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Four Important Stock Picking Factors
Want to pick better stocks? I ran some tests last week that identified
four factors that could help you do just that. Here are the details.
I used Zacks’ Research Wizard, a pricey ($1,800 for the basic program)
stock-screening program from Zacks Investment Research
(www.zacks.com)
to identify what works in terms of pinpointing promising growth
stock candidates.
Research Wizard includes a backtesting feature that allows you to
conduct tests based on data that existed as long as two years ago. That
feature allows you to, in effect, go back in time to build portfolios
based on different selection criteria, and then see what returns you
would have achieved had you actually bought the stocks back then.
Using Zacks, I defined a portfolio of actively traded growth-priced
stocks (stocks in-favor with most market players) and checked the
returns that I would have achieved by buying the portfolio in January
2007, rebalancing (picking new stocks) in June, and selling in December.
I used 2007 for my test year because in 2008, stocks moved in response
to developments in the global credit crisis rather than on company
specific issues.
My basic growth portfolio averaged a 1%
return, the same as the S&P 500. Next, I tested various fundamental and
technical factors to see if those factors could be used to select stocks
that would outperform the overall growth portfolio. If so, those factors
would be worth paying attention to when analyzing growth stock
candidates. The factors that that fit that bill included relative
strength, expected long-term earnings growth, profitability, and recent
earnings surprises.
Relative Strength
Relative strength measures how a stock’s share price performed compared
to the overall market. For instance, a 65% relative strength means that
a stock outperformed 65% of all stocks over a specified timeframe.
I increased my returns by 10% (11% vs. 1%) by
limiting my portfolio to stocks with relative strengths of 95% or higher
over the past four weeks. That result simply confirms what many
researchers have already discovered, namely that stocks that have
already outperformed are likely to continue their winning ways.
Measuring relative strength over periods up to 52 weeks produced
positive, but less impressive results. In fact, the longer the period,
the less the effect.
Earnings Growth Forecasts
In addition to forecasting this and next years’ quarterly and annual
earnings, analysts also estimate each firm’s long-term (three to
five-years) average annual earnings growth.
Limiting the field to stocks with at least 40% forecast average annual
earnings growth upped the basic portfolio’s return by
7%.
Profitability
Profitability measures how efficiently a firm uses its assets to
generate earnings. The more profitable the company, the more cash it
generates to grow its business. Return on equity (net income divided by
shareholders equity) is the most widely followed profitability ratio.
Professional money managers typically look for at least 15% ROE. Ruling
out stocks that fell short of that requirement increased the portfolio
returns by 3%. Requiring a minimum 25% ROE
added another 2% (6%
total return).
Earnings Surprise
An earnings surprise is the difference between analysts’ forecasts and
the actual reported earnings. It’s a positive surprise when earnings
beat forecasts and a negative surprise when they fall short. Significant
positive surprises, say more than 10%, typically drive share prices
higher at report time. Moreover, many studies have found that the
positive effect on share prices persists for several weeks. My tests
backed up those findings, but with a caveat. The effect is more
pronounced if you require significant positive surprises in the last two
quarters. Limiting the portfolio to stocks surprising by at least 30%,
on average, over the past two quarters, added 5%
to the portfolio returns.
What worked in 2007 won’t necessarily pick the best stocks now. Still,
the four factors that I’ve identified are worth keeping in mind when you
evaluate stock candidates. You don’t need the expensive Zacks’ screener
to find stocks with one or more of the requisite factors (finding one
stock with all four is difficult). You can use free screeners, such as
Google’s easy to use Stock Screener (www.google.com/finance/)
and MSN’s powerful Deluxe Screener (moneycentral.msn.com).
published 2/15/09 |
