New Year 'Naps' - Top 10 Stocks for 2015

Morning Vik - sounds like a good start for your Nap portfolio.

Is your question about the best time to pick the naps or when is the best time to buy into the market generally? If the former, Ed may have some data on whether there is some kind of seasonal pattern to Stock Rankings/share price performance patterns. His strategy of buying last January seems to have been very successful compared to some of the other portfolios devised later in the year. If the latter, my experience is that although the market in general shows some seasonality, buying (or selling) based on a previous year's pattern is tricky. As soon as a trend is identified it repetition seems to break down.

There are a few general adages that may be broadly helpful but are by no means infallible. There has been a bit of a year end Santa rally so far (fund managers acquiescing to higher prices on thin/nil volumes to window dress year end fund performance). We often see a further rise in the first quarter peaking late March as retail investors fill up their ISA allowances and II's place their capital allocations for the new year. There is then a bit of a sell off as activity tails off - leading to another established saw of "sell in May, come back on St Ledger day" (early September as I recall).

Of course, laid over all this are event driven market moves that can break up these patterns. Last year we had marked sell offs due to concerns over Greece, China, oil price etc.. Many of these factors are still latent going into 2016. Short answer is that calling market timing correctly is difficult - probably even harder than for a specific stock since there are so many more variables for the market as a whole.

My personal approach is to phase my investment over time - hopefully missing the peaks albeit at the risk of missing the troughs - and once invested staying in the market rather than trying to trade in and out due to the expenses involved and the view that time (ie compounding) is more important than timing.

Good luck with your investing.

All the best,

Gus.

If you have not seen it you should read this: http://www.stockopedia.com/content/semi-year-snaps-more-top-stocks-for-2015-103099/

This was after 6 months. Your theory seems to make sense but a lot will depend on timing. 3 months maybe to often? Some sectors its difficult to find 2 stocks with high enough ranking, such as Ultilities, Telecoms, Health.

Thats sounds like a good idea, must admit I'm gutted having missed out on most of the naps in January. Not keen on H&T myself. I would consider Novae, which is similar company to Catlin, SR 96.

Hi Paul,

It's interesting that you've included Cenkos Securities (LON:CNKS) and Quindell (LON:QPP) in the same paragraph as they seem like their fortunes are rather tied at the moment with Cenkos being the last advisor standing for Quindell.

When I did my research on Cenkos I stripped out the profit from the AA so I could get a feel for what a normal year would look like - clearly, I didn't do enough research as I could have spotted that they advised Quindell - an expensive mistake!

Regards,

Sully.

Hi Paul,

Firstly StockRank isn't a momentum based approach, it's a hybrid - Quality, Value & Momentum based approach.

Sooner or later there's going to be a change of trend, and momentum strategies will stop working.

Of course stop losses will be triggered and portfolios will turn over to cash. It doesn't have to be the case that this occurs as a dramatic crash, but it could be. It could be that a momentum approach keeps you out of a bear market as opposed to a value investor who sees opportunities coming out of the woodwork.

Also a loss in momentum in stocks with a high StockRank doesn't necessarily mean you'll end up with overvalued stocks. In fact if you're selecting stock with 97+ StockRanks on the whole you'll be selecting high ValueRank stocks too.

As regards momentum, if you look at the US indices (which drive everything in the UK too), then it's been a continuous rising market, with occasional small corrections, since 2009. So that would greatly flatter momentum investing strategies in the last 5-6 years.

Well that only flatters momentum approaches if you think it will stop any time soon ... 5 years+ and counting.

If I'd told you in 2009 that the markets would go on a bull run for 6 years+ would you have used a momentum based approach? If the answer is No, then surely you've missed out on some major gains as you waited for stocks to correct and fall into traditional value territory. My own portfolio closely mirrors (in terms of holdings as opposed to value) my fantasy fund and has gone up by 56% in 23 months. Very early on in the establishment of this portfolio I switched to a QVM/QGM approach (heavily influenced by the Stockopedia research and The Naked Trader approach)

Who's to say that this market won't go on for another 5 - 6 years? Patience is the watch word of the value investor. The value investor knows best, has done the research, spotted the opportunity that the market has missed and is sure they have it right. They are so sure they even buy more stock when the price drops. Maybe my watch word is 'adapt'.

If the market conditions change, I'll look to adapt my strategy. Even if a catastrophic market event happens and wipes 30% off my portfolio I'd still be significantly ahead of most other private investors. Personally speaking even the growth shares I buy are cheap in terms of growth so I'd be very surprised to see 30% wiped off my portfolio.

With respect to Quindell, it's never popped up on my screens but I did take a 13% gain on a punt in the recent upetty/downy ride. However I did buy Let's Gowex SA (MCE:GOW) when it appeared on my screens and it did run into serious problems. That however was only after I bought and sold it again (when it lost price momentum) for a 166% profit. My point is in a diversified portfolio whilst attempting to avoid total losses with screening parameters:

1) a share that may well go under can still be bought and sold before the disaster strikes (of course I'm not looking to buy into companies that are headed this way but it happens)

2) even if the share did pan with a portfolio of 25 shares it isn't disastrous

Ultimately, you are a hunter whereas I'm a farmer and this plays into this statement too

So it's still vital to properly check out every company

The definition of "properly check out" is subjective. For me my screening rules help me to weed out the duffers as best I can and I read recent releases. I evaluate risk/reward by generating price targets and considering points of technical support. I know that this will be quite different to your definition of "properly check out", e.g. I rarely if ever look at the accounts (sacrilege to some I know) but rather I 'rely' on the Stockopedia metrics that drive my screens, e.g. P/S, Altman, Montier, EPS estimates, PEGR, etc.

I recognise that not all of my choices will work out and so I sell them at a loss, knowing that my other selections will (so far) in general do well. The exception to this selling strategy has been when there has been a market wide sell off. In this situation I tend to sit tight for a while, let the dust settle and give the winners a chance to recover.The ones that falter I sell and move on until they pop back up on my screens at some stage in the future. On average I hold for a year to 18m but this can be skewed by the relatively quick selling off stocks that falter.

I guess in this post I'm trying to offer an alternative to the Value only approach that requires detailed company research. I try to not get an emotional attachment to my stocks and I expect to get some wrong. I think in the Value approach there is a lot riding on one's evaluation of a company and as such the ego can become wedded to a selection. Each to their own I suppose.

Disclaimer, this is very much my own approach that I have developed it over time and it could be fluke, good fortune, market conditions, etc. etc. I'm no means an investing expert so there's my wealth warning. What I do say though is that I'm completely transparent in my selections which you can see in my fantasy portfolio. I'm passionate about providing a way for the every day Joe/Jo to manage their own financial future without needing to know the ins and outs of accounting principles and as such to me that doesn't sit well with a value based/hunter based approach whereas a farmer approach does.

Enough rambling.

Happy New Year and I hope you all enjoy a prosperous 2015

Phil

Interesting selection, David. Not sure I would class Reed and Galliford Try as Industrial. Cenkos depends on Quindell investigation which of course screens will not pick up on. Yes Dee looks good, just bought some myself. Energy depends on oil price. Looking at a few others on your list, hope the sp will fall back a bit. Looking at ZYT in technology.

On the subject of diversification...

I think it's important to say that this article isn't designed as an investment system. I've selected the top ranked stock from each sector to write about as it's a broader set of stocks and makes for a more interesting discussion. I could have selected a set of stocks that I personally believe have a higher probability for outperformance in 2015 - which would have been more concentrated in fewer sectors - but that would have skipped over some of the subjects we are now discussing - like diversification and risk. Important topics and I'm glad they've been brought them up.

We have been writing a lot of articles in recent months on the subject of risk, diversification and portfolio management which you can catch at this link. It is a complex topic and one that depends on one's personal portfolio size, time horizon and tax status. As a result there's really not a one shoe fits all approach here.

Equities obviously are only a single asset class among many. We love equities here but as a result this post can only cover the subject of diversifying within equities. The first thing anyone should do is ensure they are diversified away from equities too - but that's beyond the scope of our site at present. There's bags of literature on this subject though which Google can help on.

There are though several schools of thought on the subject of diversification within the equity asset class. These include breadth, sector diversification, geographic diversification, factor diversification and correlation. All these ideas try to reduce risk, volatility and drawdowns in portfolios... but often the more one diversifies, the more one sacrifices returns in the process. The extreme of diversification can be thought of as an index fund - which gives you the market or index return - so one doesn't want to take it too far. All of us here invest directly in equities because we want to improve on the index return - so all that follows in the next few paragraphs needs to be taken in moderation. The goal is to maximise the 'risk adjusted return' - i.e. to reduce risk, but not sacrifice all the possibility to beat the market. We don't want to completely cage the bird.

So here goes... firstly on portfolio breadth - I've written an article on the subject here which I won't duplicate, but essentially there's a lot of evidence that one should diversify across 20-30 stocks as soon as it's economically feasible rather than the 5-10 that most naive investors favour. There's a far lower risk of ruin investing in broader portfolios, and the upside is just as strong with lower risk.

By factor diversification I mean diversifying across stocks that have exposures to Value, Momentum and other return drivers. This is a more modern approach to diversification - it ensures you won't be only exposed to e.g. value stocks when value investing goes out of vogue. Nobody wants to be stuck in value stocks when there's a bull market in other parts of the market (e.g. late 1990s) - so diversifying across other 'factors' like momentum stocks helps returns and lowers the risk of underperformance. I've written on this subject many times, and the StockRanks system to some extent helps ensure exposure to these ideas. Some believe you should take half a portfolio of Value stocks, half a portfolio of Momentum stocks.. others believe you should just buy Value & Momentum stocks (like our ranking system) - how one skins the cat is again a personal decision.

I appreciate I may be going off topic as the question I was asked predominantly relates to sector diversification. But my take on sectors is quite simple - try to focus on high probability shares while avoiding concentrated sector exposures. One doesn't need to mirror the sector weightings of the index or get too neurotic about ensuring exposure to all parts of the economy. What we should be trying to do is ensuring that we don't get caught out investing in purely e.g. energy stocks when the bottom falls out of the energy market. We sometimes never know when an issue will hit a part of the economy, so it's prudent to diversify sector wise. How much is a personal decision - utilities may never make you rich, but they sure can provide a defensive base in rough waters.

We use the Thomson Reuters Business Classification Schema for sector categorisation which includes 10 economic sectors. I think it's a good system. Though there are others like the GICS classification or the FTSE sector classification which we don't publish. You can read up on TRBC here. I also personally further segment the market into 3 super-sectors - cyclicals, sensitives and defensives - which I'd like the site to reflect over time.

• Cyclical: Financials, Basic Materials, Consumer Cyclical
• Sensitive: Energy, Telecoms, Industrials, Technology
• Defensive: Consumer Defensive, Healthcare, Utilities

And of course one shouldn't forget that most UK portfolios are exceedingly biased towards the home UK market. Home bias is a well researched blight on portfolio returns as it ignores the returns to foreign stock markets and economies- never ignore geographic diversification. There's a lot on this subject in our ebook Getting Started in US Shares. The UK is a mature market with an ageing demographic - should we really be ignoring the big opportunities abroad? You don't need to go and buy foreign listed stocks -one can gain exposure to foreign markets through UK listed stocks, but it does need some conscious effort to ensure stocks selected have foreign sales exposure. This isn't something we can do yet at Stockopedia but I'm hoping we'll be able to in the not too distant future. (Of course you can research US and European listed shares here.)

I'm sure with all the above I've lost a few readers. Investing should be simple, but it shouldn't be made hard. There's often too much to think about when diversifying and fulfilling the above checklist may seem impossible. The software will help on the above in future - but it doesn't quite yet - so it needs to be a personal, conscious thought process.

I will leave this extended comment with one last thought... volatility is designed to separate fools from their money. We diversify to reduce short term volatility - creating safer short term returns often at the expense of long term returns. Reducing volatility is a balm that makes us feel safe, but it can ultimately ruin our long term returns if taken to extremes. I believe everyone investing in equities should try and feel comfortable with risk, and comfortable with occasional short term pain for long term gain as long as they are exposed to real return drivers.The best book for understanding this ideais here.

So my own personal take is to diversify just enough, but not too much... I call it Goldilocks diversification... and it's very hard if not impossible to know when you've got it right - so don't sweat the small stuff !

Ed,

Will look forward to the backtesting facility. Think you are correct that there are to many, "budding Buffets" after QV type stocks and that momentum is not sufficiently considered. An interesting Autumn 2014 paper called, "Fact, Fiction and Momentum Investing" by Asness strongly suggests that Value should be combined with Momentum (VM) for best results. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2435323

Ian

Hi Phil,

QVM is preferable to QVGM because the academic research shows positive returns to Quality, Value and Momentum but negative to Growth. Any outperformance in the short term is probably just noise and a reflection of the market overpaying for some big name growth shares Ocado (LON:OCDO) etc. The returns to these factors need long term commitment - probably why they keep working. In all markets, shares, countries and time periods the market simply overpays for growth, on average, over the long term and leads to negative relative returns to growth.

Re: your choice of 97.5% cut-off i think this may be too tight - it implies a level of refinement that really doesnt exist. You may be better off widening your stock rank criteria and filtering out the likes of Quindell (LON:QPP) and Lets Gowex via Earnings quality or financial distress metrics e.g. Beneish M-Score and Altman Z-score to reduce your choices to the right level of shares. Since you like the purer quantive strategy the book 'Quantitive Value' would show the benefit of following this approach.

HTH,

Mark

I'd like to add a few comments on why QVM gained favour over QVGM. Initially (for a few months) we favoured a QVGM StockRank, but dropped the 'G' (Growth) for a number of reasons. It wasn't because QVGM as a model was underperforming (it wasn't at the time), but because there were strong reasons to ditch growth as a factor which we became convinced would make it underperform over time. This was a very tricky decision, partly because Growth is such a popular factor for stock picking, but I think it was the right one. It really boiled down to the following 4 key reasons.

1. Little Academic backing - As dangersimpson has mentioned, there's little academic research that backs up using "Growth" as a core factor in a long term stock selection model. Stocks that have high exposure to Sales and Earnings growth actually have a tendency to mean revert - i.e. past & forecast high growers don't continue to outperform - and often they underperform slower growers. This has been backed up by the raw returns to the GrowthRanks as evidenced in the chart below. The top 5 Growth deciles have all returned similar amounts => there's been little alpha for Growth stocks !

On the other hand the literature has long shownthat stocks exposed toValue and Momentum as factors tend to outperform, while a lot of the more recent literature is backing up the idea that Quality factors have some impact (especially low volatility / high profitability or blend approaches ) - indeed the top 10% of ranked stocks for each of Q, V and M have outperformed all other deciles to a far greater extent - none more so than Momentum stocks as shown below.

2. Correlation - In our analysis we found that the stocks exposed to Growth were highly correlated (similar) to those exposed to both Momentum and Quality. i.e. Growth wasn't adding any new information. What you really want is a set of uncorrelated factors as there should be higher risk adjusted returns. We found Quality and Momentum were somewhat correlated, but Value and Momentum were inversely correlated. Q, V & M were the best set of the 4.

3. Arithmetic - If the Value factor was 1 of 4 factors in our model, stocks would only have a 25% exposure to value. Value has long been one of the most powerful stock selection factors - portfolios of cheap stocks tend to outperform those of expensive stocks in almost every 5 year cycle. What was happening in the QVGM model was that much more expensive stocks were qualifying in the top ranked sets. In QVM, there's a 33% exposure to the Value effect. Many academic models seek higher exposure to Value, so we were more comfortable with a higher exposure to value.

4. Simplicity - I'd be lying if there weren't some other lesser, but still important motives for favouring QVM. A lot of our goals with the site (and ranks) are educational as well as alpha generating. QVM is simpler and more understandable, and a stronger educational framework. Also Quality in the academic literature often contains growth factors so there is scope for its extension.

There may be some portfolios of QVGM which have outperformed over the last couple of years - but there are many ways to skin a cat. From a top decile perspective the QVM portfolio has strongly outperformed QVGM. I'll publish those results in due course.

I'll answer the sector question a little later !

Hi Ian, Yes I will be tracking the above portfolio similarly - and I'll post a link once I have.

I favour broader portfolios when using ranking systems as you are more likely to end up with a similar return to the top decile return. Concentrated five or 10 stock portfolios tend to have a huge variability of return - and it's quite possible a portfolio can under perform substantially in a single year even when constructed carefully.

So I'll be just as interested in how the 20 stock portfolio (including all the 'honourable mentions') performs. Often only 1 or 2 stocks in a 20 stock portfolio drive a large proportion of the gains, and it's incredibly hard to know which stock will pull it off beforehand - the fewer stocks listed, the more likely you will miss out on one of them. I have definitely moved me away from the 'put all your eggs in one basket and watch that basket' camp. Check out this article for more detail.

Regarding the VM & QM ranks. We will be launching the StockRanks 'back-tester' within a month or so which will allow you to view their results in a lot more detail. What we've found is that the Momentum Rank has outperformed the Value Rank over the last couple of years, which has outperformed the Quality Rank. Taken together the VM and QM have done much better than the QV portfolio.

I think there are several reasons for this - but my gut tells me that QV (or the strategy of buying 'good', 'cheap' stocks) is underperforming because it's the most well followed. There are still too few investors that trust 'momentum' which may be the reason it's often underpriced.

I'll try and post up some QM, VM results from the backtester in due course - we're doing a lot of optimisation work to get it ready for production on the website. Good news is we've got the speed down to just a few seconds for printing the performance charts - so @PhilH it's getting there. We will launch the UK backtester first and hope to follow up with the EU and US ones shortly afterwards.