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How I Use Quantitative Models In My Stock Picking Approach

|Includes: American Express Company (AXP), JPM, TROW

Fundamental analysis can be complemented with other techniques to produce higher returns.

This has helped me a lot to improve my investment performance in recent years.

My marketplace service, Financials Alpha Portfolio, builds on this investment approach.

My work on Seeking Alpha since mid-2015 has been exclusively dedicated to the financial sector. As the site focuses on fundamental analysis to retail investors, my articles are targeted to this type of investors and usually I try to write about different companies rather than focusing on a small number of names.

Why I do this? Because I use Seeking Alpha mainly to assist in my research process for new investment ideas. For the stocks that I own in my portfolio, I usually don’t write about them on Seeking Alpha.

That is why if you look at my past articles, you will see only one article on T. Rowe Price Group (TROW), even though this is one of my favorite stocks within the U.S. financial sector right now.

This was a strong reason why I wanted to launch my marketplace service. To offer to followers (and potential subscribers) a way to ‘see’ what are the stocks I expect to perform better and worse, beyond my initial coverage.

Unfortunately, this has not worked out as I was expecting (regarding subscriptions) and my service is not particularly successful right now. That is why I’m writing this blog article, to better explain what I’m offering and how I do it.

Investment Approach

As I explain in the launching page of Financials Alpha Portfolio, even though I’m a fundamental-driven investor, I use a mix of quantitative and fundamental analysis to search for new ideas within my coverage.

Why is this approach better than relying just on fundamental analysis? For instance, Bernstein says that "quantitative and fundamental approaches to stock selection can each add value to the investment process, but an integrated and disciplined strategy combining the two methods can produce better results than either method alone."

The pros and cons for each method are shown below:

I think that most readers are well familiar with fundamental analysis and can see my approach on ‘free articles’ on Seeking Alpha.

Therefore, I’ll try to explain a little in more detail what I do in the quantitative part of the investment process:

My quantitative model is based on z-scores for each factor (value, growth, momentum, quality, risk, sentiment and size), leading to an overall z-score that is then extrapolated to a rank between 0-100, considering all stocks within my investment universe.

Right now, there are 75 stocks in my U.S. financial model, including the well-known names and other medium and small sized companies. I have a different model for REITs because the business models are very different.

These models are built on relative terms, which means that each stock has a z-score for each factor compared to the peer group. Therefore, this means that each z-score is based on whether the stock has higher/lower value/growth/momentum/etc. compared to all other stocks.

A z-score above 0 means that the stock has a better value in that factor than the peer group, a z-score close to 0 means that it is in-line with peers, while a negative z-score means that it is below average.

Over time, I’ve found this model very useful to determine what shares will have higher/lower returns in a relatively short period of time (a few months rather than days or years), being very good for an investor like me that is not day trading but don’t invest for the long-term (fundamental analysis is usually used for holding periods like 1-3 years).

Given this background, here is the current score for two stocks that I’ve recently sold in my portfolios, namely JP Morgan (JPM) - which was a long position – and American Express (AXP) – a short position:

A couple of months ago, JP Morgan ranked among the best stocks in my quantitative model and American Express was among the worst. However, as can be seen above, the stocks have nowadays a similar score and are ranked 42 and 39, respectively. This doesn’t justify a long or short position in these stocks right now and that was the reason to close my positions and replace them with new ones.

Track Record

How has this resulted since I’ve launched my marketplace service? Both U.S. and Europe portfolios have delivered positive returns since inception, but the U.S. has been the best one.

Since April 9 to June 20, the U.S. Long/Short portfolio is up by 10%. During this period the S&P Financials Index is flat (return of 0%), and the S&P 500 index is up by close to 6%.

Given that my L/S portfolio has zero exposure to the stock market (long and short positions offset each other), I think this performance in a relatively short period of time is quite good and clearly shows that my investment approach, different from what most investors do, works over time.

If you want to make money in financials please consider investing alongside me and take a look at my marketplace service here.

Thanks for reading, if you want to give any feedback or have questions, please use the comments section below.

Disclosure: I am/we are long TROW.