Why You Think There Are More High StockRank Profit Warnings Than There Really Are

16th Nov '15 by Edward Croft

55 comments 26495 reads

On Thursday evening DX Group was ranked amongst the top 1% of stocks in the UK according to the Stockopedia StockRanks. Unfortunately for holders, the company announced a profit warning on Friday morning and was brutally punished by the market. It fell 73% from 85p to 23p on the day. As usual, Paul Scott was very quick off the mark with his analysis in a post which has drawn a wave of more than 60 responses from the community since.

Catching up this morning I discovered many, often rather angry, comments about the fact that DX Group had a 99 StockRank before the profit warning. For those who don’t know, the StockRanks grade all UK and international shares from zero (worst) to 100 (best) across a range of fundamental and technical factors, so when one of the top rated stocks falls out of bed it tends to cause a stir.

As one of the architects of the system, some of these comments were pointed in my personal direction, so I feel I have a duty to respond. While I’ve written extensively on how to think about high StockRank stocks before, there was one comment in particular that has prodded me to pick up the quill. Be warned - my response won’t be comfortable reading for some but I do hope though it will clear up some of the misinformation that has been shared on the discussion boards.

Have lots of high StockRank stocks really been “disasters”?

Whenever there’s a profit warning in one of our highly ranked stocks I often see this kind of comment:

Quite a number of high StockRank rated stocks have disappeared, gone bust or become disasters lately.

This is a very normal response to a painful situation such as a profit warning, but it is an observation driven by software bugs in the human brain rather than from rational investigation.

In order to analyse whether lots of high StockRank stocks have indeed ‘disappeared, gone bust or become disasters’ I have taken a closer look at the performance of the 142 shares that had a StockRank of 90+ on 31st March 2015.

Performance In just over 7 months, the average performance of these 143 stocks has been a gain of 11.4%. For comparison the FTSE All Share has fallen by 8% in the same period. i.e. these 142 high ranked stocks have beaten the All…

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Ken Lowes

17th Nov '15

Thank you Ed for the advice it is accepted. Regarding the statement that set off this whole debate and which your title piece countered My experience of the SR system was in fact 100%, two out of two, these investments at the time of purchase appeared to be "wonder stocks" according to the SR and supporting statistics. Now that I know better and I am not really complaining about the loss, how can I trust the system in the future and without trust what is the value of any system? Not investing in non UK based managed and controlled stock is a given, so it must rank high as a problem to consider but this is not reflected in any of the rankings.In order to satisfy those who may be thinking, but not vocalising my fears, why not look to see how many stocks had a high ranking two years ago and what proportion of those stocks have disappeared gone bust or become disasters lately. Let us say that 20 stocks have a ranking between 95 and 100 and five fall into the category that makes 25% which is a high number. As I said in my piece 28 above I think the StockRank system is very useful and I want it to survive but the quiet majority is what decides if companies survive. Please take all of what I have said as constructive, we all want a system we can trust, it wont be perfect, nothing is, all I am doing is due diligence which is what you would recommend as a prudent investor.

troytea

The FCA publishes lists of companies being shorted at http://www.fca.org.uk/firms/markets/international-markets/eu/short-selling-regulations/notifications-disclosures

If you subscribe to IC, they also have a Low, Medium, High but I find the FCA one more useful as it also tells you how much stock is on loan and who by,

pka

"Use rules of thumb - (mine are to invest in no foreign stocks, and avoid overly popular stocks) My own judgement about popular stocks & foreign stocks comes from painful experience - I got caught up in some popular Chinese AIM shares back in 2008 and lost a bundle."

My own rules of thumb are to restrict myself to stocks that pay a dividend in the FTSE 100 or 250 indices and to avoid any stocks whose principal activity is in a dubious overseas country. I think my rules significantly reduce the risk of buying stocks in fraudulent companies (of which AIM seems to have a disproportionate number), although they do not completely eliminate the risk (e.g. Maxwell Communications). My rules might reduce the average return of my portfolio to some extent, but they help me to sleep better at night!

tomomo

Ed thanks for this article. It made me wonder whether boringness would be susceptible to quantification -- whether it cannot just be treated as another "factor". Q, V, M + B.

When I rank stocks using a spreadsheet, one of the things I look for it their "anti-glam" qualities. So, other things being equal, I'll be pointed away from stocks with a high CAPE, a high 5y and 3y price change, high beta, low dividend yield, and low rolling yield vs. 5y high. This nudges me towards boring stocks.

Could something along these lines (but much better, with proper empirical grounding) be calculated by Stockopedia? Presumably industry group, forecast growth, volume, and recent volatility might also be relevant.

Edward Croft

Ken - it's incredibly unfortunate that you've selected 2 of the worst performers in a set of shares that have done remarkably well. I hope that this article does at least help restore your faith in the StockRanks and illustrates how best to use them. You can of course review the StockRank performance at any time at this link.

We offer tools, data and education here, not personal advice, it's up to each subscriber to DYOR and decide on the strategy/approach that suits them based on their own risk profile. That said, we have repeatedly stated our own view that the way to wealth in the stock market is to buy broadly diversified portfolios of shares that have strong exposure to the fundamental and technical factors that are shown to pay off. It's vital to focus on diversification - the only free lunch in investing - to ensure that the inevitable losers are outnumbered.

Why not look to see how many stocks had a high ranking two years ago and what proportion of those stocks have disappeared gone bust or become disasters lately?

I have done as you asked. I've taken the 2013->2014 batch of original high StockRank stocks and looked at them over a 1 year holding period. That year was a good one for the market and the All-Share rose about 9%. The top decile of StockRank winners rose about 40% on average.

Of the 133 stocks above a £10m market cap... there were 120 winners and 13 losers. I don't think there was a single stock in that set that went bust. You can again review the spreadsheet at this link.

564b4e331bfadStockRank__Hit_Rate__Apr_20

The truth is that 2015 has been an annus-horribilis for many in the stock market. This year we've seen many of the sinful companies washed away - there have been more frauds and dodgy stocks washed out than I can remember. We shouldn't extrapolate this year to the previous years - I do though imagine that a really bad bear market year such as 2008 could be far worse.

I've always thought of Stockopedia as a community project so all feedback is highly welcome. Given your feedback - I would like us to move towards 100% data transparency so that all of the above StockRank holdings data can be reviewed in the browser. I do though ask for patience as implementing this may take a long time. In the meantime I'll be as transparent as possible in posts such as this.

Nujinho

Hi - I am brand new to stock buying (bought my first ever individual stocks 2 weeks ago) and have had a baptism of fire by having DX in my portfolio.

After a lot of research on how to construct a portfolio, and building various different screens, I settled on a tweaked version of Ed's NAPS portfolio with the following criteria:

• The 25 highest SR stocks
• Cap >£20m
• Low spread <250bps
• No tobacco, pharma, oil or arms
• Diversified:
1. top SR stock from each of the 10 sectors with QR >80 and SR>80
2. if no stock over 80 in certain sector, skip that sector
3. then next top SR overall stocks, factoring:
? no more than 5 stocks <£150m
? no more than 5 AIM stocks
? no more than 5 stocks in any one sector

Based on my research the above feels like a balanced and diverse portfolio, but obviously based on Stock Ranks as my quant source. I plan to rebalance in 6 months.

Therefore, I was obviously quite surprised by what happened to DX, although I do understand Ed's article and many of the comments above. My hope is that by having a well balanced and diversified portfolio overall the performance across the 25 stocks will be positive. I do however have a few questions that have sprung from this:

- if I was to put in an additional filter (around Z score, current ratio etc) to try and weed out potential DXs in the future, is the feeling that this could as easily weed out some potential winners as well as losers? (think someone else asked this question)

- I understand the risks of stocks, but does a 73% fall in a single day represent a pretty severe punishment? Whilst the profit warning wasn't great, it doesn't sound DX is going out of business. (Please excuse my naivety)

- I kind of feel like I've lost most of my money on this stock now, if I sell I'm locking in those losses. Everything I've read though, says this kind of thinking is idiocy and is a common trap that investors fall into. However, whilst there were flags that my SR based approach didn't take into account, there is still some quality in this stock from the stock report I can see, and it certainly now represents very good value!! If I was coming to this stock afresh it looks like a decent QV play - is that just crazy thinking?!?! (Don't worry, I'm not asking for advice, just interested in opinions).

- On the day of the profit warning I was in meetings a lot of the day so before I knew what was going on it was nosediving. I had been led to believe that a terrible day was a 40% loss, so I didn't really understand what to do. Does anyone have any advice on how to approach similar situations? Not sure there is a right answer to this but having zero experience of owning stocks I'm unfamiliar with different tactics are on dealing with bad news

I guess as an investor you will inevitably experience bad times, but I just didn't expect to have one so soon and so severe. The good thing is that it's just one stock in my portfolio therefore not life threatening on its own. If it happens again soon though, I'll start to believe that Lady Luck has it in for me................

Cheers

Ed , I joined you June 2014, so what happened before that date I know nothing about, I am sorry if an analysis of the last eighteen months doesn't help your case. As you say 13/14 was a good year. The industry is full of promoters who promote the right points on the graph, sadly that is not real life. Your original piece mentioned six disasters but there are more. My question is simple Since April 2014 to the present day, how many stocks with a ranking of SR 94 or better have gone bankrupt disappeared or been disastrous. You promote the SR system and of course the majority of the stock will follow the market trend, what I am getting at is - what percentage of those who are given the highest accolade don't. I have experienced the 1975 market collapse, 1987, 2000, 2008 but I have never seen a fall of 75% in one day as a result of a trading announcement. Paul Scott said last week that he believed many Aim shares were over valued I wonder how many stocks with a SR95 Paul would actually buy. Sadly not all your subscribers are as expert as some of those on this blog so human frailty being what it is why should they not buy the top twenty ranked SR stock? I can think of a good reason if it contains 25% that are disasters. Hindsight is always a winner..

cig

I don't have references handy, but I've seen a few papers that looked at this and found out that short selling pressure indicators indeed do predict under-performance on average. It seems plausible: shorting is hard to do technically, with open ended downside and limited upside, so those who survive in that business have to be good at it (it's not an anomaly that's easy to arbitrage).

Re Stocko using the FT's indicator: it's a commercial product from MarkIt, so licensing cost would be an issue.

The FCA regulatory reports are free, though possibly a mixed bag in data quality terms (they don't necessarily show net positions, involve a possibly biased category of short sellers, and it's self reporting which can be error-prone).

Whitbourne

I thought the following two sentences summed up the position brilliantly and should be written in large font across the top of every StockRank listings page:

The StockRanks are statistical measures which work best for systematic investors across portfolios of stocks. They are not a short-cut for discretionary stock-pickers to do less research.

That is such an important statement. Like others here, I'm using StockRanks as one element of a screen and seeking as much diversification as I can afford with decent position size - currently 17 holdings. That's fewer than I'd like but enough to avoid one or two under-performers pulling down the whole portfolio. A good spread of sectors also helps.

Hi Nujonho,

I think your approach is a very sensible one. DX losing 73% of its value in one day was very unusual and very unlucky for you. However as you have 25 stocks in your portfolio, each stock represents just 4% of your portfolio's value, so a 73% fall in one stock means a fall of just 3% in the total value of your portfolio. That shows the benefit of diversification!

Your rules of having: "no more than 5 stocks <£150m and no more than 5 AIM stocks" are helpful in reducing the volatility of your portfolio, because small companies (and AIM stocks in particular) are much more likely to suffer such shocks than large companies. But those rules still let you suffer a major shock in > £530m rebalanced every 3 months from May 2013 to November 2015 has been slightly worse, at +54%, than the +68% performance of top decile stocks with market cap > £10m, as can be seen on these graphs:

http://www.stockopedia.com/stockranks/performance/?marketId=gb&field=_QVMScore_?=350&period=1&buckets=deciles

http://www.stockopedia.com/stockranks/performance/

However, those performance figures ignore the benefits of reinvesting dividends and the cumulative costs of trades when the portfolios were rebalanced every 3 months. Small companies tend to have lower dividend yields and higher bid-offer spreads than larger companies, so I suspect that taking those things into account would bring the cumulative performances close to each other. Therefore if you restricted yourself to stocks > £350m, I think you would greatly reduce the future volatility and risk of a 25-stock portfolio without much difference to your expected future returns.

My apologies, some text got lost and jumbled in my previous post. I meant to write:

"But those rules still let you suffer a major shock in your portfolio. The performance of top decile StockRank stocks with market cap > £350m rebalanced every 3 months from May 2013 to November 2015 has been slightly worse, at +54%, than the +68% performance of top decile stocks with market cap > £10m, as can be seen on these graphs:"

andrewdb

The FCA report only lists individual shorters > 0.5%.
A more accurate - but less timely answer can be found in the Euroclear stock lending report.
The free one is only updated once a month, but (I think) includes all stock lending.

Peter171

18th Nov '15

I think stockopedia is a great tool for identifying stocks for further scrutiny and further investigation, it is not a tipster service, and shoukld not be treated as such. As they say frequently DYOR, it pays not to follow the crowd. I always try to think the worst scenario about a share. Another word of warning, beware of what I call professional NEDs. I have met a number in my time, and did not hold any of them in a high regard.

Ken - I've really tried to answer your questions in as much detail as I can. I've put together a bunch of spreadsheets and shared them. But if you really want to know the hit-rates within each decile I suggest you read my latest blog which goes into a lot of detail. http://www.stockopedia.com/content/if-you-want-to-win-at-the-races-you-need-to-know-your-odds-112164/

Aislabie

I have tried to ensure that I do not invest in the low stock rank companies and for the most part the reason for the ranking becomes clear when you do the research.
But there also stocks where it appears that good companies are carrying surprisingly low rankings. Chesnara , stock rank 41 ,would be an example where it would appear that debt, which is part of its business model , is having an inordinate impact on its ranking for company that has shown a very respectable performance over many years.
Would you agree that some business models do not fit well with the rankings (wherever debt is at a fixed rate and matched to a fixed return as often happens in leasing for instance)? Or am I looking at Chesnara for example through rose tinted glasses and the ranking is seeing something I can't?

Rusty2

I tend to agree that the rankings do not always fit certain companies or its behind the times. I do hold Chesnara as it happens although I'm considering selling soon as its not performing. Another company that was lowly ranked was Inland Homes (LON:INL), performed very well but only ranked in the 40s, could not understand it but now since the latest figures its in the 90s but the share price has not moved up in fact its gone down but forecast EPS for next year is -59%.

stockscreen

20th Nov '15

Ed, I think Paul was right in his comment on DX to say that you may wish to fine tune what goes into StockRanks. I am surprised by some of the companies with high rankings.

DX operates in an awful industry, with all of the many players vying to get more marginal business to cover their high fixed costs. Remember Citilink which went bust last Christmas Eve?

Some sort of Porter style ranking would have highlighted this, and Paul's suggestion is to focus on balance sheet strength (? and free cash flow) and not just inexpensive looking PEs. I suggest that you include some more sophisticated factors.

Equally, a reading of their recent announcements and a study of their share price would have left you unsurprised by the warning.

PhilHofGrowYourDough

At an office in Oxford a strangled scream was heard ...

Are any of these cashflow, balance sheet, profitability, trend, margin, earnings quality or leverage rankings sophisticated enough for you? http://help.stockopedia.com/knowledgebase/articles/182926-how-do-you-calculate-the-quality-rank

Paul was discussing the Value Rank. Let's not confuse the Value Rank conversation with the overall StockRanks.

21st Nov '15

You may wish to fine tune what goes into StockRanks. I am surprised by some of the companies with high rankings.

This comment is actually brilliant. It really underpins one of the reasons why factor investing works. The StockRanks are just an implementation of factor investing (with the factors being Quality, Value and Momentum). The stocks most exposed to these factors are very psychologically hard for us to purchase. Good (quality) stocks are often too dull and boring to consider, cheap (value) stocks often have problems which we find repulsive, and stocks at new highs (momentum) have share prices that scare us off.

Who wants to buy dull businesses with problems that appear to be trading too high ?

We much prefer to buy the same kinds of familiar, popular stocks as everyone else. We have a psychological tendency to purchase stocks that offer average returns. But as John Templeton said...

“If you buy the same securities everyone else is buying, you will have the same results as everyone else.”

Why you think there are more high StockRank profit warnings than there really are

Have lots of high StockRank stocks really been “disasters”?

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Edward Croft

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