Towards A Taxonomy Of Stock Market Winners

19th Mar '15 by Edward Croft

13 comments 27010 reads

Peter Lynch's great classic “ One up on Wall Street" was one of the first books to open my eyes to the fact that there are many different ways to make money from the market. He liked to categorise his winning stock selections as: 'slow growers', 'stalwarts', 'cyclicals', 'fast growers', 'turnarounds' and 'asset plays'. I'd always been a die-hard “growth at a reasonable price" investor before coming across Lynch, but once I'd digested his thinking I started to become more aware that there were different approaches to the same goal.

Of course most of us are not Peter Lynch. The great man had the excellent 1980s Fidelity team around him who perhaps helped him understand the different nuances of investing in asset plays and fast growers . One of the mistakes that many part time investors make is trying to be jack of all trades, so when my own early dabbles in mining stocks were not wildly successful (Sardinian Gold?) I realised it was time to retreat back to the comfort of my own circle of competence. But the idea of classifying archetypes of stock always stuck.

Aligning with the payoffs

Finance academia is a busy place, and over the last 30 years they have come to a broad consensus about which fundamental and technical indicators best payoff in stocks. They call these indicators 'factors' with the most powerful and well studied agreed to be company size, quality, value and momentum.

You don't need to get complicated to have success in the stock market as long as you align your portfolio with these payoffs. While the Stockopedia StockRanks take a broad approach to assess quality, value and momentum - it's quite simple to put together a high probability investment strategy using simple criteria such as low P/E (value), high ROE (quality) & new 52 week highs (momentum).

If we allow ourselves to take inspiration from Lynch we can realise that there are eight different combinations of the three quality, value and momentum factors. Each of these combinations illustrates a different archetypal profile of a trade… a taxonomy of winning and losing stocks.

While what follows are all gross generalisations, they do provide a very useful mental model that is exceptionally useful in understanding the nature of a stock, and what might be worth watching out for. Let's dive right in….

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Edmund Shing

19th Mar '15

Ed, you may need to edit this bit:

High Flyers
Q: high, V: high, M: low (good & improving, but expensive)

Should be: Q High, M High, V Low

Edmund

Bonitabeach

Good story Ed (almost worth the subscription), but needs a little meat on the bones:

Define: High, Medium & Low

Back-testing?

Rotation time-scale?

Keep up the thinking.

bsharman

Very interesting and informative article Ed. I would say that my natural style is Contrarian, in that I look for good businesses (high quality/value) that have perhaps fallen on lean times due to external/cyclical issues or businesses which have been poorly performing but with a change of management. Standard Chartered (LON:STAN), Balfour Beatty (LON:BBY) and Tesco (LON:TSCO) are examples of the latter. However as a contrarian it's always difficult to judge when to start putting in money and generally speaking I usually invest slightly too early. Perhaps I should look at indicators such as improving broker forecasts or look to invest after the new CEO has 'kitchen sinked' the bad news as well as paying attention to momentum. When is the highly anticipated smart money module going to be launched!!?

janebolacha

The introduction to that classic, "One Up On Wall Street" is worth reading, it's perhaps quite
relevant to the discussion there was yesterday around Synety and story stocks in general. I
actually did re-read it yesterday. Even though it was written twenty-five years ago, it remains
an essential read for any private investor, imo.

PhilHofGrowYourDough

23rd Mar '15

Hi Ed,

Inspired by your article I've just been building a Contrarian Screen, i.e. high quality and value with mediocre/low momentum.

However, I want to spot these stocks as they start to gather momentum and breakout. So it would be useful if I could screen for momentum delta (i.e. change in momentum).

Presently I'm running my filter, downloading a CSV and running the stocks through my own Ichimoku Chart scanner looking for breakouts. The addition of the momentum delta would speed this up no end.

Thanks
Phil

Edward Croft

Phil - I've been having the same thoughts. What would be great is one of the following... either make the various StockRank deltas screenable (1m/3m etc), and/or make ChartSignals screenable.

We are working on both... but blimey it's all a lot of work and a tsunami of data !

To be honest the chart signals don't give me what I need. What I'm looking for is change of trend, i.e. from bear to bull or from congestion to bull.

I personally use Ichimoku charts to help me spot that in a clearly defined way and the chart signals you provide aren't sophisticated enough (at present). So what I currently do is filter, download csv and pump the data through some software I've written that identifies Ichimoku Chart signals. That gives me a list of charts and I can filter them by signal. I then take a look at each chart, take a view then look at the StockReport, etc.

However even this isn't ideal as it highlights stocks that have broken out and that can be too late. I'm looking for stocks crossing the breakout cusp and that's where the momentum delta helps to thin the field.

A chart signal alternative is to identify where a consolidation rectangle has formed over a period as the price has become range bound and then identify a break north of that price. Now that would be really useful and is actually what I'm really looking for.

Another strategy might be extending the % vs 52w high to add % vs 30d high, % vs 90 day high and % vs 180 day high

A good example contrarian stock highlighted by this approach is £MN where the price is trying to break out of the base around $12

It doesnt quite make the grade in terms of Ichimoku signals, but it's going on my watchlist. I need the price to rise to around $14 which will take the price through cloud and it will bring the purple Chikou (lagging line) through the cloud too. Hopefully then resistance should be limited.

UK Value Investor

24th Mar '15

Hi Ed, excellent idea. I suppose most people have these categories floating around in their heads but it's good of you to lay them out more formally.

22nd Feb '17

Hi Ed,

I caught up with the StockRank Styles Webinar from June last year earlier and I've heard your recent encouragement to consider a high VM strategy given their excellent performance.

I guess it got me thinking about the migration path across the StockRank's taxonomy.
For me (and I guess for any investor) I am looking for a price appreciation over time and what that means in terms of StockRank is that with all other factors being constant that as price appreciates ValueRank decreases and Momentum Rank increases.

The phenomenon means that if all other factors are fixed as the price appreciates:

1) A High Flyer (High QM) will increase it's QM rank as its proximity to 52 week high decreases and RS is strong. A high QM stock with a strong price momentum is a virtuous circle and as such a High Flyer can hold onto this status for a prolonged period which reduces churn and transaction costs.

2) A Turnaround (High VM) will increase its Momentum Rank whilst the Value Rank is eroded. This means that the Turnarond will migrate towards a Momentum Trap as price appreciates. The quicker the price appreciates the sooner this migration will occur and this might well encourage one to sell, increasing churn and transaction costs.

3) A Contrarian (High QV) will increase its Momentum Rank whilst the Value Rank is eroded. This means the Contrarian will migrate towards a FallingStar or if the Momentum Rank increases enough towards a High Flyer

For the Turnaround scenario (which have generated great returns) it'd be interesting to know the typical timespan for the migration and where the gains are made, e.g. are the majority of the gains made when a Turnaround or do they still continue as the stock transitions into a Momentum Trap? Is the quarterly rebalancing of the Turnaround portfolios selling the stocks before or after they turn into Momentum Traps?

I'd be interested in any insights you have
Cheers
Phil

23rd Feb '17

Phil - I have to admit we haven't done any extensive research around Style persistence (yet). We will at some point I'm sure.

I think your comments have significant merit. But I would add that one has to consider the relative scale of the rankings. I don't think you can consider the V and M rankings to be a perfect counterpoint. Often Value stock valuations are so low that prices need to shiftconsiderably before they can be considered moderately valued. So from a VM perspective, the high VM often persists as momentum rises.

Also High Momentum often is a leading indicator of Quality Rank improvements (especially given the earnings momentum weighting).... so the turnaround style can easily migrate to fully rounded QVM rankings. I've seen that happen regularly.

Tom Firth here has taken over the research in this area - we're actually working on some StockRank Style Classifications for the stock reports. We are using some fuzzy classification techniques using data science libraries as we aren't keen on using hard-cutoffs for classifications. Hard cutoffs can be great for building strategies, but we're keen to create broader groups of Style categorisations for the stock reports. Hopefully we'll have something live in the not too distant future. It's being baked into our compute architecture at the moment.

The stockrank deltas would be really useful in this scenario in order to screen cheap stocks with increasing momentum and poor but improving quality.

Thanks for the reply!
Phil

Towards a taxonomy of stock market winners

Aligning with the payoffs

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Edward Croft

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