July 11th, 2014

Lists of “Value” Stocks Often Miss Target

image“After 5 years of a bull market, the only place left to invest is in value names”
“The best protection in this volatile market are value stocks”

But how reliable are these sorts of claims?  Those promoting the approach offer lists of stocks that are considered undervalued typically when they meet such financial criteria as low price/sales, low price/book value, or high, stable and growing dividends. However, they rarely attach timeframes or price targets.

So I decided to do some “back testing”.  By searching the term “value stock lists”, I gathered a small random sample of such lists published in 2012-13; stocks in these lists met one or more of criteria that qualifies them as “value stocks” at the time.  I then compared their stock price on the publication date with that of twelve months later; as a benchmark, those changes were compared with against the S&P 500 change over the same period.  These were selected at random and space limitations prevented including more, I suspect others would show similar results:

  • MagicDiligence.com: “Top 10 Dividend Yields, Lowest P/S, and Lowest P/B Stocks” – 1/5/2012: “Every so often, MagicDiligence compiles a list of Magic Formula® Investing stocks sorted by their dividend yield, price-to-sales ratio, and price-to-book ratio for investors that like to use those metrics. The result produces a list of attractive value stocks for additional research.” The top 10 in each of the three metrics were:
    Value MagicDiligence
  • Valueline: “Value Line’s 6 Safe Dividend Stocks” - 11/22/12 : “Value Line is an independent investment research and analysis company that has developed a safety ranking methodology which focuses on the long-term stability of company’s stock price and financial standing.  The fund invests in companies that carry Value Line’s ratings of 1 and 2, representing the most stable and financially-sound dividend-paying companies and higher-than-average dividend yield, as compared to the indicated dividend yield of the S&P 500 Composite Stock Price Index.”  The top picks were:Value - Valueline
  • Forbes: “Return To Value Stocks: Cisco And Three Others To Buy” – 10/7/13 : “At ValuEngine.com we show that 77% of all stocks are overvalued, 40.8% by 20% or more. 15 of 16 sectors are overvalued 13 by double-digit percentages, seven by more than 20%.  This week there are four Dow components on this week’s ValuTrader watch list.”  The list included:Value - Fobes
  • SeekingAlpha: “12 Large-Cap Stocks Selling Below Book Value” : “Price-to-book ratio is used to compare a stock’s market value to its book value and it is calculated by dividing the stock price by the book value per share. The higher the price-to-book ratio, the higher the premium the market is willing to pay for the company above its assets. A low price-to-book ratio may signal a good investment opportunity, as book value is an accounting number and rarely represents the true value of the company.”Value - SeekingAlpha
  • 24/7 Wall St.: “Value Search: Dirt Cheap Tech Stocks” – 7/10/10:…” when you get companies that trade under 10-times believable forward earnings expectations and which have low multiples of sales and even a low implied book value, this is where value investors tend to focus.  Whether a turnaround comes or not might not even matter if stocks get “cheap enough” for the value investors.”Value - 24x7

The hit rate (performance exceeding that of the benchmark S&P 500 Index) of the 60 stocks for this random sample of five lists was 50%, not much better than randomly selecting 60 stocks from any or combination of the major Indexes.

We’re continually subjected to academic studies purporting to show the failure of technical analysis.  For example, Stockopedia had a piece entitled “Technical Analysis? 5 Reasons To be Sceptical about Charting in which they quoted an academic study that back tested the effectiveness of “5000 technical trading rules” grouped into four categories:

  • Filter Rules – prices move of various percentages.
  • Moving Average Rules – prices move above or below a long moving average
  • Channel Break-outs – prices move above or below a channel (trading range)
  • Support or Resistance Rules – prices move a certain percentage above or below a maximum or minimum price a number of periods back.

;The study concluded that “no evidence that the profits to the technical trading rules we consider are greater than those that might be expected due to random data variation.”

I’ve now turn the tables and measured the effectiveness of some fundamental trading rules.  Although perhaps subject to criticism for being insufficiently rigorous, I convinces me that there is “no evidence that the profits to the fundamental trading rules are greater than those that might be expected due to random data variation“.

Subscribe below or click here to learn more about help for navigating turbulent markets.

July 2nd, 2014

Easy, Fun and Profitable Shopping

imageIt’s been quite some time since I wrote something for the public side of Stock Chartist but it sometimes the market feels like the “good ole” times so it gives me the urge to put some thoughts down again and share them with all of you.  By the “good ole” days, I’m referring to the beginning of the bull market, like July 23, 2009 and March 2, 2012 when I wrote “Stock Picking Now Feels Like Shooting Fish in a Barrel“ and Part 2, respectively.

In the early stages of the bull market, it almost didn’t matter which stock was picked, it was just more important to put money to work.   If you happened to pick a stinker, you cut your losses quickly and rolled the money into something else that worked.  Unbelievably, the situation is almost the same today (when looking at the charts) even though it’s been five years since the bull market began on March 9, 2009.

Back in 2006-7 I was looking to save some trees and reduce my overhead by eliminating subscription, like Investors Business Daily.  While I liked many of their concepts I found their approach to market timing to be weak; it seemed like they followed Cramer’s “there’s-always-a-bull-market-out-there-somewhere” principal.  I’d moved beyond that by having developed my own Market Momentum Meter approach to market timing.  But when it came to stock picking, there was nothing wrong with their “Stocks on the Move” approach.  I was able to replicate the factors IBD used into one of the automatic scans in my charting software (Worden Bros. Telechart).

Those two posts in 2009 and 2012 were based on My “Stocks on the Move Scan” (click on the 2009 article like above for a complete description of the scan), the same scan that I use today. Scans are used to filter out from the universe of over 4000 stocks, those stocks that meet various user defined criteria.  Scan aren’t “silver bullets”, they don’t give you the complete and final answer but they do present a place to begin.  Depending how precise the criteria, scans can screen out anywhere from 50 to 300 stocks that meet the parameters.

As a matter of fact, over the past 4 weeks, the Stocks on the Move scan has flagged about 300 stocks that fit its criteria.  I’ve taken the stocks that are screened each week and perused these stocks’ charts to further whittled the list to arrive at 92 stocks that looked like they had or were about ready to breakout the topside of various chart patterns.  We assumed with some confidence that they will likely cross those upper resistance boundaries because the total market as measured by the all the major indices (Dow-30, the S&P-500, the Russell-2000 and the NASDAQ composite) had or were about to make new highs.

I posted the 92 stocks in Watchlists on the members-only side of the Stock Chartist blog.  Since posting them, I’ve been swapping the underperforming or lagging stocks in my Portfolio for the new names on those Watchlists.  With over 90 stocks from which to pick, I knew there was a high probability that most would wind up being winners, winners big enough compensate for the few selected that might turn out to be losers or laggards.

Here’s the scorecard:

Scan results

Of the 92 stock candidates for selection, 3 out of 4 generate gains and only 25% a loss (only 2 had losses of 8%).   But avoiding losses isn’t sufficient.  Of the stocks in the list, 63% outperformed the S&P 500 Index from the time they were added to the list and their average gain was 4.4 percentage points better than the S&P 500 over the same period.  Of the 37% that underperformed, their losses so far were 2.6% under the S&P 500.

If you had selected a basket of the stocks generated by this scan, the odds are that you would have outperformed the S&P 500 over the same period.  Get your shopping cart ready, the shopping is easy, fun and can be profitable.

Subscribe below or click here to learn more about help for navigating turbulent markets.

August 23rd, 2013

Portfolio Management – Part 5: The Hidden Cost of Diversification As “Insurance”

Risk and Opportunity


In economics, risk is defined as volatility. Furthermore, one truth of economics is that high risk accompanies high return while low risk means lower return. Investment managers put us in a dilemma when they play on our fears by asking us to take the safe course by accepting low volatility and lower returns. They want to convince us to diversify away from the higher volatile and higher return of stocks by adding a large dose of lower volatility/lower return fixed income securities to our portfolios (the standard is a 60/40% mix). But what are the sorts of risks they warn us of? How likely are they to actually materialize?

Investor advisors essentially try to convince us that sometime in the future, they don’t know what or when, our portfolio could be significantly impaired sometime in the future if we don’t diversify to reduce its volatility, probably just when we need to liquidate some of the assets to provide funds for a specific large expenditure like tuition, a wedding, a 25th anniversary trip, extraordinary medical costs, job loss or retirement. They claim that the values of our portfolios are vulnerable to a wide range of real world risks, including:

  • Company risk from
    • financial or operating performance which, if the market perceives to be negative, adversely impacts the price of that company’s stock
    • technological risk
    • competitive risk
  • Industry risks including
    • government regulation
    • product or technological obsolescence,
    • international competition
  • Economic risk arising from
    • either governmental fiscal or monetary policy,
    • international events and
    • inflation risk
    • interest rate risk
    • exchange rate risk
  • Political risk

There’s no question that these sort of “risks” can actually happen; they happen all the time but how significant is that risk? For the time being, let’s put aside individual stock risks and focus instead on risks that influence most stocks, the economic or political risks that are characterized as “systemic” risks. No one knows what, how or when these sorts of risks will become real events but, when they do, their impacts are huge and affect nearly every single stock. As a matter of fact, in today’s global investment climate, they impact most investment vehicles both domestic and foreign stocks and bonds. There’s usually no place to hide, no safe haven. These risks often manifest themselves as stock market crashes.

For example, the recent Financial Crisis Crash significantly damaged real estate values, cut stock prices in half and even brought down international stock markets. Because of the fear of financial collapse and corporate failures, the value of all debt with the exception of US debt was also adversely impacted (until the Fed stepped in with their Quantitative Easing program that drove debt values higher and interest rates down).

Since the stock market suffered two major crashes in the past decade, investors are especially loathe to invest in stocks. Investment managers play on these fears and push such strategies as the “Ultimate Buy-and-Hold Strategy” as a panacea. But how unusual were the events of the past decade and how likely is it that they and other risks will occur over the long-run future? Should any of these risks materialize, what sort of impact might they have on the stock market and a stock price volatility? Putting individual companies risks aside for the moment and instead focusing exclusively on systemic, total market risk, we find that the probability of significant stock market declines (i.e., declines of more than 15% in a year) are actually quite rare:

Risk Dimensions

There have been 894 months over the past 75 years since 1939 when, during that period, the market suffered monthly declines 41% of the time however in 57%, or more than half, those declines were less than 2%. In fact, during any single month, almost none of those declines were more than 10%.

What happens when the holding period is extended to a year? During the 882 rolling, sequential 12-month periods, 70% ended in a gain; 12 month loss occurred in less than 30% of the cases. In fact, many of those declines were bunched together in short time periods since they occurred during extended market crashes. In the 30% of cases when there was a loss at the end of 12 months, the losses were less than 10% more than half the time. The market increased fairly regularly over the past 75 years and the increases have been substantial:

Profit Opportunities

The market closed higher in 70% of the 12-month periods since 1939 and in almost half of those instances the gains were 10% or more; in a third of those periods, the gain was 15% or more. Among the nearly 900, shorter 2-month holding periods, the market advanced 62% of the time and nearly half of those gains were 2% or more.
One way of interpreting the trade-off presented by the market In the very short-run (i.e., each and every single month):

  • hold stocks for a month for a near 60% likelihood of capital growth with a 35-40% probability that the growth would be 2% or more and
  • a 30% likelihood of a capital loss that has a 57% probability of being less than 2%.

For two months is succession, clearly enough time for someone to evaluate the market’s longer-term risk and adjust a portfolio’s exposure to that risk the market, a typical trade-off is:

  • hold stocks for two month for nearly a 62% likelihood of capital growth with a nearly 50% probability that the growth would be 2% or more and
  • a 37% likelihood of a capital loss that has a 44% probability of being less than 2%.

The past 75 years probably cover nearly every possible type of macroeconomic, technological and geopolitical event and the above statistics summarize the stock market’s reaction to them all. Could the future introduce anything more dramatic than these and could the stock market’s behavior in the future be much different? I think not. These statistics cover all sorts of market conditions including:

  • World War II, Korean, Viet Nam, Iraq and Afghanistan and the first attach on U.S. soil,
  • two secular bear markets (the 1970′s and the 2000′s), crashes (Tech Bubble of 2000-2003 and Financial Crisis of 2007-2009)
  • 17-year bull markets (post war 1949-1966 and 1962-2000)
  • technological upheavals with the beginning of space age, biotechnology, PC’s and the introduction of the Internet into everyday life
  • major geopolitical events like the fall of Soviet Union
  • global economic crisis including the 20-year Japanese economic winter, Federal budget and debt ceiling crisis and the launch and near collapse of the Euro
  • presidential assassinations, resignations and near impeachments
  • natural disasters including hurricanes, earthquakes and tsunamis
  • market flash crashes and the largest single day stock market loss of 22.6% on October 19, 1987

Even though they say they are looking out for you personally, the typical investment manager has many clients and protects you through a cookie-cutter, one size fits all approach. You don’t want your manager to be a passive manager but instead an active one continually reacting to ever changing environments.  Instead of paying your investment advisor fees to continually anticipate extreme yet relatively infrequent market declines, expect them to navigate around major declines when and if they happen. You should expect them both to protect your portfolio and to earn returns greater than could be earned by owning an index fund.

During the next parts of this series, I’ll discuss my approach that’s less costly than the “insurance premium” by intentionally foregoing profit opportunities (higher volatility); that approach is to incrementally, in part or totally, move to the sidelines when volatility increases in the wake of bear markets and crashes.

Subscribe below or click here to learn more about help for navigating turbulent markets.