Over the decades, academics and practitioners who study the markets have found many anomalies and trading strategies that were proven to be profitable. However, once the results are widely known, these profitable trading methods attract so much money that the edge is lost and returns diminish dramatically.
We have seen this happen with things like the January effect, the Friday effect and the stock split effect — all have seen returns diminish and even disappear once they were widely known. Strategies like risk arbitrage, convertible arbitrage and fixed income spread trading have seen returns diminish dramatically as enormous amounts of cash poured into the space to capture the profits.
But there are a few market-beating characteristics that simply cannot be arbitraged out of existence.
The small book to market edge is never going to go away because big money is never going to be able to pour into these stocks. The insider edge will never go away because insiders have information the rest of us do not and can make better judgments about the prospects for their business and stock price. The outperformance of companies with high F-scores isn’t going to go away because improvements in financial condition and improving prospects is going to be rewarded with a higher stock price.
All three strategies rely on long-term ownership of equities and that’s another reason they will persist in the short-term-obsessed markets of today.
As markets become more uncertain, we can combine these three anomalies to find a portfolio of stocks that are cheap with improving fundamentals that insiders think are going higher. It is a simple matter to screen for small companies that have great F-scores, trade below book value and have seen recent buying by officers and directors. Although there aren’t many of them right now, we can find some that will give us strong upside potential and defense against a steep market decline.
Seneca Foods (SENEA) processes, produces and distributes processed fruits and vegetables under several different brand names including Libbys and Seneca Farms. It also packs canned and frozen vegetables for Green Giant and Le Sueur. The stock currently trades at just 90% of book value, and the company earns an F-score of 7. Insiders seem to like what’s going on at the company, as two directors have been buying stock in recent weeks.
Small banks have been a favorite sector of mine for some time now, and many of them have great F-scores as industry condition improve and are still trading below book value. Peoples Bank of North Carolina (PEBK) is trading at a small discount to book value and earns an F-score of 6. Officers and directors including the Chairman of the Board and CEO have been steadily buying stock the past several months. The stock is already up 8% this year, despite a return of -4% for the S&P 500.
Another good play in small banks is First Citizens Banc Corporation (FCZA), which trades at 70% of book value and also has an F-score of 6. Insiders have been buying the stock over the last six months, including a purchase by a director just two weeks ago. The stock is up nearly 13% year-to-date, proving just how defensive these kinds of stocks can be when the market starts to dip.
In the past few weeks we have seen former market darlings like Best Buy (BBY), Twitter (TWTR) and even Apple (AAPL) decline by double-digit percentages as the market increasing shows signs of nervousness. Investors would be wise to consider putting the odds in their favor with these three stocks with long-lasting edges.
As of this writing, Tim Melvin was long SENEA and PEBK.