Super Stocks - why multi-factor stock selection offers higher returns at lower risk

Friday, Feb 26 2016 by
Super Stocks  why multifactor 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.


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…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>

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Edward Croft 27th Feb '16 24 of 43

In reply to post #122606

I think it was Joel Greenblatt who said that one of the reasons these kind of strategies keep working is because so often they don't. Greenblatt found in "The Little Book that Beats the Market" that there were regular 2 year periods over a 30 year test where his strategy ( a simple Q+V strategy ) stopped working... he suggested that most investors just can't stick to a discipline if the market is moving away from them - they get attracted to the other hot areas that are working - people tend to chase returns rather than sticking with a philosophy through thick and thin.

If you were a value investor in the 1990s you'll know what I mean.  It's all very well in principle saying "I'm a value investor" but the reality of staying one is far more difficult. 

You have to think about factor returns a bit like selling insurance.   One collects premium in the good times but you have to pay some of those premiums back in the bad times.   When the top deciles are underperforming the bottom deciles - that's when the premiums are being paid back. There are a few good books/papers that explain this stuff - it's all quite highbrow but really cemented my own thinking on the topic.  Anti Illmanen's book Expected Returns  and Andrew Ang's book on Factor Investing (one chapter here) are good on these topics.

Ultimately if a strategy worked all the time it would be arbitraged away. It's key to not be too greedy as an investor and accept certain levels of market rewards, the timeframe they take to mature and the times they underperform as part of the bargain.

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BillyChapel 28th Feb '16 25 of 43

In reply to post #122612

Hi Phil

I'd be very interested to know - How often do you re-balance? Is it, say, quarterly or based on the movement of each individual stock as it happens. ie when it drops below 90 stockrank you sell out?


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PhilH 28th Feb '16 26 of 43

In reply to post #122627

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:

  1. I have a quick rummage into the last two statements and I'm looking for positive news (Naked Trader strategy). I reject any that aren't positive.
  2. I look at the Ichimoku Chart for the stock and I'm looking for a bullish stock that is breaking out of a price range, preferably setting new highs. I'm looking left on these charts to find any 'shadows' (previous price action that will provide resistance to the breakout)
  3. I look at Point n Figure charts to determine potential price targets
  4. I go back to the Ichimoku charts and work out potential places of support that if broken would induce me to sell. With the price target and sell price I can evaluate the risk reward of the opportunity

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

Professional Services: Sunflower Counselling
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Nick Ray 28th Feb '16 27 of 43

In reply to post #122612

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.

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brucepackard 29th Feb '16 28 of 43

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?

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cig 29th Feb '16 29 of 43

In reply to post #122642

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.

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herbie47 29th Feb '16 30 of 43

In reply to post #122615

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.

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PhilH 29th Feb '16 31 of 43

In reply to post #122651

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.

Professional Services: Sunflower Counselling
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herbie47 29th Feb '16 32 of 43

In reply to post #122654

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?

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PhilH 29th Feb '16 33 of 43

In reply to post #122657

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

Professional Services: Sunflower Counselling
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fahrhb 1st Mar '16 34 of 43

"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.

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PhilH 1st Mar '16 35 of 43

In reply to post #122702

But there aren't any.

Well do you change your investment approach or do you change the pond you fish in?

Professional Services: Sunflower Counselling
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fahrhb 1st Mar '16 36 of 43

In reply to post #122705

Not sure I get you phil. I fish in US, UK and EU. That's a big pond.

Cheap is 10x free cashflow in a growing company with sustainable high roe. You need a crash to get these. But a crash contraindicates the momentum requirement, no?

I see many on 20x FCF. Too much.

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PhilH 1st Mar '16 37 of 43

In reply to post #122708

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

P.S. Edited to include link

Professional Services: Sunflower Counselling
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fahrhb 1st Mar '16 38 of 43

In reply to post #122711

Thanks. Appreciated.

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herbie47 1st Mar '16 39 of 43

In reply to post #122711

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).

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herbie47 1st Mar '16 40 of 43

In reply to post #122690

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.

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BillyChapel 6th Mar '16 41 of 43

In reply to post #122633

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 :)

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stonor 4th Aug 42 of 43

Hello Everyone .

Might l ask if any research has been run on the basis of a portfolio of , say , twenty stocks  of highly Q V rated stocks equally - weighted ?

Best wishes , Julia .

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Howard Marx 4th Aug 43 of 43

In reply to post #500226


Click on 'Ranks' at the top of any page & select 'Top StockRanks'.

On this page select 'Performance', top left.

You will arrive here :

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.

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