I believe that ramblings about “the economy,” whether “housing has bottomed,” “what is the yield curve telling us,” or if “Dr. Copper has lost his PhD” are patently useless. I also believe that debate about what amount of assets should be in cash/stocks/bonds is of limited efficacy in achieving long-term investment outperformance or eventual financial freedom.
Below are Fundamental, Technical, and FundaTechnical stock selection and screening criteria that are shown in academic literature, backtesting, and/or forward testing, to be effective in outperforming the market. I’ll let the pocket-protector crowd debate whether these factors are sources of Alpha or Beta, whether the Alpha is “portable,” or whether CrAPM version 4.45 can be expanded to include these considerations.
Fundamental Factors
Fundamental factors are those that relate to the underlying company, its management, financial performance, financial strength, and changes therein, without regard to the stock price.
* The accrual anomaly is well documented and is known to be international. Check for operating cash exceeding net income.
* Firms with low financing cash flow (normalized by relationship to assets) tend to outperform, again documented in academic literature.
* Cash flow ratios such as ability to cover interest payments have been documented as signs of solvency risk.
* Improvement in Current Ratio is one test of the Piotroski value screener.
* Improvement in Return On Assets is another test of the Piotroski value screener.
* Return On Invested Capital, ROIC, is cousin of ROA and used by many value gurus.
* Governance issues can create price shocks for long-term holders, hence the reading of Ks, Qs, and Proxies is part of fundamental analysis.
Technical Factors
Technical factors are those that relate to the stock price and its movement, volume, and trading characteristics.
* Price reverts from extremes, back to trend, over either short (days/weeks) or long (years) timeframes. Day and swing-trading robots can and have been built around this, and the long mean-reversion is the bread and butter of asset class investing, and to some extent, value investing. This technique is more reliable in stocks for mean reversion up (i.e. long-only strategies).
* Price tends to trend over medium time frames (weeks/months). Trend-following systems ride these price trends toward profitability.
* Suspicious levels of volume mark some, but not all, changes in trend. Extremely high volume always marks immediate or impending change.
* Companies with low float and low institutional ownership are more likely to make explosive up moves.
* Companies with high float and high institutional ownership, once momentum has stalled, are more likely to underperform and/or decline over time.
* The “days to cover” or shares shorted divided by the average daily volume, is a key indicator of the potential for a short squeeze and/or of a floor in prices should calamity befall.
FundaTechnical Factors
FundaTechnical factors are those include both Fundamental and Technical analysis.
* Various measures of “cheapness” have been found to be predictive of long-term outperformance. Arguably the most effective in the literature is the ratio of current price to book value, although ratios of price to sales, free cash flow, cash on hand, earnings, and doubtless others have been used and are effective. This is essentially a mean-reversion play with a long time horizon, filtered by a fundamental sign of company strength.
* Growth At a Reasonable Price measures (GARP) are similarly FundaTechnical. The basis of PEG is the Price to Earnings Ratio divided by the Projected Growth in Earnings. A free cup of nothing to the first person who can identify the Technical measure in that formula.
* Dividend Yield strategies are FundaTechnical. Yield is projected dividend divided by price. High-yield stocks, as a group, tend to outperform the indices.
I believe that the above information, in combination with an overall methodology that controls position size and risk, is actually useful.
You should now feel free to go and visit your favorite macro analysis blog. Say “hello” for me.
5 Comments
Hello.
I think your best posts are when lay it out Bruce Lee style, not focused on one school but mixin’ it up to get results.
Seriously though, this single post (and the “super-size me” post) could start make people so much money if they just sat down, read it, and thought about it.
This post and the “super-size me” article is why you are one of my top 5 blogs.
Keep them coming.
What amazes me is the amount of mis-information out there. Security selection will do more for your returns over time than macro analysis, broad market timing, or diversification.
Specifically, the “value” guys almost constantly dis’ the TA guys, you’ve got books where they statistically test short-term trading entry/exit signals but set up straw man arguments on PE methods (among other methods) in a short “what doesn’t work chapter” (notably lacking in statistical tests), and the academics, who have abso-frickin-lootly no business commenting on the matter, say “retail Joe can’t beat the market.”
There are pitifully few well-known writers integrating multiple methods; even those tend to have tunnel vision as to what works.
I think there are literally hundreds of methods that can beat the market over the long term. It’s not a question of which is “best” or “what works” but rather one of which is “best for me” and “what I chose to use” based on my desired level of trading activity, as well as an issue of discipline and risk control.
I’m glad you liked the post!
Bill, I’m guessing, based on this post, that you aren’t one of the posters over at Barry’s Big Picture jerking off on one of his million posts about the imminent collapse of the free world thanks to the housing market? The last six months have made concrete for me that you can’t listen to an economist when you are engaged in stock selection.
I go there occasionally, just to rattle their cages with a comment or two. Probably too often, since the enjoyment I get from baiting them doesn’t make up for the time I could spend screening stocks.
One Trackback
[…] contained in price, volume, sentiment, balance sheets, cash flow statements, etc. A well-designed technical, fundamental, or fundatechnical trading system will keep one on the right side of the economic trends, without having to expressly […]