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Winning the Stock Market Game with Numbers
How would you like to outperform the market by 20% per year?
That’s what Eugene Fama and Kenneth French found in their 1992 study, The Cross-Section of Expected Stock Returns. Low price-to-book stocks outperformed the highest group by 1.5% per month, or 20% annually.
In other words, cheap stocks do better than expensive ones.
But like most other good things on Wall Street, such exploits were bound to end. Since 2000, cheap stocks have outperformed by just 4.5% per year, likely as a result of more quant-based hedge funds playing in liquid markets.
Penny Stocks Continue to Outperform
But what about the world of penny stocks? Surely, the illiquid market would scare off the largest and most sophisticated of these high-powered traders?
It turns out, the answer is “yes.” When the same price-to-book test is applied to stocks under $5, the outperformance doubles to 9%. It’s still not as high as the 20% returns that Fama and French found, but it’s a start.
Today, we’re going to look into quant-based penny stock investing, and see if we can regain the 20% edge that hedgies arbitraged away long ago.
Using Quant to Gain an Edge
One of my favorite ways to pick out winning penny stocks is about as far from rocket science as you can get:
- Momentum. Fast-moving stocks outperform slow-moving duds.
- Quality. High-performing companies with real value.
- Cheapness. Cheap companies priced under intrinsic value.
And guess what?
To illustrate, I’ve taken data from Thomson Reuter’s DataStream service and tested the following penny stock universe from 2000 to present. Specifically, I looked at stocks whose:
- Stock price. Less than $5.
- Equity value. Greater than 0.
- Location. U.S. based company.
In each of these tests, qualifying penny stocks are divided into five quintiles and their past performances are ranked against each other.
Low price-to-sales companies win.
There’s long been an argument between growth and value investors. Are cheap stocks trading at low price-to-sales (P/S) ratio the best investment? Or do high-flying tech stocks offer more bang for your buck?
Using data from Thomson Reuters, we find that… drumroll please…
The former group is right. Cheaper is better.
Low price-to-sales stocks beat high ones by 22% per year, and do particularly well in low-growth industries. In other words, you want to buy up companies like Gamestop (NYSE:GME) when they’re trading at 0.04x P/S, not when they’re at 4.5x P/S.
Cheap Stocks to Check Out
- Helix Energy (NYSE:HLX). With its 0.3x price-to-book value and 0.86x price-to-sales, this offshore energy services company is a potential 5x winner on rising oil prices. The $4 stock once traded at $40 during the 2006 oil boom.
- Transocean (NYSE:RIG). Much like Helix Energy, Transocean is a key beneficiary of high energy prices. And though its earnings quality is lower than HLX’s, RIG’s 0.2x price-to-book value gives it a much higher 15-20x return potential.
Fast-moving stocks outperform.
Next, there’s price action. Running the same test with 6-month performance figures, we find that both high-return and low-return companies do well.
This makes sense when you consider the Momentum Master strategy. Certain asset classes (crypto, tech stocks) are momentum-seeking, where past gains suggest future growth. Other assets (consumer cyclicals, commodities) are mean-reverting, where price dips are usually followed by recoveries. Taken together, that means assets that have moved more in the past six months tend to outperform those that have moved less.
A Momentum Stock You Can’t Miss
- Genworth Financial (NYSE:GNW). GNW’s 40% rise over the past several months reflects a growing realization that higher bond rates are on their way. With GNW stock at a cheap 0.15x price-to-book, investors are looking at 2-3x upside.
High-quality wins — with a twist.
Finally we have quality, a seemingly obvious element to Moonshot investing.
Consider cash flow to sales, one of my favorite accounting metrics. The figure does a solid job when it comes to traditional companies with long operating histories. But it falls flat when analyzing 1) zero-revenue startups and 2) dying companies that are cashing out what’s left of their assets. That means companies with both very high CF/S and very low CF/S tend to underperform — it’s the companies in the middle that do best.
And what about profitability? Again, it’s hard to tell based on that metric alone. Companies with high net margins are usually stronger than those with low ones. But those with the very highest figures — Workhorse (NASDAQ:WKHS) and Bio Rad Labs (NYSE:BIO), for instance — are often riding one-time gains and tend to disappoint once times go back to normal.
That leaves us with using a combination of metrics to determine quality. Even if a company fools us on one figure, it certainly can’t outperform on all of them.
For this, I use the Reuters StarMine Earnings Quality Score, a figure that includes accruals, cash flow, effciency and exclusions. The results (finally) look as you would expect, with higher-quality companies beating their lower-quality peers.
Quality Stocks to Keep an Eye On
- Gran Tierra Energy (NYSEAMERICAN:GTE). GTE ranks in the top 40% of all U.S. companies by earnings quality, an unusual feat for an oil exploration company. If energy prices continue to climb, GTE should see its stock rise by up to 4x.
- TrueCar (NASDAQ:TRUE). Finally, this online car-buying portal should continue to ride demand higher. Shares are already up by 12% since August, and Wall Street analysts expect another 40% upside from here.
Putting It All Together
So what happens when we take all the above factors and put them together to analyze penny stocks?
The results are predictably excellent.
A four-factor model using 1) price-to-sales, 2) price-to-book, 3) momentum and 4) StarMine Earnings Quality shows that investors can outperform the market by 20% through selectively picking mean-reverting stocks.
At first glance, these figures might seem lower than the 22% you can get by only following price-to-sales. But the 4-factor model shows more consistent outperformance, with a maximum monthly drawdown of only -39.5% vs. -53.6% for the P/S model. Removing the past two liquidity-driven years also pushes the 4-factor model above that of the P/S one.
Putting Quant to Use
The best thing about the quant model is that you can run them in reverse to find high-potential stocks. This week’s all-star list includes companies making a post-pandemic comeback.
- Waitr Holdings (NASDAQ:WTRH). Shares in this online delivery service traded as high as $14 in 2019 before embarking on a rollercoaster ride down to $1.40. But WTRH might yet surprise. Last week, investment bank Morgan Stanley disclosed it owned 10% of the firm.
- Diversified Healthcare Trust (NASDAQ:DHC). One of America’s worst-performing healthcare REITs finally looks cheap enough to buy the dip. The company trades at 0.4x price-to-book, four times cheaper than rivals Medical Properties Trust (NYSE:MPW) and Welltower Inc. (NYSE:WELL) And if stock prices rise, that would create a virtuous cycle where DHC management can issue new shares, pay down debt and send shares even higher.
- Voyager Therapeutics (NASDAQ:VYGR). Five months after the departure of its CEO and chief medical officer, VYGR seems to be making a comeback. On Oct. 6, the company announced a licensing deal with Pfizer (NYSE:PFE), sending shares up almost 60% to $3.87. There’s a good reason to expect more gains: Voyager is focused on a high-growth industry of “shells” that carry the genetic material used in gene therapies.
- PaySign (NASDAQ:PAYS). PAYS company primarily works with blood plasma payments, a duopolistic industry with typically high margins. With international demand for plasma picking back up, PaySign’s cheap $2 price could easily yield 200% returns in a matter of months.
The Derivative Dance
Many of these penny stocks aren’t particularly attractive. Show me a person who gets excited about cheap blood plasma companies (i.e., yours truly) and I’ll show you someone who needs to get out more.
But the thing about these unsexy stocks?
They work as investments.
$10,000 invested at an “average” 5% return will turn into $43,200 over three decades. The same $10,000 outperforming that figure by 20% will turn into $8.1 million.
If that’s not attractive, then I don’t know what is.
FREE REPORT: 17 Reddit Penny Stocks to Buy Now
Thomas Yeung is an expert when it comes to finding fast-paced growth opportunities on Reddit. He recommended Dogecoin before it skyrocketed over 8,000%, Ripple before it flew up more than 480% and Cardano before it soared 460%. Now, in a new report, he’s naming 17 of his favorite Reddit penny stocks. Claim your FREE COPY here!
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.