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David Trainer
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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
My company:
New Constructs
My blog:
Hidden Gems and Red Flags
My book:
The Valuation Handbook
  • Investment Strategy 101 0 comments
    Jul 24, 2012 3:11 PM

    The key to suc­cess­ful Invest­ing is max­i­miz­ing upside poten­tial and min­i­miz­ing down­side poten­tial for every invest­ment decision.

    Since the future is inherently unpre­dictable, there are no "sure things" in the stock mar­ket (none that are legal…). Ergo, when bat­tling against an uncer­tain future, the best strat­egy is to max­i­mize one's odds of suc­cess - which means "max­i­miz­ing upside poten­tial and min­i­miz­ing down­side poten­tial for every invest­ment decision". In other words, we want to be long "good risk/reward" (low risk/high reward potential) and sell/short "bad risk/reward" (high risk/low reward potential). Finding the best and worst risk/reward in the US stock market is what New Constructs is built to do.

    That's the theory.

    Here's how we implement.

    Because we cover over 3000+ of the largest and most actively-traded US stocks, our broad market perspectives are well-informed. Figure 1 highlights the pockets of inefficiency we see in the valuation of stocks across the entire U.S. equity market. The figure also shows that the market is fairly efficient on a large number of stocks as well.

    Figure 1: Market Efficiency: Not Perfect By Any Means

    (click to enlarge)Sources: New Constructs, LLC and company filings

    Next, we determine the true economic profitability to identify (a) undervalued stocks with understated cash flows and (b) overvalued stocks with overstated cash flows.

    Figure 2 provides another illustration of our broad-market insights into how companies' reported profits correlate to their true economic profits. It is not a very pretty picture. Most companies, in an effort to keep up with their peers, manipulate accounting rules to overstate their profitability.

    Figure 2: Earnings Are Not What They Appear To Be Most Of the Time

    Sources: New Constructs, LLC and company filings

    Next, we overlay valuation and economic profitability to find the best and worst stocks in the market. See Figure 3.

    Figure 3: Long = Most Attractive Stocks; Short = Most Dangerous Stocks

    Sources: New Constructs, LLC and company filings

    We focus on the stocks where the fat tails overlap. We want to be long stocks with the best risk/reward as measured by a very low valuation (limited downside) and understated cash flows (earnings upside). We want to be short the stocks with the worst risk/reward as measured by a very high valuation (high downside) and overstated earnings (earnings downside).

    All the other stocks where valuation seems fairly efficient and earnings somewhat accurate are of limited interest to us. I think focusing on the extreme inefficiencies in the market is best.

    You will see a Risk/Reward Rat­ing on every­ one of the 3000+ com­pa­nies we cover. For an exam­ple, down­load a free report from our Free Archive.

    For articles featuring some of our best long and short ideas, click here.

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