The Profit and Protection Quantitative Stock-Picking System

stock picking - The Profit and Protection Quantitative Stock-Picking System

Source: Shutterstock

Here’s a deceptively simple question:

What’s the best strategy for beating the market?

Growth stocks… Deep value… Trend following… Swing trading…

Every talking head on CNBC has the magic answer — as long as you sign up for their course or buy their book.

But unlike the kids at Lake Wobegon, we know that not every stock picker is above average. Half of all stocks underperform the market. And besides, why would these minor celebrities ask you for money if their system is so profitable?

And that’s why I’m here.

Thanks to my time on Wall Street, I’ve realized that only a select few have the discipline to follow strategies for very long. The market is large enough for those like us.

It’s the reason why I’m giving my Profit & Protection strategy away for free.

In this article, we will look at what actually works in investing.

You’ll find out whether high-momentum stocks outperform…

Whether high-profit companies outperform low-profit ones…

If you should “buy the dip” or “buy into strength.”

In other words, you’re going to get the playbook that I use to help pick stocks.

And we’ll start with the most obvious question: Does growth investing work?

Part 1: Does Growth Investing Work?

Apple (NASDAQ:AAPL)… Amazon (NASDAQ:AMZN)… Netflix (NASDAQ:NFLX)…

One of the most popular investing strategies is to find promising high-growth companies and get in on the ground floor.

It’s easy to see why. $10,000 invested in “hypergrowth” companies like Chinese electric vehicle maker Nio (NYSE:NIO) in 2019 is still worth $110,000 today. That’s how my colleague Luke Lango managed to become the No. 1 rated analyst on TipRanks in 2020 with a stunning 81% success rate.

Yet these companies can also be blindingly expensive. Nio would fall 75% from its peak as electric-vehicle mania faded. And successful firms like Amazon can trade sideways for years while their fundamentals catch up to sky-high valuations.

So ultimately, who’s right? Should you buy fast-growth stocks or slow-growth ones?

To answer this question, I’ve examined financial data from the 1950s to the present day. And for building my quantitative system, I’ve included figures starting in 2013 to avoid the pre-2008 era when accounting rules were significantly different.

The results are fascinating.

Does High Sales Growth Predict Outperformance?

First, we’ll consider sales growth — one of the most straightforward signals of a fast-growing firm.

For this study, I divided companies from the broad-based Russell 3000 index into five quintiles, from the fastest-growing to the slowest, based on the prior year’s revenue growth rate. I assumed a 1-year holding period, with a purchase date 60 days after the quarter-end to allow companies to report earnings.

Here are the results for data from 2013 to 2022.

Graph of sales growth vs returns 2013-2022

It turns out that turnaround companies win by a wide margin.

Over the past business cycle, the quintile of slowest-growing companies gained 17.1% per year, outperforming the higher-growth groups by 6%. At that rate, $10,000 invested for 10 years compounds to $48,480 over a mere $28,651.

Interestingly, growth investors also do well. The fastest-growing companies returned 12.2% during the period, suggesting that companies with high growth in the past can sustain stock returns the following year.

Put another way, investors looking for abnormal profits today need to focus on companies with abnormal growth potential.

It’s why I favor stocks in a barbell distribution — buying shares in either high-growth tech companies or low-growth turnarounds.

Does Earnings Growth Predict Outperformance?

Next, let’s consider earnings-per-share growth — a figure Wall Street often obsesses over.

This metric is somewhat trickier to analyze. Companies that lose money in one or consecutive years have no meaningful earnings “growth rate” (i.e., When a company swings from negative to positive earnings, there’s no basis for calculating a percent increase).

Net earnings figures also have some practical weaknesses. Accounting tricks like “accelerated depreciation” can disguise profits at companies like Amazon to reduce tax liabilities. And in the banking sector, super-normal profits often come from reducing provisions for bad loans — a trick that surely didn’t help companies like Lehman Brothers or Bear Stearns.

But earnings can also be a helpful guide for understanding more “typical” firms. Stable growth companies like Apple usually see multi-year improvements in their earnings, while cyclical ones like airlines or automakers will have bumpier rides

To analyze earnings growth, I again took all companies from the broad-based Russell 3000 and divided them into quintiles. Investments are bought 60 days after the quarter-end and held for a full 12 months. All companies with negative EPS were dropped from the study.

Do companies with high or low earnings growth beat the market?

Graph of earnings growth vs 12 month returns profit and protection

Once again, turnaround companies do best. The quintile of companies with the worst earnings shrinkage rose at 18.2% over the following 12 months, 6.2% faster than other stocks.

Meanwhile, companies with past earnings increases don’t see the same boost.

Do Wall Street Analyst Projections Work?

Finally, does future growth predict stock returns?

Since no one can actually see into the future, I took the next best thing:

Analyst estimates.

These projections are the bedrock for stock valuations. Any company that “misses” earnings or revenue estimates tend to see share prices drop like stones. And millions of dollars can trade hands when a high-profile analyst changes their ratings.

To get the best data, I turn to Thomson Reuters’ I/B/E/S SmartEstimates, a gold standard of normalized analyst estimates.

Again, I take stocks from the Russell 3000, but this time the 12-month holding period begins immediately after quarter-end. Forecasters don’t have access to future filings, so we can safely transact at the quarter-end without creating accidental bias.

Graph of estimated sales growth vs stock returns

Thankfully, I have some good news for those high-paid analysts on Wall Street (and those who employ them):

It turns out their sales forecasts are a strong source of returns.

The top quintile of companies with the fastest expected sales growth would have returned 15.8% per year, compared to 10.1% for the lowest group.

And when it comes to earnings growth, the results are also good:

Graph of estimated earnings growth vs stock returns

Investors focused on estimated earnings growth would have netted returns of 14.9% — much higher than the 9.5% from companies with the lowest-expected earnings growth.

The Bottom Line on Growth Investing

The data tells us that investors can beat the market by buying stocks 1) going through temporary growth slowdowns that 2) are expected to improve in the future.

The results are also robust, even for downturns. During the 2015 commodities crash, companies with the slowest earnings growth returned 20.1%, compared to the 10.9% loss for other stocks.

In other words, investors seeking superior returns should buy shares of companies with diverging growth, not those sitting in the middle.

Part 2: Does Value Investing Work?

Next we consider value investing, a concept popularized by investing legends from Warren Buffett to Peter Lynch.

In 1963, Mr. Buffett scooped up cheap shares in American Express (NYSE:AXP) after the financial firm revealed it had lost the equivalent of $1.6 billion in today’s money in a massive fraud.

The rest, as they say, is history. Value investors have been buying up shares of beaten-down companies ever since.

But…

Is buying cheap stocks a winning long-term strategy? For every American Express (or meme oil stock) that rebounds, many more seem to go straight to zero.

To answer this question, I once again turn to Thomson Reuters’ financial data. By taking information from our most recent market cycle spanning from 2013 to 2022, we can outline an updated version of what works in today’s markets.

The Price-to-Earnings (P/E) Ratio

The most famous of these “value” yardsticks is a company’s price-to-earnings ratio (also known as the P/E ratio). The metric takes a company’s share price and divides it by earnings per share. The higher the number, the more “expensive” the company.

Let’s be clear: The P/E ratio has some obvious weaknesses:

  • Zero or negative earnings. Non-positive earnings create nonsensical P/E ratios (i.e., a company with zero earnings will have an infinitely high P/E ratio).
  • Taxes and depreciation. Net earnings figures are easily massaged by talented accountants, allowing firms like Amazon to pay less in corporate profit taxes and throwing off value metrics in the process.
  • Debt structure. Interest payments can skew a company’s P/E ratio downwards. And P/E ratios routinely fail to capture the value of assets on the balance sheet.

Most importantly, there’s anecdotal evidence that P/E ratios have become less valuable with time. High-performing firms (and their accountants) have become more adept at hiding taxable income, and the rise of intangible assets at tech companies make shenanigans even easier to hide.

But P/E ratios remain a powerful tool. Cheap firms trading at 10x earnings are generally considered “safer” than those trading at 50x… 100x… or 500x multiples.

So without further ado, let’s dive in. For this study, I sort the same universe of Russell 3000 stocks by P/E ratio into quintiles. Companies with zero or negative earnings are ignored, and holdings are updated every twelve months.

The Results: Buy Middle-of-the-Road P/E Stocks

The results are fascinating:

Over the past 10 years, companies with middling P/E ratios performed marginally better.

Graph of pe ratios vs returns 2013 through 2022

There were many years of exceptions. High-P/E companies performed well during the commodity crisis of 2015 and the Covid-19 pandemic of 2020, while low P/E companies did better in 2013 and 2018.

But for an entire business cycle, the hum-drum players did best of all. A company with an “average” P/E ratio like Apple was a far better bet than big, unprofitable bets like 3D Systems (NYSE:DDD) or cheap ones like Exxon Mobil (NYSE:XOM).

The Forward Price-to-Earnings Ratio

Meanwhile, intelligent investors will quickly realize that the P/E ratio is backward-looking. Wouldn’t the future matter more?

That’s where the forward P/E ratio comes in. By considering estimated earnings, investors can supposedly get a better sense of a firm’s future value.

For this section, I use I/B/E/S earnings estimates gathered by Thomson Reuters.

Graph of forward pe ratios vs returns 2013 through 2022

Again, the results are intriguing. Over the past decade, the most expensive companies on a forward price-to-earnings basis have outperformed, albeit by only a small degree.

In a sense, it’s a reflection of America’s tech boom. Growth stocks have outperformed value for the past decade, with the S&P 500 Growth Index rising 2.25x faster than its value counterpart.

The performance of middling P/E companies might also be less pronounced because Wall Street analysts can often conflate the earnings of high-growth companies, making them look “cheaper” than they truly are.

The Price-to-Sales (P/S) Ratio

Next up is the price-to-sales ratio, a commonly used metric among deep value investors eyeing companies on the verge of bankruptcy.

It’s a historically rich vein of 10x plays, particularly among companies with >$2 billion in sales and <$400 million market capitalization — think GameStop (NYSE:GME) at $4 or AMC Entertainment (NYSE:AMC) at $8.

Graph of price-to-sales ratios vs returns 2013 through 2022

The data backs up anecdotal evidence: Some deep-value stars have been such outsized winners they skew the entire underperformance of other value stocks. Companies like Owens & Minor (NYSE:OMI) and Alto Ingredients (NASDAQ:ALTO) would rise 400% in 2020, more than offsetting those that went to zero.

Bottom line: Investors seeking moonshot returns should consider companies with rock-bottom P/S ratios.

The Price-to-Book (P/B) Ratio

Finally there’s price-to-book, a metric once popular with investors like Benjamin Graham — the guru who introduced Warren Buffett to value investing.

Price-to-book has declined in use as the “intangible economy” has gained prominence. Most of Facebook’s value can no longer be found on a GAAP balance sheet. Even financial, real estate and utility firms seem to have little use for price-to-book today.

Graph of price to book ratios vs returns 2013 through 2022

And it turns out that price-to-book values are relatively weak predictors of success.

Instead, investors looking to invest in balance-sheet-heavy firms are still better off considering other factors such as growth. Here are the results for Russell 3000 financial firms based on revenue growth instead of price-to-book.

Graph of revenue growth vs returns 2013 through 2022

Over the past decade, financial firms in the fastest growth quintile actually underperformed the middle quintile by nearly 5% annually. In industries with a unique capacity for self-destruction, investors now need to look beyond a firm’s balance sheet to get a clue about its “cheapness.”

The Bottom Line on Value Investing

There are plenty of other value metrics that investors can use.

  • EV/EBITDA. A popular metric among SPAC and hypergrowth investors.
  • EV/EBIT. A valuable yardstick for M&A evaluators looking to take companies private.
  • Price-to-Cashflow. A lesser-used metric that considers cash earnings instead of accruals…

And so on.

But these metrics all tell similar stories. Except for low price-to-sales firms, those with middling or higher valuations have done better over the past decade.

That’s why the Profit & Protection playbook hedges these bets. Low price-to-sales companies are favored in the system, while value-based ratios hold less weight.

Part 3. Does “Quality” Investing Work?

Next, we consider “quality,” the third aspect of the Profit & Protection playbook. It’s why the Perpetual Money Machine does so well, and a foundational building block to picking stocks that go up thousands of percent.

The “Fade” Of Greatness

First of all, high-quality companies all have the same problem:

It’s hard to be king forever.

No matter how innovative a company is, those operating in free markets will always face competition from new entrants.

Wall Street has long acknowledged this fact. Whenever analysts talk about “3-stage discounted cash flow (DCF) models”, that second stage is a “fade” period where any super-normal performance returns to some long-term average.

In other words, any rational analyst should assume that high-growth companies like Tesla (NASDAQ:TSLA) will eventually become more average. And low-growth ones such as Stellantis (NYSE:STLA) tend to recover — as long as they don’t go bankrupt first.

That’s why the Profit & Protection system ignores metrics like operating margins, a popular stand-in for “quality.” In fact, companies with abnormally high margins tend to underperform over the following 52 weeks as rivals chip away at fat margins.

Graph of operating margins vs returns 2013 through 2022

But some firms seem to have a magical ability to extend their “fade” period. These companies — such as Amazon (NASDAQ:AMZN), Apple and Microsoft (NASDAQ:MSFT) — are those that can turn $10,000 investments into millions of dollars.

And that’s where the Profit & Protection definition of “quality” comes in.

Return on Invested Capital (ROIC)

My top method for finding high-quality companies uses a metric known as Return on Invested Capital (ROIC).

This mouthful of a term takes “net operating profit less adjusted taxes” and divides it by “invested capital,” a measure of a company’s debt and equity value. The higher the resulting figure, the more effective a company is at turning investor dollars into profits.

And guess what?

ROIC works.

Graph of ROIC levels vs returns 2013 through 2022

Over the past decade, Russell 3000 companies in the highest ROIC quintile have outperformed their counterparts by 4.1%. $10,000 invested at that rate of return turns into $951,900 over 30 years, compared to $324,633 for all others.

ROIC is such a powerful tool compared to operating margins because it better reflects a company’s ability to generate long-term returns (more sophisticated measures like CFROI also do well).

Consider the airline industry, a sector that has traditionally disappointed long-term investors with bankruptcies and significant losses. Though operating margins might temporarily rise in years of low jet fuel prices or abnormal demand, the slower-changing denominator of ROIC still paints a bleak picture of massive capital investments and large debts.

Meanwhile, companies like Apple and Amazon take relatively small amounts of capital investments (i.e., investments into data centers) and turn them into money-spinning machines.

These are the “quality” companies that my Profit & Protection strategy identifies and elevates.

Return on Equity (ROE)… With a Twist

Some quality-focused investors prefer Return on Equity (ROE), a more straightforward form of ROIC. It’s a bit like a two-ingredient grilled cheese sandwich: Take a company’s net profit, divide that by its equity value, and voila.

ROE’s simplicity however, comes with some disadvantages. The measure ignores debt, taxes and other adjustments; financial firms from Lehman Brothers to Citi used these loopholes to juice their ROEs in the years leading up to the 2008 financial crisis to avoid triggering regulatory alarm bells.

Negative equity values can also lead to headaches. A loss-making firm can theoretically improve ROE by going deeper into debt, since dividing two negative numbers makes a positive one.

Graph of ROE levels vs returns 2013 through 2022

That means a similar backtest of ROE quintiles performs worse than ROIC. The top ROE companies only outperform others by 3.5%.

But here’s a twist that lands ROE in the Profit & Protection strategy:

What if you considered the stability of ROEs as well as their magnitude?

Here’s where a bit of math comes in. To give companies an “ROE quality” score, I take a company’s average ROE for the past five years and subtract one standard deviation from that figure.

(A firm that generates 10% ROE every year will have zero standard deviation, and receive a 10% score. Meanwhile, a company that generates 20%/15%/10%/5%/0% ROEs over the five years will have a standard deviation of 7.1% and a “2.9%” ROE score despite having the same average return on equity.)

Graph of ROE stability vs returns 2013 through 2022

The results are phenomenal. Companies with high and stable ROEs have 1-year returns twice as large as the others. From a relative standpoint, it’s one of the best weapons of the Profit & Protection arsenal.

In other words, if you’re looking to outperform the market, having suitable measures of a company’s quality is the key to success.

Do Turnarounds Work?

Observant readers will immediately ask, “what about the lowest-quality companies?”

Much like a cubic zirconia engagement ring, these low-cost deals are often rather tempting.

Shares of near-bankrupt GameStop and AMC Entertainment turned ordinary investors into millionaires. And let’s not forget Peabody Energy (NYSE:BTU), my 2020 office Christmas party entry that ended up surging 15x.

To answer that, we’ll use Z-scores to measure a company’s solvency. The original formula was developed in 1968 by Edward Altman and has since been updated to better reflect modern accounting standards.

Graph of Altman Z scores vs returns 2013 through 2022

Between 2013 and 2022, the quintile of lowest Z-score companies would have done roughly average. Those buying companies with the highest Z-scores would have been better off.

However, investors with a bankruptcy-sensing crystal ball could have outperformed by a wide margin. An investor who bought companies in the lowest Z-score quintile while avoiding all delisted stocks would have generated almost 25% returns per year!

Graph of Altman Z scores without de-listings vs returns 2013 through 2022

In other words, investors who understand credit markets can buy turnarounds to their benefit.

I used this tactic to scoop up Hertz (NYSE:HTZ) during bankruptcy after realizing its asset value likely outweighed its debts. And it’s why I’m suggesting stocks like Bausch Health Companies (NYSE:BHC), despite its negative Z-score of -0.2.

In other words, markets occasionally overestimate the probability of bankruptcies, leaving room for Profit & Protection investors to make small fortunes.

Part 4. Does Momentum Investing Work?

Growth… value… quality…

We’ve found that fundamental factors do work in investing, provided you can work around some counterintuitive conclusions.

But what about technical strategies? Tactical traders use them every day, drawing “resistance levels” and “breakout lines” all over price charts. They throw around terms like “dead cat bounce” as if the market were a sentient being with feelings.

And the surprising conclusion?

The data shows that some of these strategies work.

By analyzing decades of financial data, I’ve found that certain strategies can help boost the performance of a fundamentally driven portfolio.

But forget what you know about drawing lines on a chart — and don’t assume technical analysis alone will make you rich. Academic studies have long struggled to find alpha-positive technical strategies in liquid markets.

Instead, think of technical analysis as a signal for market timing. Over long periods, a 2% to 4% performance improvement can turn into meaningful gains.

3-, 6- and 12-Month Momentum

Readers of The Moonshot Investor will already be familiar with the concept of Momentum Master investing:

  • Growth stocks = Positive momentum. Winners continue to win while losers keep dropping.
  • Value stocks = Negative momentum. Stocks driven by fundamental values tend to revert to a central price.

Once again, we can turn to financial data to check these findings. By analyzing pricing information from the past decade for all Russell 3000 stocks, we see what’s worked best over the past full market cycle.

Our first study involves 3-month momentum: stocks that have risen or fallen the most over the prior three-month period (i.e., if a stock has risen in the past three months, will it keep going up for the next 12?).

Graph of 3 month momentum vs returns 2013 through 2022

As expected, the measure shows some promise over the following 12-month holding period. Stocks with the lowest quintile of momentum gained 17%, or 0.9% higher than average. Those in quintiles 4 and 5 also outperformed.

In other words, stocks at the extremes tend to do better than middle-of-the-road names.

Meanwhile, a 6-month momentum period offers slightly better outcomes for growth stocks. The lowest momentum group still performs 0.9% higher than average, but quintile five now does 1.9% better.

Graph of 6 month momentum vs returns 2013 through 2022

Finally, the 12-month momentum period is the best of all for turnarounds. The quintile of the lowest-momentum stocks outperforms the average by 2.7%.

Graph of 12 month momentum vs returns 2013 through 2022

That means momentum isn’t symmetrical for rising and falling stocks. Instead, investors should buy high-momentum stocks sooner only after seeing 3 to 6 months of gains.

As for “buy-the-dip” stocks? It turns out investors can afford to wait up to 12 months before jumping in.

200-Day Simple Moving Average (SMA-200) and Other Trading Tools

Some readers might wonder about other common tactics.

RSI… MACD… ADX…

The alphabet soup of technical strategies can feel overwhelming.

The Profit & Protection system however, ignores these signals for longer-term picks. No strategy I’ve tested has shown statistically significant improvement over pure momentum ones.

The one exception is SMA, also known as a simple moving average. The measure is useful because it also considers where a stock has traveled, not just its final endpoints. (i.e., a 6-month momentum strategy ignores the difference between a slow-and-steady gainer and one that jumped in the past month).

Graph of SMA momentum vs returns 2013 through 2022

The data shows promise. The quintile of lowest SMA stocks outperforms the average by 1.7%, while quintiles 4 and 5 outperform by a small margin.

But when it comes to pure outperformance, it still fails to live up to a simple 6- or 12-month momentum gauge.

Bottom Line on Momentum

The data tells us that investors looking for superior returns should focus on buying stocks with… well… superior momentum. Stocks in quintiles 1, 4 and 5 consistently outperform their humdrum peers in quintiles 2 and 3.

There are some logical reasons for this effect. Efficient market theories maintain that investors need to be compensated for risk — and stocks at the extreme ends of momentum tend to be particularly volatile and require an additional return.

Faster-moving stocks are also more challenging for Wall Street analysts to evaluate. A freshly listed tech startup will have far more uncertainty surrounding its price than a dividend aristocrat, opening the door for greater mispricings.

And finally, momentum is a reflection of natural human emotions. Rising stocks can create a halo effect, giving the company a greater ability to raise capital and keep its share prices moving higher. Meanwhile, falling stocks can eventually become so cheap that bargain-seeking investors jump in, regardless of the firm’s bankruptcy risk.

In all the above cases, investors can make small amounts of alpha at the margins by sticking with diverging stocks.

Conclusion: Putting It All Together

In this article, we’ve covered the essential aspects of the Profit & Protection investment system.

  • Growth
  • Quality
  • Value
  • Momentum

And here’s the twist:

The system doesn’t necessarily pick obvious companies.

As the data shows, some commonly held standards like “high operating margins,” “low P/E ratios” and “fast past growth” are actually negative indicators for future stock growth.

Instead, investors are statistically more likely to outperform by buying turnarounds, ultra-low price-to-sales companies, high-growth stocks and those with extreme momentum in any direction.

It’s why finding a “magic bullet” for investing is so difficult:

It’s often hard to explain these counterintuitive multi-factor models.

It’s also why I use these data points as the basic building blocks for my quantitative Profit & Protection scores. Companies that look like past winners (i.e., low P/S ratios, high earnings growth) earn higher scores, which are then tallied up into a final recommendation. Meanwhile, underperforming factors such as unstable ROEs and low ROICs will decrease the final grade of a stock. Discounted cash flow (DCF) modeling, industry analysis and old-fashioned research come next.

In the end, these all serve to help tilt the scales in our favor. Because with thousands of stocks to choose from, millions of data points, and a stock market that occasionally borders on madness, we need all the help we can get to outperform.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.


Article printed from InvestorPlace Media, https://investorplace.com/the-profit-and-protection-quantitative-stock-picking-system/.

©2022 InvestorPlace Media, LLC