Super Stocks - why multi-factor stock selection offers higher returns at lower risk
Regardless of what the marketing departments at some major fund management firms might like you to think, the concept of ‘factor’ investing has been around for decades. The characteristics of Quality, Value and Momentum have long been credited as a source of some of the strongest returns in the stock market - it’s an open secret. But despite validatory evidence from academics and high profile investors who have successfully used these factors, most individual investors fail to do the same. Part of the problem is that despite making so much sense, there are strong behavioural and risk based reasons why many of us struggle to apply them properly.
To understand how and why Quality, Value and Momentum work so well together, it’s worth exploring some of the history of these factors. The case for buying good quality stocks that are undervalued dates back at least as far as Benjamin Graham’s 1934 book, Security Analysis. He’d witnessed at first hand the consequences of chasing stocks on stretched valuations and then watching them tumble as confidence evaporated in the 1929 crash. The young Graham nearly lost everything and so built a new Value philosophy that aimed to buy assets as cheaply as possible.
Fast forward nearly 80 years and Graham still has a following that boasts some of the most respected and successful investors around. The likes of Warren Buffett, Seth Klarman and a multitude of fund managers subscribe to the power of buying stocks when they’re underpriced. In turn, each of them applies different standards of Quality to the stocks they assess.
But while value investing has a rich heritage, most agree that it’s a strategy at odds with the behavioural preferences of most investors. Buying unloved, potentially broken businesses that no-one else wants is difficult to stomach and prone to periods of underperformance - even if they are good quality firms. Yet, with patience, Graham’s principles remain just as powerful as they ever were. Buffett observed precisely this in his now legendary paper, The Superinvestors of Graham-and-Doddsville. So while buying exciting growth shares might seem to be much more palatable, it’s nowhere near as profitable, if at all.
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Next, there’s the self-perpetuating nature of positive price Momentum. This has been a much more recent observation, and one that’s largely been driven by quants. Over the past 20 years, finance professors and hedge fund practitioners have explored the phenomenon that stock prices that have risen the most have a tendency to maintain momentum - continuing on the same trajectory typically for up to 12 months, and sometimes longer.
Historically, momentum has suffered short, sharp periods of reversal, particularly in bear markets. But in terms of investor behaviour, the biggest barrier to trading on momentum is that it means buying stocks that may have already risen sharply in price - an idea that most investors hate. Ironically, this psychological hurdle is one of the reasons why momentum works. Investors in a stock that’s already risen in price, can be slow at pricing-in further good news about it. This leads to a share price that drifts upwards over time, much slower than it might do otherwise.
Josef Lakonishok, one of the key figures in momentum research (and a fund manager in his own right) credits the behavioural errors of investors as a reason why momentum works so well. He believes investors have ‘a tendency to extrapolate the past too far into the future, to wrongly equate a good company with a good investment irrespective of price, to ignore statistical evidence and to develop a “mindset” about a company.’
So, to summarise, investors have a tendency to see value stocks as risky, quality stocks as boring and momentum stocks as scary. Who on Earth would want to buy stocks with this type of profile…?
Modern day multi-factor strategies
Blending factors to figure out the most influential drivers of success in the stock market is nothing new. One of the most famous is the Fama-French three-factor model, which was published in 1993. That pinpointed stock size, value and market risk as the most important factors. Since then, though, a huge amount of research has been done to assess every conceivable variable that might influence returns and prove that markets are not efficient at pricing shares.
A giant in this field was the late Robert Haugen. As a critic of efficient market theory, Haugen spent years studying market data to model the profile of the ideal stock. In his book, The Inefficient Stock Market - What Pays Off and Why, he introduced Super Stocks.
Haugen’s detailed modelling had uncovered some quite staggering results. He found that the 10 percent of stocks with highest expected return, in aggregate, were low risk and highly profitable, with positive trends in profitability. They were cheap relative to current earnings, cash flow, sales, and dividends. They had relatively large market capitalisation and positive price momentum over the previous year. He wrote: “This is a dream profile, the profile of a stock you would love to own.”
By contrast, the 10 percent of stocks with the lowest expected return had exactly the opposite profile to Super Stocks. These low quality, expensively priced, deteriorating shares he christened Stupid Stocks. Our own research at Stockopedia has highlighted how attractive this profile of “stupid” stock is to individual investors. We believe the attraction comes down to the fact that we’re hard wired to empathise with the optimistic stories that surround these companies. As a result in the Stockopedia lexicon we have rechristened this poor profile as Sucker Stocks.
Haugen’s work was part of a new generation of research into the power of multi-factor models. Routinely, these studies have concluded that Quality, Value and Momentum used together can be highly effective...
What the experts say
Value and Momentum have long been paired as powerful, uncorrelated drivers of stock market returns. Research by a quant team lead by Cliff Asness (formerly of Goldman Sachs, now at AQR Capital) explored this theme in a 2012 paper called Value and Momentum Everywhere. It showed how the two factors can very effectively smooth returns over time. In a later study, AQR showed how the addition of Quality could produce superior returns when combined with Value and Momentum. They noted:
“We have found that three styles are particularly useful in actively managed long-only equity portfolios: value, momentum and profitability. Ample evidence shows that each of these styles can generate long-term excess returns on its own — and go a long way toward explaining why some portfolio managers excel — but research suggests that these styles work even better when united.”
In 2012, US finance professor Robert Novy-Marx published a paper taking a detailed look at the interplay between Quality and Value in investing. His research considered the essence of what is meant by Quality and how it influences Value investing strategies. He concluded that a combination of factors was preferable:
“Over time, tilts towards value, momentum and profitability have outperformed the market, and due to the diversification benefits, a combined portfolio of these three has provided much higher reward per unit of risk and a significant reduction in extreme risk or losses.”
Financial academics and quant statisticians continue to argue in favour of blending Quality, Value and Momentum factors. Among them, the equity research teams at investment banks like Credit Suisse and Societe Generale, among others, have modelled investment strategies based on very similar multi-factor approaches.
Digging into QVM
In general terms, a Quality company is one that is highly profitable ( ROCE, ROE, GPA ) with high industry leading margins, stable, growing and ideally accelerating sales and earnings, with a strong and improving fundamental trend (F-Score), a good shareholder payout (Yield, Buybacks) without having any risky red flags (e.g. Bankruptcy risk, Earnings Manipulation Risk or Share price volatility).
When it comes to valuing a stock, the most common measures focus on what a company earns or what it owns. Therefore, the most frequently used valuation ratios compare the share price to earnings, book value, cashflow or sales. Alternatively, it may look at the earnings yield or even the dividend yield.
A Momentum stock is one whose share price is up or above its 52 week highest price, is within the top 20% of share price percentage winners for the last 6 or 12 months (using Relative or Absolute Price Strength), is beating broker estimates (earnings surprise) and seeing estimate upgrades and recommendation changes.
Tracking the performance of Super Stocks
To get an idea of how stocks with the greatest exposure to Quality, Value and Momentum have performed in the UK in recent years, we can use the Stockopedia StockRanks. The following chart shows the performance of stocks using the following rules:
- Market Cap > £10m
- StockRank > 90 (i.e. high quality, attractive value, strong momentum)
Since April 2013, a quarterly-rebalanced portfolio of stocks (with a minimum market cap of $10m) ranking in the top 10% of the market for their combined quality, value and momentum has returned 67%. The lowed 10% of stocks against the same rules has lost nearly 57%.
What we can learn from Super Stocks
A compelling reason for looking closer at Quality, Value and Momentum in stock market investing is that decades of research shows that stocks with high exposure to these factors are often overlooked. Investors are generally predisposed to stories, good news, popularity, and excitement. They veer away from shares that appear to be troubled, staid or have seen their prices rise in the recent past. Yet it’s precisely this profile of stock that tends to win in the stock market...
Perhaps it’s best to leave you pondering this point with a marvellous quote from Teddy Roosevelt:
“Nothing in the world is worth having or worth doing unless it means effort, pain, difficulty… I have never in my life envied a human being who led an easy life. I have envied a great many people who led difficult lives and led them well."
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Phil - That is a very impressive performance from your fund. It looks as if you even managed a decent 2014 perhaps because you were also including stocks from Europe as well as the UK.
Personally, although the stock ranks (or some similar filter) is very useful for selecting stocks, I then switch to a simple momentum measure when they are in the portfolio and would not swap them out just because they fall out of the top 10% high momentum stocks. If they can stay in (say) the top third then I think they deserve their place.
I guess the stuff about fat tails etc is deserving of a post of its own some time really. But the one key takeaway "revelation" for me was "sell your losers - not your winners". I know it is mentioned a lot on Stocko but it is vital. Don't set limit sells. Don't get in the way of a stock which is still moving upwards and has positive news flow.
Hi Ed, sounds like you are having fun and working hard. Thanks for the post.
I am intrigued by Jason Hsu idea that factor returns are cyclical and therefore, predictable. However, evidence also exists that indicates that the end investor isn't fully benefiting from this insight due to behavioural biases. Specifically, this is caused by performance-chasing.
You mention this yourself, no factor does well all the time, not even Joel Greenblatt or Mr Buffett (who seems to have had a tough 2015 by his high standards) - so it might be interesting to see what has done well, and what has done badly on a 12M and 5 year view?
Is a 12M view is that useful in the context of factor cyles? The higher the sampling frequency, the higher the chance(!) you hit gambler fallacy. 5 years maybe, though at this point in time the past 5 years from today is a very special period (post-2009 bounce) where long term effects may be blurred.
Hello Phil,
I would like to ask you about momentum on 2 of your holdings being Character (LON:CCT) and Epwin (LON:EPWN), for me Character (LON:CCT) momentum has been lost, if I was a holder I would have sold out around 500p, also the outlook is rather uncertain. Epwin (LON:EPWN) does not seem to have much share price momentum, I do hold this one but think I will sell soon.
Hi Herbie,
The first thing I want to say is both stocks have 90+ Stockopedia Momentum Ranks
I use Ichimoku charts to evaluate price momentum (but all sells go on hold if the market gets very unsettled)
So here is the chart for Character ...
First look back to late August as the price approached 550. There's a big gap down. I'm not selling there as the cloud underneath often acts as a support. The price tightens and consolidates and in hindsight I should have sold around November as I even posted about a pinch occurring in Character Group on November 9th. I should have sold on the spike down in late November/early December and I definitely should have sold around christmas when it went below 475. Perhaps my annoyance at not acting on the pinch prevented me from acting? Perhaps I missed the spike down and saw the spike back up again and left it? That said looking left on the chart the flat bases of the cloud ('shadows') can form support lines and the price rallied strongly from 450.
However for now Character is neutral in terms of price momentum. Perhaps it's a candidate to swapped out? With a stock rank of 99 I'm in no hurry to swap it out especially as I don't want to over trade particularly as I'm heavily focused on European stocks where I incur a 1% FX charge on buys and sells.
Here's the chart for Epwin ...
So I don't generally sell automatically sell when the price breaches below the cloud (Kumo) as quite often the cloud can provide support. So I'm looking for a concerted break below the cloud or significant support levels below the cloud. It would be very rare for me to sell with the price action above the cloud. Again looking left the flat base of the thick cloud formed in July/August has repeatedly provided support (around 115). With a StockRank of 97 again I'm in no hurry to exit.
I'm not saying I'm a robot with hard and fast sell rules so I'm not a true quant but rather (as with my model of psychotherapy) I integrate approaches and sometimes I get it wrong or miss something but I have a clear idea of what I'm trying to do and sometimes we need to let a stock breathe a little, especially if its been on a run and even more so if it's a small company.
I hope that helps.
Phil
Phil, thanks for your detailed answer. I do not use Ichimoku charts myself but I can see how they can help. Yes its difficult in this market to know when to sell, I have been inclined to take some profits and increase my cash proportion as I think there is some way to go before the market settles down and I'm still not finding many shares to buy. Re: CCT and EPWN the share price has not fallen that much so you maybe right to hold. Did you see Jane's articles on £CCT?
I have briefly seen Jane's writings on various subjects including Character and it's clear she's a talented an thorough analyst. However:
1) Can I work with or interpret what an analyst has to say and what impact does that have on my investment?
2) By listening to external analysts/commentators I'm starting to externalise my investment decision making process. I don't like that because ...
3) On results day or when strange price movements are happening, I'll be seeking that external input to guide me.
Each to their own of course.
Best of luck
Phil
"He found that the 10 percent of stocks with highest expected return, in aggregate, were low risk and highly profitable, with positive trends in profitability. They were cheap relative to current earnings, cash flow, sales, and dividends. They had relatively large market capitalisation and positive price momentum over the previous year. He wrote: “This is a dream profile, the profile of a stock you would love to own.”
But there aren't any.
But there aren't any.
Well do you change your investment approach or do you change the pond you fish in?
Here's a screen that looks for Superstocks and filters out stocks with P/FCF < 14 and mkt cap > £50m
In Europe & USA it generates 52 potential candidates!
Maybe if the screens aren't generating options it's time to keep your powder dry?
Best of luck
Phil
P.S. Edited to include link
Only 4 in the UK. Wizz Air Holdings (LON:WIZZ) I have considered and still am but I have have others in that sector already. H & T (LON:HAT) I think will be good in a recession but it has not done much over the last 10 months, not sure why its a superstock? Debenhams (LON:DEB) and Shoe Zone (LON:SHOE) hmmm, 2 retailers I don't regard that highly, again I would not regard them as potential superstocks. For retail I would be looking for more online based ones like Boohoo.Com (LON:BOO).
Yes find whatever system works for you. I always welcome 2nd or 3rd opinions on shares, I can look at results but not always interpret them or miss something in the balance sheet. But yes I take your point, its frustrating when results are out there is no coverage. I will be hoping for Paul to review Hydro International (LON:HYD) and STM (LON:STM) results today but even without, the results look good and I'm happy to hold both.
Phil - excuse my lateness to reply and can I say a huge thanks for this enormously helpful post! Took me a week to understand it (most of it!) but it was well worth the effort. As a Stockopedia newbie it's amazing how quickly I can learn from the community - I feel like it's saved me years of expensive mistakes! So cheers for that :)
Julia
Click on 'Ranks' at the top of any page & select 'Top StockRanks'.
On this page select 'Performance', top left.
You will arrive here : https://www.stockopedia.com/stockranks/performance/
From here use the drop-downs to change region, factor or company size.
Hope this helps.
PS all of the above directions refer to the old website. If you are in the new site, the StockRanks can be found on the Home page, 2/3rds of the way down, on the right.
I am a firm believer in "future" stocks for the 15% speculative section of my portfolio - over the last 18 months, this has included Apple (+150%), Ilika (LON:IKA) (+126%) and Itm Power (LON:ITM) (+158%). Over the same period I have also put spare money into my grandchildrens' JISA accounts, half into individual shares and half into Investment Trusts favouring non-UK stocks - Scottish Mortgage Investment Trust (+135%) did well for my grand-daughter and now amounts to 25% of her portfolio
The real dogs in my portfolio (by value) have been "safe" income producing shares - Carillion (-100% !!!), Lloyds Bank (-34%), Centrica (-81%) and BT (-55%). Unfortunately, I did not investigate the dropping prices at the time. Another one of my "dogs" is Topps Tiles (LON:TPT) which has an 85 StockRank value but is 58.5% down on what I paid. (Does this 85 mean that I should still have faith in its eventual recovery ?)
Having just become a Stockopedia member, over the next 12 months, I'll liquidate 25% of my low StockRank value holdings (apart from my "speculative" holdings) and invest the resultant £40,000 in stocks recommended here. If that produces better results over the 12 months than the original portfolio would have done, I'll carry on with Stockopedia; otherwise, I'll just go back to investigating stocks that take my fancy.
I would suggest that it is never a good idea to buy shares that are going down in price. Often it is better to buy them when they are going up. But there can also be a case to buy them when they are going sideways if you have good reason that the business prospects are improving.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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I've been reflecting upon this.It's probably worth having Ed's Taxonomy of Winners handy. A Superstock scores high on Q, V & M, however a stock can have a high StockRank but only score highly on two factors, e.g. Q & M or Q & V, etc.
I have two screens, one searching for cheap growth and the other looking for value, however they both have a common base which checks for tight spread, sensible or no debt, no bankruptcy concerns, low price to sales for the industry, earnings growth for 3m FY1 & FY2, no 1m earnings downgrades for FY1 & FY2, low risk adjusted peg for the industry (this is a great value criteria), reducing PE estimates (FY1 vs FY2). I also add in balance sheet checks: a positive price to tangible book value and current ratio > 1.2 (from Paul Scott's SCVR)
So at a base level I'm looking for cheap growing stocks. Robbie Burns (Naked Trader) encourages you to find something to drive the price and for me the cheap potential earnings momentum is just what I'm looking for. I use the risk adjusted PEG to ensure I'm not overpaying for it. This means if they miss their estimates the price isn't going to get slaughtered as they are reasonably cheap. I also try to avoid stocks with weak balance sheets or at risk of insolvency or accounts manipulation.
For my growth screen, I then add additional criteria that look for a positive EPS Growth %, a greater than 5% 1yr rolling EPS growth rate, and a positive sales growth % and finally I filter for stocks with a stock rank of greater than 90. This screen spits out HighFlyers (high Q & M) and the ValueRank for these stocks tend to be greater > 40 as I guess my cheapness criteria helps to weed out very expensive stocks.
For my value screen, I still want positive a EPS growth % and a positive sales growth % but I'm less demanding, I then add filters for QualityRank (> 80) and ValueRank (> 80). This screen spits out SuperStocks.
If you run the filters on the UK market you get very infrequent selections. Currently only the value screen is highlighting Trans-Siberian Gold (LON:TSG). However, if you are open to the EU and US markets you can get a variety of stocks as the ValueScreen is highlighting three stocks, Trans-Siberian Gold (LON:TSG), one Swedish stock and a French stock all of which are SuperStocks. The GrowthScreen is highlighting seven stocks from Finland, France, USA, Austria & Poland.
At this stage I just don't go out and buy these stocks. I follow this approach:I then select the stocks that are breaking out and have a good risk reward profile. I might add to a position if it keeps appearing on my screen and it continues to post positive news and it keeps increasing in price.
I monitor the portfolio most evenings by taking a look at the Ichimoku charts as they enable you to quickly evaluate if momentum is turning. I don't use broker stop losses but I have notional stops that I monitor.
I sell when a stock breaks the notional stop losses, usually the day after of a few days after. I might also sell if there is bad news but to be completely honest I don't tend to monitor news flow. Sacrilege to some perhaps <shrug>. I don't sell when StockRank wanes, rather I just let the price momentum take me out the position. I do my absolute best to run my winners and cut my losers. Generally I don't rebalance unless I see a really good opportunity and I have no cash. In that scenario I might switch horses particularly if an stock has started to consolidate and has a reduced StockRank. Typically then I purchase SuperStock or HighFlyers. I sell the HighFlyers as the transition into FallingStars (the cheap growth hopefully means that this doesn't happy with a BUMP). I sell SuperStocks as they become Contraian (loss of momentum). It might well be that they recover and are great value, but I'm not prepared to wait for others to work that out. It could take years.
Exceptions to the stop loss selling strategy are when the market has a wobble, e.g. the market in the last few weeks. I let the dust settle and just watch. Most of the stocks will start to recover but I sell the ones that don't and move on. Finally I have of late used the NakedTrader strategy of shorting an index to hedge if I think the market is looking bearish. I was probably a little late this time around but I'll keep it in place for now.
I know very little about the companies and people rarely comment on the stocks I hold so I'm not swayed (for good or ill) by anyone else's opinion. That is the best thing that has happened to my investment approach (in psychology we call it internalising your locus of evaluation). If things go wrong I can't blame anyone else.
This approach has worked for me for the last three years but who knows it could go BANG next week? I owe a debt of gratitude to Ed and the Stock team for providing me with the tools and data, Robbie Burns for his easy to understand approach and Paul Scott for the balance sheet tips. The combination of these tools and strategies has been transformative and has allowed me to smash the performance of those 'in the know'.
It's been suggested that high stock rank increases your winner hit rate and I know from a previous snapshot analysis it appears to significantly reduce your big losers but I also wonder if my strategy of picking stocks that are breaking out also increases winners and reduces losers. Also because I'm not holding for a set period I can cut losers quickly.
I appreciate that not everyone will have the time to monitor their positions most evenings so you have to find a system that work for you.
Best of luck
Phil