How to think about high StockRank stocks

The Stockopedia StockRanks are proving more and more popular, not only as a stock picking guide but also as an educational framework to what works in investing. One of the main goals of the system was to be able to rank every stock in the UK market, regardless of sector or stage of their business cycle, while aligning the site closely with the key findings of academic finance. The exceptional performance of the ranks since launch has surpassed even my own expectations, but their growing influence does mean we have a responsibility to help subscribers understand, and not misuse them. 

This post I hope will go some way to clarify how to 'think' about the StockRanks.

Never cross a river because it is on average 4 feet deep

One of my favorite of Nicholas Nassim Taleb's maxims is that you should "never cross a river because it is on average 4 feet deep". Nicholas Nassim Taleb, as a derivatives trader and the author of "Fooled by Randomness", has an understanding of probability that goes much deeper than most. What he meant was that while averages are extremely useful, they can be dangerous as they don't give any indication of the underlying variability of a distribution. In simple terms, there's a big difference between crossing a river you know is consistently 4 feet deep, to crossing a river that is generally 2 feet deep but has occasional yawning 10 feet deep pools.

This analogy really helps when thinking about the StockRanks. A stock that is ranked 90+/100 scores extremely well across the three key drivers of stock market returns - quality, value and momentum. Historically, over most multi-year time periods, stocks with these characteristics have on average tended to outperform the market. But individually they have zero guarantee of outperforming.

Monkeys with darts

There is an old game in the stock market where brokers give their best picks to the press and go head to head with a monkey throwing darts. The monkey invariably wins. If we took our monkey and asked him to throw darts at high StockRank stocks how would he have done?

To answer this, lets go back and look at the performance of the set of top ranking (90+) stocks on LSE since launch in April 2013. Excluding the tiddly microcaps with a smaller than £10m MktCap, there were 134 stocks in this basket. A quarter of them have returned more than 50% since that date. 5 of them have more than doubled, with the best performer being Renew Holdings up 232%. But 19% of these stocks have had underperformed the FTSE All Share, with the worst performer being Synectics down 63%.

On average, the monkey would have done very well. If he'd only thrown a single dart he'd have had a 4 in 5 chance of picking a market beater. But averages, as we've seen are dangerous. The last 18 months have been quite kind to investors. A 1 in 5 chance of picking a loser may not have yet ended in ruin, but in a bad year it very well could have.

Here we come to the key point. The StockRanks only work well if one thinks of them as a 'general tendency' for good, cheap, improving stocks to outperform. These are not buy recommendations on stocks, they are averages. What matters for the StockRanks is the performance of baskets of shares - sets of random 25 stock+ portfolios - not what happens to an individual high scoring share.

Don't overweight precision

Another key point is that a 99 ranked stock may not be, on average (we're learning right?), any better than a 92 ranked stock. If we were to slightly tweak the inputs in our model, the general range of rankings may stay the same, but the precision may well differ. While it's very exciting to find a stock ranked 99 there is absolutely no reason to consider it a more optimal investment than one ranked 10 (or possibly even 20) grades lower.

Running the statistics, stocks ranked 97.5+ have returned 33% in the last 18 months which is the exact same return as stocks ranked 90+. 99+ ranked stocks have returned 36%, but that may well be down to randomness - it's not yet a statistically significant result.

Seeking comfort in troubled, boring, scary stocks

One of my favourite moments during my speech at the London Investor Show was showing a StockReport with the name of the company blurred out. Across almost every fundamental and technical score this stock looked first class. Strong growth, low valuation, good return on capital, low debt, high share price strength and ongoing broker estimate upgrades. A StockRank of 99 and GuruScreen count of 4 added to a compelling investment case - the audience agreed - until I unveiled the company name... Barratt Developments.

One of the reasons that high StockRanks stocks have had a tendency to outperform is that they are not the kind of stocks that people like buying... it's uncomfortable to own them for the following reasons:

• Cheap stocks are often troubled or face problems (investors prefer glamour)
• Good stocks are often boring (investors prefer excitement)
• Improving stocks are often scary to buy (investors hate buying at price highs)

There are behavioural reasons why stocks with these qualities are often underpriced. When reviewing high StockRank stocks it's worth remembering that it's alright if they make you feel uncomfortable - the fear centre triggering may be why these kinds of stocks outperform. 

Joel Greenblatt's found that investors using his Magic Formula system, which is designed using similar principles, tended to avoid buying most of the biggest winners and underperformed for precisely these reasons. As John Templeton once said - "If you want to have a better performance than the crowd, you must do things differently from the crowd."

Understanding the distress zone

There has been a lot of discussion lately about the fact that Wincanton has a StockRank of 98/100 when it 'shouldnt'. Our own Paul Scott has been vociferous in his criticism of the company.

A terrible company with an incorrectly high StockRank. They capitalise a large chunk of their payroll into the balance sheet. This is one of the worst companies I've drilled into. It getting a StockRank of 98 is a serious worry.

Wincanton is highly levered and clearly labelled with a high risk of bankruptcy on the StockReport. So why should a stock like this still have a StockRank of 98/100 ? Well it's simple.

Firstly, the QualityRank is only one third of the overall StockRank. If a stock is cheap AND has high momentum then the ValueRank and MomentumRank will outweigh low QualityRank scores. None of the StockRanks trump one another - they are all equally weighted. In fact, according to all the academic literature, quality as a factor is less predictive than value or momentum. My own biggest worry about the StockRanks is whether we should be weighting Quality as highly as we do... as there's plenty of research that suggests that we shouldn't.

Secondly, and more specifically, while financially distressed stocks as a whole tend to underperform the market, there is a subset of these stocks which do recover. There are various techniques for separating the wheat from the chaff amongst bargain stocks which we've discussed in our ebook "How to Make Money in Value Stocks". One of the best ways to do this is to measure the trend in the fundamentals - whether they improve or continuing to deteriorate. We do this using a nine point checklist called the Piotroski F-Score - companies with improving fundamentals score up to 9, deteriorating fundamentals as low as zero.

The QualityRank is designed to score the quality of a company's franchise (stability, profitability and growth), in tandem with its fundamental trend (F-Score) and its riskiness (financial and earnings quality). The bankruptcy risk is only 1 factor in what we call a multi-factor approach. So the baby is not thrown out with the bathwater in the instance that a company is flagging red on only one signal. It will be thrown out when it's flagging red on them all. The fact that a stock like Wincanton has a positive fundamental trend balances the bankruptcy risk in the scoring system.

While Wincanton may of course go bust, there are no certainties in investing. Statistically, Trinity Mirror was another stock with a very similar StockRank profile (high bankruptcy risk, but strong fundamental trend and price momentum) which more than quadrupled in price... so...

...don't confuse ranking with portfolio construction

If an investor doesn't want to include highly levered or risky stocks in the set of stocks they purchase, they can of course deliberately exclude them from their portfolio construction rules. A simple filter to remove all high bankruptcy risk or highly levered companies from a portfolio would instantly remove a Wincanton from a set of stocks for purchase.

This is precisely the step we've recommended in many of our seminars, and also recommended similarly in the book "Quantitative Value". The authors found higher returns at lower risk by removing these stocks from their strategies. It's really up to you how you wish to use the rankings in portfolio construction.

Being comfortable with the error rate

Barry Ritholtz recently interviewed the legendary James O'Shaughnessy - author of "What Works on Wall Street" and great inspiration to our work here at Stockopedia. In the interview he mentions the fact that all quantitative processes have a built in error-rate.

Some subscribers have been alarmed as this 'built in' error-rate (which is inherent in all quantitative systems) shows that computers are dumb and get it wrong. Others have been alarmed that we have zero qualitative "human" based ratings on the stocks in our system.

But there's never perfect foresight. One has to remember that human analysts can get it spectacularly wrong. One of my favourite slides shows that the average analyst forecast is 47% wrong on a 1 year basis. We have faith that the error rate is lower in well thought out quantitative processes than it is in qualitative (human based) processes. Maybe in future we'll launch a panel based internal qualitative rating system and put man vs machine to test it out !

But that's in future, for now the key takeaway is to make sure you think about high StockRanks from the portfolio perspective, not from the single stock perspective.

Safe investing !

If you want find out more about the Stockopedia StockRanks - please watch the 1 hour webinar I did earlier in the summer. We are constantly publishing eBooks and guides and will be publishing an ebook on the StockRanks in due course.   You can of course take a 2 week free trial at any time to test out our services.