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Aug. 16, 2019, 10:40 a.m. EDT

How a quant strategy outperformed by picking fast-growth Facebook and a decimated Stamps.com

Federated MDT’s automated decision process takes emotions out of the equation

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By Philip van Doorn, MarketWatch

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MDT Advisers

The Federated MDT All Cap Core Fund seeks to outperform the Russell 3000 Index /zigman2/quotes/210598149/delayed RUA +2.92%  not by limiting the portfolio to “high conviction” names, but by taking a broad approach and holding stocks of companies across sectors (in the same sector weighting as the index) that are most likely to rise over a three-month period. In addition to the sector weighting limitation, the fund “will be no more than 2.5% above the benchmark weight in a name, and no more than 2.5% underweight,” Mahr said. The Russell 3000 Index is weighted by market capitalization, so the fund’s top holdings are also large-cap names.

Looking at the decision tree (there’s a simplified version, above), you can see that the first culling of the stock universe is to separate companies that “need a lot of external financing.” This may include, for example, a company that is increasing its long-term borrowings significantly in order to fund stock buybacks. It may also include a company whose stock has crashed recently, but also has been increasing its borrowings — this company may be in big trouble if lenders now have cold feet.

In this simplified tree, you can see two green groups. Group two includes stocks for which analysts have been cutting their estimates, but have some other redeeming financial characteristics identified by the model, making it possible they have been oversold. Group four includes stocks for which analysts have shown enthusiasm by raising estimates while prices have been rising.

Examples of stocks in favored ‘buckets’

The full version of the decision tree will assign a percentage number of each stock’s expected gain or loss over the next three months and place the stocks into 10 “company type” buckets, rather than the five in the simplified tree. Getting back to the list of eight stocks held by the firm listed at the top of this article, here’s why the decision trees rated them favorably:

• Facebook /zigman2/quotes/205064656/composite FB +2.05%  and Mastercard /zigman2/quotes/207581792/composite MA +3.00%  are large-cap companies in the bucket described as “very high analyst conviction, price near high.” HubSpot /zigman2/quotes/209389444/composite HUBS +1.68%  and Atlassian /zigman2/quotes/207177221/composite TEAM -0.06%  are mid-cap names in the same bucket. Development of additional factors to identify companies in this bucket was essential to improving the fund’s recent performance, as described below.

• Biogen /zigman2/quotes/201531540/composite BIIB +2.29%  and EOG Resources /zigman2/quotes/204634330/composite EOG +7.03%  are in the bucket described as “neutral to high analyst conviction and high structural earnings.” The decision tree analyzes earnings quality with a focus on gross profit. “We look very high on the income statements,” Mahr said, because various items, including depreciation and amortization, can make bottom-line earnings “lumpy.” Mahr described this bucket as including “classic value companies” or “former growth companies that have matured.”

• Stamps.com /zigman2/quotes/202777086/composite STMP -2.27%  and Peabody Energy /zigman2/quotes/203600175/composite BTU +19.82%  a coal miner, are in the bucket described as “depressed price, no significant financing required.” These are stocks that have been hammered, but the decision tree indicates they may have been oversold.

Shares of Stamps.com plunged 58% on Feb. 22, after the company said it would not renew its exclusive deal with the U.S. Postal Service to sell stamps online, because its customers were demanding that it provide other shipping options to its customers. Then the shares sank 56% on May 9, after Stamps.com lowered its earnings guidance. This is an example of the decision tree taking human emotion out of an investing decision. Mahr said the stock was “priced for the worst-case scenario,” and that any other scenario could lead to tremendous gains. Stamps.com provided an example of this when the stock rose 27% on Aug. 8, after the company reported better-than-expected results for the second quarter.

Improving performance

The Federated MDT All Cap Core Fund has $310 million in total assets and is rated four stars (of five) by Morningstar. Here are return figures for the fund’s R6 shares /zigman2/quotes/206359824/realtime QKACX -0.20% for various periods, compared to its benchmark, the Russell 3000 Index:

Total return - 2019 through Aug. 13 Average return - 3 years Average return - 5 years Average return - 10 years
Federated MDT All Cap Core Fund - R6 Shares 18.6% 13.9% 9.4% 12.2%
Russell 3000 Index 18.0% 12.1% 10.3% 13.4%
Source: FactSet

The R6 shares are an institutional share class, primarily used for retirement accounts, with annual expenses of 0.74% of assets under management. It does not have a sales charge or 12b-1 fee. The fund has many share classes with different expenses and possible sales charges, depending on how the shares are distributed. It is very important that you learn what your total expenses will be, including your adviser’s annual fee, for any fund you invest in.

As you can see, the fund’s performance against the index has been good over the past three years, but has trailed for longer periods.

When asked why the fund’s performance lagged the benchmark for the longer periods, Mahr said that growth stocks have had “a very strong run” over the past 10 years and that he and his team had “struggled with the outperformance of the highest-growth names.”

“We really didn’t have a mechanism for being overweight the FAANGs as a shortcut,” he said. The FAANG stocks are fast-growing tech and social-media stocks that have dominated indexes over the past decade, including the Russell 3000: Facebook, Amazon.com /zigman2/quotes/210331248/composite AMZN +0.76% , Apple /zigman2/quotes/202934861/composite AAPL +2.54% , Netflix /zigman2/quotes/202353025/composite NFLX +0.76% and Google holding company Alphabet /zigman2/quotes/205453964/composite GOOG +2.17%   /zigman2/quotes/202490156/composite GOOGL +2.04% .

“So we did a lot of work to figure out what factors we could develop to help us highlight that kind of company as an alpha opportunity,” Mahr added. (Alpha is an investment term for return above that of a benchmark index.) The new factors were added to the decision tree in 2015, he said.

Fund holdings

Here are the top 10 holdings (of 172) of the Federated MDT All Cap Core Fund as of June 30:

Company Ticker Share of fund Total return - 2019 through Aug. 13 Total return - 3 years
Lockheed Martin Corp. /zigman2/quotes/200691238/composite LMT 2.9% 46% 54%
Stryker Corp. /zigman2/quotes/207664662/composite SYK 2.8% 41% 97%
Chevron Corp. /zigman2/quotes/205871374/composite CVX 2.8% 15% 35%
Charter Communications Inc. Class A /zigman2/quotes/201656355/composite CHTR 2.7% 33% 47%
Automatic Data Processing Inc. /zigman2/quotes/207661132/composite ADP 2.7% 30% 100%
Allstate Corp. /zigman2/quotes/201974803/composite ALL 2.5% 28% 60%
Live Nation Entertainment Inc. /zigman2/quotes/203077299/composite LYV 2.5% 45% 170%
Global Payments Inc. /zigman2/quotes/201234787/composite GPN 2.3% 54% 113%
Mastercard Inc. Class A /zigman2/quotes/207581792/composite MA 2.3% 46% 191%
DuPont de Nemours Inc. /zigman2/quotes/203606582/composite DD 2.2% -9% 0%
Sources: Morningstar, FactSet

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Philip van Doorn covers various investment and industry topics. He has previously worked as a senior analyst at TheStreet.com. He also has experience in community banking and as a credit analyst at the Federal Home Loan Bank of New York.

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