Should investors always avoid lowly ranked stocks?

Should investors always avoid lowly ranked stocks? sounds like a question with an obvious answer. After all, Stockopedia subscribers will know that the lowest-ranked stocks on the QVM measure, which we often call Sucker Stocks, have a terrible track record:

However, in a recent article, I raised an uncomfortable possibility. Since the lowest-ranked stocks on each of the ranks perform very poorly, should investors avoid the lowest-ranked stocks for each of the individual Q, V, and M ranks? For example, here is the long-term chart of the performance of the Value Rank in the UK:

As expected, the average stock with a Value Rank below 10 performs terribly over the long term. Included in that set of stocks will be some real stinkers, such as persistent loss-making companies with no asset backing. However, there will also be some High Flyers, stocks with high Quality and Momentum Ranks that have risen so far that the Value Rank is now very low. Do these stocks buck the trend and keep performing, or does that low Value Rank drag them down like the rest of the lowest-ranked stocks? After all, Momentum investors need to be wary of “Stale Momentum”, where stocks have Momentum for so long that corporate mean reversion is the more powerful effect.

Alex has helped me answer this question, together with the equivalent questions for the other “crossover” styles: Should Contrarian (high QV) Investors avoid stocks with a low Momentum rank, or should Turnaround (high VM) investors avoid low Quality-ranked stocks?

The test

To answer these questions, Alex has backtested investing in an equal-weighted portfolio of each “crossover” stock style. For technical reasons, using the Stock Style classification itself makes the effect hard to measure. So, instead, we have gone for a simple setup. To measure the impact of Momentum on Contrarian stocks, we looked at the set of stocks that are greater than 75 on both the Quality and Value Ranks and asked the question, how do portfolios of the different quartiles of Momentum Rank perform? We go back 10 years with annual rebalancing. The same goes for the other “Stock Styles”.

The results

Contrarian Stocks

For contrarian stocks, the Quality and Value Ranks are high (>75), and we look at the impact of the varying Momentum Rank on these stocks:

In this case, the outcome of this backtest is pretty clear. Investors who prefer to look for Quality-Value stocks would benefit from paying attention to the Momentum rank. A high Momentum rank isn’t a guarantee of success, but over almost all periods, investing in cheap, high-quality businesses that have poor Momentum leaves investors swimming against a strong tide of underperformance.

Turnarounds

For turnarounds, the Value and Momentum Ranks are high (>75), and we look at the impact of the varying Quality Rank on these stocks:

The impact of the Quality Rank on turnaround stocks is less clear-cut. The lowest quality stocks come out worse in this backtest. However, the bulk of the underperformance came in the latter half of 2024. Low-quality stocks also had limited periods of swift outperformance. The best quartile was actually the above-average but not great quality companies. I’m not sure the outperformance here is consistent enough to conclude that turnaround investors will always do badly in low-quality stocks. However, it looks like they may have a less volatile time by focusing on above-average quality stocks, and that in itself has some value.

Including the Quality Rank may also protect turnaround investors during the worst of times. Here is a zoom in on the period from 2022 to now, which highlights the poor performance of the worst quality stocks after the UK budget:

Again, this isn’t a huge sample size, so it may be a coincidence, but there is probably nothing wrong with being cautious and avoiding the worst quality stocks during challenging times.

High Flyers

For High Flyers, the Quality and Momentum Ranks are high (>75), and we look at the impact of the varying Value Rank on these stocks:

Again, this is a more nuanced outcome. The lowest Value-ranked High Flyers came out on top. However, the bulk of that outperformance came during periods where investors were particularly enthusiastic about “compounders” and seemed willing to pay up for business with such characteristics, i.e. 2016-2018 and 2020-2022.

Again, zooming in to more recent times, it seems that in the current markets it may be wise to avoid the lowest Value-Ranked high flyers:

Overall, the conclusion here is perhaps not as strong as the others. It appears that the Value Rank is not always a good indication of High Flyers to avoid in all market conditions, but may well be worth paying attention to in more difficult market conditions.

Why not just invest in Super Stocks?

While writing up this article, there is a voice in the back of my head (possibly Ed’s) asking why bother with this analysis when one can invest in Super Stocks, which have reasonable scores in all three ranks? I think there are a few reasons:

1. Most of us have a preference for a particular type of investing, and it often aligns with one of the “crossover” styles better than the Super Stocks. Personally, I look at the list of current Super Stocks and see some with forward P/Es of around 30. I’d struggle to buy those, no matter how strong their Q and M Ranks.
2. Most of us are not purely quantitative investors, so we are not buying and selling hundreds of stocks on a specific date. This means that the Ranks of the stocks we invest in will change over time. What started as a Super Stock may become another winning style, such as High Flyer, but that doesn’t mean we should sell. I once wrote an article about Surfing the Stock Ranks, with the thought that an investment could benefit from several different styles during a successful investment journey.
3. The Super Stocks can tend to cluster around certain sectors. Financials, Industrials and Consumer Cyclicals comprise the bulk of these at the moment. People businesses are often rated highly by the algorithms but rarely by the market, for good reasons. Therefore, restricting ourselves to only Super Stocks may lead to missing other opportunities, even if the core principles are sound.

Conclusions

This has been a very valuable exercise for me because my preferred style is investing in Contrarian stocks. Here, the data suggests a clear course of action. On average, I will do better investing in these types of stocks if I don’t buy them while the Momentum Rank is very low. For the other “styles”, the outcome is not as obvious. It seems Turnaround investors may get smoother returns by only investing in above-average-quality companies. Finally, it seems that investors in High Flyers would benefit by looking at the Value Rank during more challenging market conditions, but not during boom periods.

Addendum

While it appears that the Value Rank doesn’t always indicate when a High Flyer is no longer a good investment, there may be better indicators of when to avoid these. Anecdotally, it seems that selling when a High Flyer becomes a “Falling Star” is too late. Take investor favourite Warpaint London (LON:W7L) as an example. This made investors a lot of money as the shares went up 6x between mid-2022 and mid-2024:

By the end of 2022, the company had high returns on capital and good fundamental momentum. However, it never looked cheap on many metrics, so this was classified as a High Flyer by the Stockopedia algorithms. Further fundamental momentum became share price momentum, and the company remained a High Flyer. It stayed there until a share price fall to £4 reclassified it to a neutral rating in mid-February this year. It had become a Falling Star by the end of February, by which time it had already lost investors around half their money from the peak. Of course, it may still be worth selling now as its current Falling Star designation is a losing Stock Style. However, in this case, it would have been better to exit before the Stock Style changed.

I don’t think any investor consistently manages to get in at the bottom and out at the top. However, if it is possible to find better signals that allow investors to exit a High Flyer before a stock gives back most of its gains, that would be great news for investors in such stocks. I will be looking for these indicators in a future article.