Finding Interesting Stock Ideas The Herd Isn't Seeing

by: Marc Gerstein

At Seeking Alpha, Warren Buffett may be the single most written-about investment guru. That’s great insofar as it helps readers appreciate the benefit of sound fundamental analysis. But it may be a bit unfortunate in the way it distracts users from some incredibly valuable wisdom proffered by others. One living legend who seems much less discussed today than ought to be the case is Peter Lynch. Many associate him with the notion of backyard investing (use what you learn in the course of your day-to-day life to help find ideas), but there was, actually, a lot more to his repertoire. I’m going to offer two of my favorite quotes from his book "One Up on Wall Street" (Fireside 2000 Edition), which can greatly benefit any investor.

If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train – and succumbing to social pressure, often buys.

Page 149.

If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm.

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Yes, yes, yes, many can relate anecdotes about how well they did with popular stocks, but how often does it happen? And when it does occur, are crowd-followers actually able to consistently cash out at the right time? And do they tell you what’s happening with the rest of their portfolios?

Lynch’s preference for obscure stocks reflects much more than folk wisdom. It relates directly to the heart of one of the most vigorous theoretical market-related debates: Is the market “efficient?” Do stock prices truly reflect all available information to the point where lucky streaks aside, nobody can consistently outperform the averages? There’s a lot of brainpower behind affirmative answers and a lot of it is backed by dollars and cents, enough so to make the S&P 500 SPDR ETF (NYSEARCA:SPY) a spectacular commercial success, and then some.

Libra that I am, I’m going to suggest that the answer to the efficient-market question is a definitive “yes” and “no.”

The Stock Market Is Efficient . . .

At this point in time, I almost hate to use the phrase “information age” because it seems trite considering how far we’ve come. Suffice it to note that an investor who wants to look at company financial statement no longer has to call the corporate secretary, ask for the latest report, and hope it’s sent more quickly than via Third Class mail, or visit a regional SEC office toting a briefcase full of coins for the copier. A technician who wants to look for chart pattern no longer has to spend countless hours at a big table working with rulers and reams of graph paper. Nobody needs to wait any more by their mailbox for delivery of the monthly S&P Stock Guide (hopefully, your broker sent it to you for free) in order to look up EPS numbers necessary to calculate PEs. Those who want to keep up with the news need not subscribe to a ticker tape or wait for the next day’s Wall Street Journal.

Today, even novices can access massive amounts of information incredibly more quickly and easily than even the pros could a generation ago. Whether the efficient market theory was reasonable back when it was formulated is hard to say, but it does seem likely that today, where pretty much everybody knows pretty much everything pretty much right away, it cannot be ignored. However hard it may have been to consistently beat the market a generation ago, it’s a heck of a lot harder to do it today. And even when it can be done, the rewards are often not as exciting as they once were.

. . . Or Not

Information isn’t the only driver of today’s markets. There’s also liquidity.

Institutions and hedge funds dominate trading today. Maybe they’re smarter than you. Maybe they aren’t. What’s relevant is that they have more money than you do so their opinions, whether reasonable or not, move stock prices. Add in the impact of the algorithmic trading routines we’re seeing nowadays (these include, among other things, trading protocols are designed based on key words and phrases found in computer scans of news feeds) and it’s getting harder than ever to get a handle on stock price movements when institutions and hedge funds are on the scene. That’s the bad news.

Now, here’s the good news. Institutions and hedge funds have so much money to invest, there are many stocks they can’t touch on anything other than a minor basis. These are situations where their cost-benefit tradeoff doesn’t work. There’s no point in devoting resources to due diligence regarding situations where even if a stock doubles, the stake would necessarily be so small that the benefit to the overall portfolio would be invisible unless one were to round performance to more decimal places than usual. So as far as these companies are concerned, the information age might just as well never have happened. It’s not that the information is absent. It’s there. It’s just many investors don’t care enough to look at it.

This is the ideal Peter Lynch was addressing in the second of the quotes presented above.

Be aware that this is an ideal, not an exact description of reality. The big guys recognize the horrors of the largely efficient market that characterizes their home turf (the large cap stocks, the ones that can most comfortably absorb the dollars they must put to work) and they are desperate in their efforts to break free to the extent they can, with hedge funds having a bit more maneuverability. Hence the recent popularity of nouvelle approaches such as alternative asset classes, exotic derivatives, algorithmic trading, etc. It’s hard for them to do much with small-caps because these issues can absorb just so much money, but the pros are trying to invest here, too, the limited extent they can.

So don’t expect to find many, or even any, worthwhile stocks that precisely meet the specifics of the Lynch quote. But you can find a lot of stocks, a heck of a lot of stocks, where the big guys, although not absent, are a heck of a lot less prominent than they are among the mainstream names, making this sub-institutional segment of the market a heck of a lot less efficient than the large caps.

An Off-The-Beaten-Track Strategy

I want to establish up front one important ground rule. I never ever ignore fundamentals. Although fewer investors analyze and own small caps, the ones who do participate in this segment are generally as smart as the ones who look at large caps. So don’t expect a dog to turn into a gem based solely on small market cap. Note, too, that I confirmed this notion several times via back-testing. The benefit of getting away from the limelight is not to be found in being able to dispense with fundamental analysis, but instead, in being able to be rewarded more richly when the analysis is sound.

Let’s now focus on a model I created for Stockscreen123 called Off The Beaten Track. It uses screening rules to identify a group of stocks likely to fall outside the investment-community mainstream, stocks whose price movements are likely to be much less efficient than those that get all the attention, but which are showing indications that institutions may be starting to tune in to the limited extent they can. Here are the rules:

  1. Basic liquidity rules:
    1. alternative 1: price is at least 5 and market capitalization is at least $250 million, or
    2. alternative 2: price is at least 2 and market capitalization is at least $20 million and daily volume averaged at least 15,000 shares over the past twenty days
  2. Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks sought by most users
  3. Research coverage is by three analysts at most
  4. Institutions own less than 50% of the stock and the level of institutional ownership is less than 80 percent of the industry average.
  5. Institutional net share purchases in the latest reporting period are positive; i.e. more buys than sells (which suggests that the company may be starting to get discovered)
  6. Share price performance over the past 52 weeks must have been positive, and in the past four weeks, the percent change must have been no worse than minus 10 percent
  7. The year-to-year EPS comparison in the latest quarter must have been positive and better than the industry average

Notice I’m staying clear of penny-stock country. I don’t just want to find interesting ideas. I also want to have a chance to actually trade under reasonable terms (i.e. spreads). That said, I’m still going a heck of a lot further down in size than institutions usually do. Also, when I run this screen for myself, I add two additional rules: (i) I eliminate ADRs, and (ii) I bar OTC traded stocks, even if above penny levels.

Notice that the last two rules establish a broad (very broad) measure of respectability. But it hardly amounts to serious fundamental assessment. To accomplish that, the model limits results to the top 15 stocks based on the stock screen QVG (Quality - Value - Growth) ranking system. This brings the full panoply of fundamental analysis to bear on the couple hundred so stocks (less during the serious market downturns) that usually pass the screen.

I’m going to compare the performance of this model with the performance of the 15 highest rated (as per the QVG ranking system) stocks drawn from among those included in the S&P 500 (SPY). The results are shown in Figure 1.

(Click charts to expand)

Figure 1

As expected, being a top-ranked QVG stock (i.e. one that has fundamental merit) has been likely to reward shareholders much more boldly when it’s drawn from the off-the-beaten-track universe than you’re likely to get when the exact same analysis is applied to the largely-efficient S&P 500 universe.

Why Do Obscure Stocks Perform As They Do

Note that at times above, I equated relative obscurity (the off-the-beaten track group) with small-cap status. One might also suspect relatively obscure stocks to offer more attractive valuation metrics. Let’s perform some benchmark tests to see if, in fact, the model’s performance can be explained by small-cap status and/or valuation. If so, we can ditch the model (which entails monitoring and rebalancing as well as trading costs), and make our lives easier by using a single ETF. (For more on using benchmarks to evaluate the efficacy of strategies, you can check my recent Seeking Alpha article on that topic.)

Figure 2 compares the performance of the model to a small-cap benchmark, the iShares Russell 2000 ETF (NYSEARCA:IWM), which I could own if I want to track the small-cap-oriented Russell 2000.

Figure 2 - Model measured against a small-cap benchmark, 10-year test

Clearly, the model has outperformed the small-cap benchmark, by a lot, over the entire test period. I can also tell you the performance comparisons look very similar when the model is benchmarked against value, using the iShares Russell 3000 Value ETF (IWW), and the small-cap-value combination, using the iShares Russell 2000 Value ETF (NYSEARCA:IWN).

But upon further examination, I learned that the Model’s post 2007 peak-to-peak performance has been a lot less spectacular than what we saw in the early 2000s. Obviously, the financial crisis to do with it, but I can’t tell from Figure 2 whether it was significant; the powerful early-2000s performance caused the scale of the benchmark to, essentially, look flat. So I decided to take a closer look at just the more recent period.

Figure 3 compares the model to small-cap and value benchmarks for only the past five years.

Figure 3 - Model measured against a small-cap benchmark (IWN), 5-year test

Figure 4 - Model measured against a value benchmark (IWW), 5-year test

So here’s where we are so far.

  1. Obscurity as a catalyst for superior investment performance when joined with fundamental prudence seems a valid notion only for bull markets. That doesn’t mean, however, that we have to try to time markets to switch to something else when times turn tough. During bad periods the strategy more or less matches what we could get from general small cap and/or value. If an investor is not confident in his or her market timing ability, there’s no need to switch to an ETF. Riding out bad times with stocks like these would be reasonable given the way such a choice would allow an investor to stay positioned for a return of better times.
  2. During good times, it’s not enough to say obscure stocks do well because of the way neglect can lead to attractive valuations. There’s clearly more, here, than value alone could deliver.
  3. The small-cap effect is more interesting. For a while, the strategy delivered way more than could reasonably have been expected from a small cap strategy, (assuming reasonable market conditions). But lately, the model and the general small-cap universe have been turning in similar results.

Tweaking the Strategy

The last point, the one involving the impact of the small cap effect, is important. It doesn’t necessarily mean the model has been losing its mojo. But if I want to go through the trouble of using an active model, I’d hope to accomplish more than I could with an off-the-shelf ETF, in this case, IWM. So if I want to continue to use this strategy, I need to give some thought to whether any improvement, relative to a small-cap benchmark, is warranted.

Actually, I was able to make short work of this process because the issue raised here is one with which I’ve already coped: an apparently more-than-passing alteration in the relationship between classic fundamentals (which, in this strategy, are reflected mainly in the ranking system as opposed to the screen) and share price performance. As previously discussed, more and more information is circulating faster and wider and if anything, these trends are accelerating. It’s one thing for a human fund manager to look at a company earnings release, think about the guidance, and buy or sell as he or she deems appropriate. It’s a whole new ballgame when a company posts its release through electronic means (such as Business Wire or a similar service) and pre-programmed algorithms detect key words such as “guidance,” “higher,” “improved,” “raise,” etc. in certain combinations and perhaps even using wild-card characters (“*”) such as to allow an entry like “improv*” to mean “improve,” “improving,” “improvement,” “improved,” etc. and generate and execute trading orders in a matter of nanoseconds.

This is not to say our favorite fundamentals or even theories such as the off-the-beaten-track have become obsolete. I’ve done enough researching and testing to confidently say that over reasonable time frames, the classic fundamentals continue to serve us well. But few are willing to get buffeted for indeterminate periods by seemingly odd and sometimes vigorous stock-price movements as institutions, hedge funds, and their trading machines do more and more things with more and more different kinds of stocks. I suspect we may not be able to completely avoid these, but it does appear we may be able to cope with the modern markets if we can find a way to at least approximately piggy-back on what the big guys are doing. I’ve had some success accomplishing this via the M-word; one that will not be deleted by Seeking Alpha editors on the basis of obscenity but which many fundamentals-oriented readers may find more utterly disgusting: Momentum.

Think of momentum as being like salt. Either alone would likely produce a pretty bad taste. But using a dash of either to enhance an otherwise strong recipe could turn out quite well. I did this on through a “seasoned” version of QVG which I refer to as QVGM (Quality - Value - Growth - Momentum). If you click the links and look at the factors used in each style (you can do this even if you’re not a StockScren123 subscriber), you’ll see that the QVG part of the recipe is pretty substantial, more than enough to satisfy anyone’s definition of a reasonable fundamental profile (some even suggest I’m guilty of overkill; I disagree, but that’s a topic for another day). You’ll also see that the M component is more like a little sprinkle of salt, a teaspoon at most, rather than a full cup.

Figure 5 shows how the model fared against the small-cap benchmark over the past five years when I select the top 15 off-the-beaten-track stocks using the QVGM ranking system rather than QVG.

Figure 5 - Model (using QVGM ranking system) measured against a small-cap benchmark (IWN), 5-year test

That’s better. Now, the strategy looks capable of substantially outperforming small-caps in general, at least during up-trending markets.

By the way, the addition of the M factor did not increase the drawdown during the market’s latest swoon. These Excel-based charts use arithmetic, rather than logarithmic scales. While the red line in Figure 5 did fall off the cliff last month, the percentage decline from the peak is pretty much the same as in Figure 3, both at about 22%. (Confirming our understanding that this strategy is bad in a bear markets, the benchmark fell by a less vigorous 17.6%.

The Stocks

Here are the off-the-beaten-track stocks that currently make the grade as per the model described here.

Figure 6

As noted, to use this strategy, you’d have to be willing to assume the market will soon find its footing (something that has not yet occurred as of this writing), or simply accept it as a high-beta approach (one that seems likely to underperform down markets but hopefully outperform good markets by enough to more than make up for the tough times).

There are two ways to approach a model-based list such as this one.

You can use it as a source for new ideas. In other words, you can accept it as an opportunity to look more closely at potentially interesting stock ideas that might never have otherwise come to your attention, the sort of idea-list that might, based on the quotes presented at the start of this article, be more appealing to someone like Peter Lynch than a collection of names drawn from today’s headlines and forum discussions. Understand up front that not all stocks will be winners: there will always be some companies that make a list by meeting the letter of the law even though they may fall short in terms of the spirit of the law. However, testing suggests that there’s a good chance there will be enough winners to make stock-by-stock due diligence well worthwhile, especially since I combined screening and ranking such as to assure that the size of the list is manageable. (Screening alone might produce a list that’s too big to be useful.)

Also, don’t underestimate the potential efficacy of a full-out buy-the-list strategy, something I do a lot since I trade at, and, hence, can accomplish it without a meaningful commission burden. I’m fine with the fact that there will always be some “letter but not spirit of the law” clinkers in my portfolio, but I’ve seen time and again how I wind up with more than enough strong stocks to provide attractive overall returns.

Disclosure: I am long CRD.B.