If you can't find the perfect stock - why not synthesise one?

Surely the simplest way to become rich in the stock market is to find the perfect young growth stock, fully invest, and ride it for 30 years. But a piece in the FT at the weekend caught my eye which illustrated just how hard it is to find long term winners in the market. The piece highlighted the biggest winners in the UK over the last 30 years -  an unusual selection of stocks which certainly didn't fit the expected profile. The truth is that near perfect companies are very hard to find, and when you do find them, they are often acquired or taken private, leaving little of the long term reward in your pocket. Anyone screening the market to find the ideal stock may find their labours are only rarely rewarded. What is an investor to do?

The profile of a perfect buy and hold stock

Many investors will agree on the characteristics of their perfect buy and hold stock - it often goes something like this:

• high growth rate (EPS, Sales) 
• low valuation (PE ratio, Price to Book, Price to Cashflow)  
• high profitability (Return on Equity, margins) 
• consistent, sustainable upward trend in profitability 
• low leverage, good interest cover 
• Mid-cap (with room to grow) rather than a 'penny' stock 
• Good price performance in last year - low volatility of share price

Intuitively one imagines that a stock continuously showing a profile like this over many years will strongly outperform the stock market. It would look like a classic 'GARP' stock (growth at a reasonable price). The trouble is that everyone knows this. It's so very obvious that these characteristics are desirable that thousands upon thousands of investors look for them on a daily basis.

As a result, stocks often display a profile such as this only fleetingly - as when investors do find them they get bid up to a premium, reducing the future returns for new investors, and ensuring they drop out of candidacy from the list.

So what is an investor to do? Many will seek to be patient, alert and pounce on the opportunities when they arrive. Some such as Warren Buffett will step in on bad news, or when the macro environment looks frightening to others. But in regular times, for those who can't watch the market like a hawk, there is indeed an answer.

What if, instead of trying to find the perfect stock you could synthesise it? I don't mean go out and build the company yourself - much easier said than done - I mean construct a portfolio that in aggregate displayed the qualities of this ideal stock, but whose component parts (each stock held within the portfolio) didn't. How would you go about that and what would the results be?

Dr. Robert Haugen

Robert Haugen has shown the way. Haugen is a now aging  financial economist and pioneer of quantitative investment techniques, who has not only been a huge critic of all the most misleading ideas in finance (such as efficent markets etc) but has led the way to show investors how to take systematic advantage of market mispricings.

Haugen's methodology, outlined in his now famous paper, 'Commonalities in the Determinants of Expected Stock Returns', is one often used by hedge funds across the city. He uses a multi-factor model that works kind of like a traditional stock screen, but rather than outputting a limited list of stocks which pass all the criteria, it outputs a score for each stock based on its expected share price return. The expected return is dependent on the stock's sensitivity to each of the criteria.

Haugen and his team tested dozens of stock ratios (or factors as the quants like to call them) across growth, value, quality and momentum categories to ascertain which characteristics of stocks were most predictive of future returns. He narrowed the list of ratios down to the dozen most important  and most predictive - which quite surprisingly (or perhaps not) pretty much mirror the ideal list of ratios we published above. Remarkably, Haugen writes "there is, in fact, an acronym in the investment business for the type of stocks that resemble those that collectively appear to populate [the list]. These are called GARP stocks (Growth At a Reasonable Price)." 

The performance history of Haugen's models are quite astonishing and can be viewed at his website as well as published in the chart above. He claims up to 30% annualised returns since 1996 for Long only strategies. These findings mirror another research paper I wrote up recently entitled 'Buffett's Alpha' which also found that extraordinary long term stock market returns came from low-volatility, cheap, higher quality stocks.

The Catch

But before anyone rushes out to hunt and find GARP stocks, Haugen presented a catch. He explains that while the best ranked stocks collectively have the desired characteristics, individually they do not have the complete profile.

Indeed, if you were to screen, requiring each [stock] to have [the best] characteristics, you might well find an empty set, with no stocks at once exhibiting, low risk, high liquidity, low price-level, and high profitability.

In other words the stocks that make up the 'ideal' portfolio have extremely divergent individual characteristics. Some may have strong 1 year momentum, some may be deep value, some may be extremely profitable and most will have some kind of strong blend of several of the factors - but none or few will show all.

Lessons for investors

We publish quite a few GARP screening strategies - including those that fit the criteria of Jim Slater and the Naked Trader, which have performed exceptionally well year to date - but perhaps the lesson from Haugen is not to get blind sided by trying to fill your portfolio with stocks having a perfect but homogeneous profile. The real goal should be to 'synthesize' the perfect stock by using the building bricks of a diverse array of individual stock components.

We plan on rolling out multi-factor models onto the website within the next 12 months or so which will aim to model some of the research papers we've been discussing lately, but in the meantime you can monitor the 'GARP' nature of your own portfolio using the growing set of portfolio tools for premium subscribers of Stockopedia, and also use the extensive screening services to find the best stocks. We are still offering a free trial for those who haven't yet tried the product. Safe Investing.