Last week, the Chicago Quantitative Alliance (CQA) held its annual fall conference. As a member, I was able to attend this interesting two-day event. The presentation I enjoyed the most was a psychology-based talk centered around the reasons why we don't perform our best and how to move toward optimal performance. It reminded me of a book I recently finished titled The Inner Game of Tennis. It's one of those books that have applications that reach much further than the title suggests. So it could have easily been called The Inner Game of Preparing for Surgery, Stock Investing or Anything Else in Life.
The basic premise of these psychological performance themes is that we tend to over-think what we're doing and would be better off simply doing. That is, of course, doing only after we've spent hours preparing or practicing to hone our game. Once you are skilled at doing something, just do it. Don't over-think. Over-analysis can cause paralysis. Certain thought processes during analysis could also lead to confirmation bias. Studies have shown that both over-analysis and confirmation bias do impede performance.
While it's highly important to do your due diligence on stocks, I do believe too many investors buy into the story and become emotionally tied or mentally committed to a stock. It's fairly clear that one should sell if conditions change, and that's harder to do if you're committed to a stock. You've got to be able to let go of a stock that's struggling or avoid it to begin with if something just isn't right.
People also make the mistake of forming initial viewpoints and then only "see" things that confirm their first opinion and ignore items that don't match that preliminary thought. This confirmation bias affects us in all aspects of life, including stock investing. If you bought a stock, you clearly have a favorable viewpoint and will tend to ignore negative aspects that should be heeded.
Avoid Potential Mistakes
That's why I take pleasure in investing in quantitative strategies. After I've built a strategy that I am confident has a good economic rationale and superior performance, I follow it even if it tells me to sell a stock that I'd rather hold onto. I remove emotion from the process and allow the strategy to drive returns by indicating when to buy and sell. I feel that's one thing that gives me an edge in the market. I don't buy a "story" and am not committed to any specific stock. I simply see them as interchangeable vehicles useful for making money. I believe there are times when investors miss out on profitable opportunities because they're tied to a "story" stock whose price remains stagnant versus buying stocks with true return potential. Remember, a good company is not always a good investment.
Also, I don't mind if a strategy tells me to short a well-known company or buy a company I've never heard of before. So quantitative strategies also help remove familiarity bias, which is when one purchases only stocks he of she has heard of and avoids ones that are unfamiliar. In fact, one of the things I like best about quantitative strategies is that they often unearth unfamiliar stocks. These little-known stocks might provide great opportunities for profits because fewer eyes are watching them.
How To Just Do It
One of the easiest ways to implement a quantitative strategy is though a screen. A screen is a great way to find stocks based on indicators that matter. There is so much information available to investors that it's best to focus your stock-picking on proven ideas.
Our Research Wizard allows one to shift through hundreds of different data items to determine which are the most important, and then develop a screen that will identify stocks that meet the desired criteria. Since the Research Wizard contains a number of pre-built strategies, we'll take a look at Growth and Income Winners as an example. Here's how that strategy compared to the S&P 500 on a historical test from August 2002- August 2012:
Those results show that, over time, the strategy significantly outperformed the S&P 500 over the last ten years. The annualized rate of return for Growth & Income Winners was 15% higher with a maximum loss of about half as much as the S&P 500. Now that's impressive!
Here's how to find Growth & Income Winners:
- First, create a liquid, investible set of the stocks whose price is greater than $5 and average daily trading volume greater than or equal to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade).
- Select only those stocks with a current Zacks Rank less than or equal to 3. (You want stocks rated at least a buy or hold.)
- Select companies with an ROE higher than the S&P 500 median. (You want higher than average profitability.)
- Next, pick those stocks with a P/E less than the S&P 500 median. (You don't want to overpay for a stock.)
- Then, choose only those with a Debt/Equity Ratio less than 1. (Some debt is good. Too much is a problem.)
- Beta should be less than or equal to 1.00. (Low volatility stocks reduce risk.)
- Finally, select the 2 stocks in each sector with the highest Dividend Yield. (You should be looking for a good dividend as well.)
Here are five of the ten stocks that passed the screen this week (9/21/12):
Ecopetrol S.A. (NYSE:EC)
Ecopetrol, based in Bogota, Colombia, is an integrated oil company that engages in the exploration, development and production of crude oil and natural gas. This company has a better than average valuation (P/E of 13), good profitability (ROE of 32%) and has a 5.9% dividend yield. Ecopetrol also has manageable debt levels (Debt/Equity of 20%) and a low volatility in its stock price.
AstraZeneca PLC (NYSE:AZN)
AstraZeneca engages in the discovery, development and commercialization of prescription medicines for gastrointestinal, cardiovascular, neuroscience, respiratory, inflammation, oncology and infectious diseases worldwide. This company, which is one of the top pharmaceutical companies in the world, has a very attractive valuation based on a P/E of 7. This company also has good profitability measures and a lower than average debt level. The dividend yield of 6.1% is also very appealing.
Reynolds American Inc. (NYSE:RAI)
Reynolds American, through its subsidiaries, manufactures and sells cigarette and other tobacco products in the United States. This company has a mildly attractive valuation, but is highly stable and profitable and offers a nice dividend for the price. What I also like about this company is that they beat earnings expectations in the most recent quarter, which leads to its Buy rating on the Zacks Rank.
Rentech Nitrogen Partners, L.P. (NYSE:RNF)
Rentech engages in the production of natural gas-based nitrogen fertilizer and industrial products for agricultural uses. This highly profitable company, which is one you've probably never heard of, pays a nice dividend and its stock price is up 124% YTD. Even considering the price appreciation, its P/E is still below the S&P 500's. Earnings projections for the company have been revised upward many times, leading to its Zacks Rank #1 rating.
H&R Block, Inc. (NYSE:HRB)
H&R Block, through its subsidiaries, engages in the provision of tax preparation and related services to the general public in the United States. It's interesting that this stock passed the screen this week because it was mentioned at the CQA conference as a stock that would perform better with a Democrat in the Oval Office. H&R Block's valuation is just a little better than average, but has a strong ROE (38%), high dividend yield (4.8%) and low debt. It has also seen earnings projections for the next couple of years improve--perhaps in anticipation of an incumbent victory in November.
Buy Results, Not a Story
Since not all analysis is good, you obviously need to focus on avoiding the bad analysis and concentrate on the good. One of the easiest ways to do that is to implement a quantitative screen. Once you have developed a screen that works, follow it! It's good to confirm the numbers and ensure everything makes sense, but don't over-think the picks and get committed to a specific stock. Get committed to the strategy and the complete portfolio!
The strategy highlighted in this article picks stocks that have low volatility and pay a high dividend. These are also perfect stocks for a retracting market because there's usually a flight to quality and stability when the market's having an identity crisis.