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Many market-beating (S&P 500) strategies revolve around tiny growth stocks with low liquidity to achieve high gains that look good on paper but very difficult in practice. It is challenging though, to create a market-beating strategy when restricted to using the companies listed within the S&P 500 index. The DJIA has a Dogs of the Dow strategy that works with varying degrees of success. What about a strategy in the S&P 500?

Relative Ranking Systems

One approach to weed through the 500 companies to determine which stocks to keep is to use a relative ranking system. What are the benefits of a ranking system?

Absolute filtering rules (such as earnings growth above 20%) are inflexible and do not account for changing macro-conditions. In the 80s you could have a ‘high-yielding’ strategy that looked for dividends in the 10-15% range without too much trouble, but this would hardly be applicable in today’s market with interest and bond rates so low. An absolute ranking system may return no stocks under certain conditions but over 100 stocks in another. This is a challenge if you want to select and trade the best 5 or 10 stocks only.

Quality + Value + Growth + Graham

In light of this, I decided to create a strategy (using only S&P 500 stocks) that combined two relative ranking systems to see if we could beat the market.

The two relative ranking systems I used are compliments of Portfolio123 and I believe Seeking Alpha author, Marc Gerstein, is part of the brains behind the development of the ranking strategy.

  1. Quality/Value/Growth (QVG)
  2. All-stars: Graham

The QVG ranking system is based on 26 different filters from earnings and sales growth to deep value in different price ratios to fundamental quality as shown in margins, turnover, and return on capital.

The Graham ranking system is much more simple with only 6 ranking criteria that looks for low valuation ratios in addition to higher 5 year earnings growth and consistent reported earnings.

Extra Filters Using these ranking systems we will choose the top 10 stocks in the S&P 500. But some say that these deep value stocks might be an indication of distress and poor future expectations. Therefore we will add in two other filters that should lower our risk of companies with low liquidity and low analyst ratings:

  • Current ratio > 1
  • Average recommendation better 3 out of 5

Backtesting our Strategy

  • Average monthly retention with this strategy is 1.73% (over 20% annualized) versus the S&P 500 index of 0.20%.
  • I tested this for robustness (559 random entry points) and 1.53% monthly retention was the average. Using monthly rebalancing – on average you would have to replace 2 of the 10 stocks every month to keep your best picks.

click to enlarge

An Example of Past PicksLet’s see how this strategy performed from early October to early November:

Ticker

Name

Start

End

Gain/Loss

MktCap

HP

Helmerich & Payne, Inc.

44.73

54.92

22.78

4494.37

HUM

Humana Inc.

72.35

87.15

20.46

11696.42

BTU

Peabody Energy Corporation

36.82

43.5

18.14

9384.05

CLF

Cliffs Natural Resources Inc

60.7

70.45

16.06

8157.96

HES

Hess Corp.

56.09

63.39

13.01

18081.74

CVX

Chevron Corporation

98.2

107.72

9.69

189081.6

JEC

Jacobs Engineering Group Inc.

35.73

39.05

9.29

4358.44

RTN

Raytheon Company

42.08

45.47

8.06

14498.13

WAG

Walgreen Company

33.67

33.14

-1.57

30250.04

DV

DeVry Inc.

41.37

37.95

-8.27

2749.93

This strategy rose an average 12.95% while the broad market rose 8.21% for an excess retention of 4.74%.

The biggest loser was Devry as they posted a large earnings miss which led to a steep tumble in share prices. The next biggest loser was Walgreen with a more modest 1.57% loss over 4 weeks. Much of this was due to an impasse with Express Scripts over prescription reimbursements. Despite Walgreens’ strong sales and earnings growth – the future impact of this disagreement weighed on share prices. Helmerich & Payne is posting some pretty big growth numbers for the quarter, year, and next 5 years with comparatively low price to earnings ratios.

Current Strategy Picks

Ticker

Name

Last

MktCap

CVX

Chevron Corporation

104.25

203629.3

CLF

Cliffs Natural Resources Inc

69.35

9683.32

WAG

Walgreen Company

34.22

29741.96

HUM

Humana Inc.

86.85

13958.32

ADM

Archer Daniels Midland Company

29.12

19197.79

GLW

Corning Incorporated

13.79

21247.75

DO

Diamond Offshore Drilling, Inc.

59.03

8059.41

JBL

Jabil Circuit, Inc.

20.65

4180.47

BTU

Peabody Energy Corporation

36.72

9561.86

BEN

Franklin Resources, Inc.

99.93

20974.64

Refining the Strategy

There are a few values that some investors like to focus on when deciding which stocks in the list to buy. Here are a few considerations you may want to think about:

  1. Some like to focus on low price to sales ratios of one or less. The stocks fitting these criteria would be ADM, JBL, HUM, WAG, and CVX. You should know that when backtesting with the addition of this rule, it lowered annualized gains and created a larger portfolio loss during the 2007/08 bear market.
  2. Only keep stocks in the bottom 50% of the S&P 500 according to price to book ratios. If that is the case you should replace JBL and BEN with Kohl’s Corporation(NYSE:KSS) and Western Digital Corporation (NASDAQ:WDC). Backtesting this strategy has boosted the annualized gains by an additional 5%.
  3. Other investors look for lower forward P/E ratios. We will add another filter that only allows the bottom half of stocks with the lowest forward P/E ratios in the S&P 500 to be selected. This also boosted annual profits by 5% on average and all of the current screened picks would fit into that category.
  4. Some prefer to look at margins. If we restrict our selection to the highest third of gross margin stocks in the S&P 500, we will need to remove all the other filters except our two relative ranking systems as it is too exclusive. Doing so will give us an average compound annual growth rate of 24.1% (over the last 10.5 years). If we go this route, our list of stocks would be quite different. We would have Diamond Offshore Drilling (NYSE:DO), DeVry (NYSE:DV), Microsoft (NASDAQ:MSFT), Snap-on Incorporated (NYSE:SNA), Chesapeake Energy Corporation (NYSE:CHK), Janus Capital Group (NYSE:JNS), Union Pacific Corporation (NYSE:UNP), CSX Corporation (NYSE:CSX), and SLM Corporation (NASDAQ:SLM).

Do you have a particular S&P 500 trading strategy that you use? I’d like to hear about it in the comments section. I have made this strategy scan public on Portfolio123 under the user-created screen name ‘S&P 500 Beat the Market System’.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: S&P 500 Stock Picking Strategy That Beats The Market