The recent credit crunch illustrated to hundreds of thousands of investors that even blue chips can’t be relied on to preserve and grow capital. And yet so many still invest first in stocks they are familiar with and think they know best. Buying what one knows may feel safe, but they can be over-followed, over-owned and over-priced. A good company may not make a good stock. So what makes a good stock?
Behavioural Finance to the rescue?
Much academic research shows that oddly enough, what makes a good stock is often what investors don’t like buying. The typical investor is scared of buying cheap stocks and even more scared of buying stocks at new highs. It’s these behavioural biases that are behind the ‘value effect’ and the ‘momentum effect’ - two of the driving forces behind market beating portfolios.
More recently, research has illustrated the power of safe, stable, profitable businesses to beat the market (a ‘quality effect’). In fact a team investigated Berkshire Hathaway’s performance (in a paper titled “Buffett’s Alpha”) and found that all Warren Buffett had done was figure out before everyone else that ‘good, cheap’ stocks beat the market - more importantly Buffett has always had the tenacity to stick to at it while everyone else loses their head.
What we’ve been doing at Stockopedia over the last few years is diligently putting rule based investing to work to find those shares that might be most exposed to these forces. We began our journey in 2011 by modelling and tracking the performance of 65 classic strategies from the stock picking literature - the GuruScreens. But while stock screening is a great way to filter for high quality candidate stocks in the market, it doesn’t help anyone to understand or compare the whole market. So we set about designing a ranking system that could.
Inspired by the work of academics like Robert Novy Marx and popular stock market authors like James O’Shaughnessy and Joel Greenblatt - we sought to quantify every company’s exposure to the factors we have been discussing - quality, value and momentum. Our goal was to highlight ‘good, cheap, improving’ stocks while shunning ‘risky, expensive, worsening’ stocks.
The Stockopedia ‘StockRanks’ - which score companies from 0 (worst) to 100 (best) - have an impressive record in the UK since launch in April…