Harry Domash's Winning Investing

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What Works & What Doesn't?

We hear many theories for picking winning stocks. Do they work?

I decided to find out.

I recently related one of my findings on that topic, namely that stocks rated “sell” by analysts outperformed “buy” rated stocks.

Here, I’ll describe additional findings regarding insider buying, valuation ratios, and share price action. I use “backtesting” to come up with my conclusions. Backtesting lets you go back in time to select stocks according to your ideas, and see how the stocks performed over time.

Best Backtesting Tool

I used Portfolio123 (www.portfolio123.com), which offers particularly robust backtesting resources, for my research. Although Portfolio 123’s (P123) data goes back 18 years, I limited my tests to the past five years to better reflect current conditions.

I set up P123 to create a new portfolio weekly and report the returns I would have received by holding each portfolio for three months. P123 categorizes the results based on whether the S&P 500 moved up (up market) or down (down market) during the test period. For each test, P123 reports returns achieved during up markets, down markets, as well average total returns.  

For my testing universe, I included all U.S.-based stocks trading for at least $1.50 per share, typically around 5,000 stocks. Over the past five years, those stocks, when held for three months, averaged 5% returns in up markets and 4% losses in down markets. Here’s what I found, starting with moving averages.

Which Moving Averages Work Best?

Market lore says stocks move in trends which you can define by comparing a stock’s current share price to its moving average (average closing price over specified period). Stocks trading above their MAs are said to be in uptrends, and vice versa. Investors typically use 50-day MAs to gauge short-term action and 200-day MAs to measure longer-term trends.

I found that selecting stocks trading above their 200-day MAs didn’t help returns during up markets, but significantly (29%) cut losses during down markets. On the other hand, buying stocks trading above their 50-day MA didn’t improve results in up or down markets.

Do Valuation Ratios Have Value?

The Price to Earnings (P/E) ratio, popular valuation gauge, compares current share price to per-share earnings. For my tests, I used current year analyst forecasts for earnings. I found that simply restricting your portfolio to P/Es below 50 typically increased your up market returns by 15%, but didn’t cut down market losses.

Going further, sticking with P/Es below 15 resulted in 25% higher up market gains, but, again, didn’t cut down market losses.

The Price to Earnings Growth (PEG), which compares the P/E ratio to forecast earnings, is another popular valuation measure. Restricting portfolios to stocks with PEGs below 1.0 gives you around 30% up market gains, but as was the case with P/Es, didn’t cut down market losses.

Insiders Are Clueless!  

Insiders are company executives, board members, and big shareholders. Theoretically, these wired-in players buy when good news is on the horizon. But, I found that picking stocks with recent insider buying not only doesn’t increase up market returns, it increases down market losses.

My tests only covered limited time periods. Longer or shorter timeframes could change the outcomes.

Published 9/25/17

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