormal return after commissions was found to be 8.6 percent [italics added, p. 711]. This abnormal return is presumably amount compound rate of return of Rank-I stocks exceeds compound rate of (AllVL stocks), prior to an adjustment for risk. It is obviously too large to be correct, and except for his repeating same figure in his conclusion [p. 718], one would assume it is a typographical error. For if we adjust Rank-I returns with his own commission adjustment equation [p. 711], a terminal value (TV) per dollar originally invested of 2.697 emerges. This amounts to a postcommission annual rate of return of 7.34 percent. The market TV for same period before commissions (also without dividends) is 1.728. As for commissions, there are only two commission occasions with respect to this market portfolio for entire 1965-78 period: at entry and at exit fourteen years later. The postcommission return of market is 3.75 annually. The margin by which Rank-I stocks exceeds market, therefore, is difference between 7.34 and 3.75 percent, namely 3.6 prior to risk adjustment, not 8.6 percent. Since 3.6 extra return just derived did not include dividends, differential would be narrowed even more if yield on market is greater than on Rank-I stocks. We can get an estimate of differential yields using Holloway's Table I [p. 712]. In Table I he compares VL reported returns with his own calculations using those VL stocks included in CRSP file. According to Table IV [p. 717], number of Rank-I stocks included therein ranged from 86 to 90 (out of 100) over four-year period he chooses as representative of whole 1965-78 period. The number of stocks which compose market of AllVL stocks on File ranged from 1476 to 1482 (out of about 1700). Holloway's calculations of return include dividends; VL's do not. Holloway uses table to show how close his results were to VL's if consideration is given to dividends.