Avoid These 15 Stocks For Their Valuation, Momentum And Trading Volume

Summary

• Today there are many bubble stocks of companies working on new technology and new products. Many investors already avoid these stocks.
• But which stocks of established companies should be avoided? I look for overvaluation, smooth negative momentum and high trading volume.
• My quantitative rankings provide a warning against holding such stocks in particular certain commodity and airline stocks.

What are stocks to avoid? Many value investors say overvalued stocks. Momentum investors say stocks with a bad momentum. I think both value investors and momentum investors are right. It is good to avoid stocks with high valuation metrics, especially earnings related metrics such as EV/EBIT, P/FCF and EV/Revenue. Also it is good to avoid stocks with a strong negative momentum.

Very few people avoid stocks with high trading liquidity. That is a pity because holding a portfolio of stocks with high trading liquidity is well known to result in lower returns. See also this scientific paper.

Is it necessary to avoid stocks that are very volatile? I think holding such stocks increases risks, so it decreases risk adjusted returns. However volatile stocks often provide good trading opportunities. Such as buying after a couple of months no news and then selling after a news release triggers a pop. Or even simpler: buy the stock, set a limit order to sell it at a substantially higher price or sell at the market price after 3-6 months.

Wesley Gray and Jack Vogel wrote a book on a strategy for investing in stocks with good momentum and a smooth chart. Such stocks represent opportunities where information is slowly spreading. As more and more individuals are getting convinced of the bull thesis more and more people are bidding the stock up.

Would it also work the other way around? Are investors better off with avoiding stocks with smooth negative momentum? I suppose yes, especially if they have multiples suggesting overvaluation. So what are the stocks one should avoid, at all times:

1. Smooth and strong negative momentum,

2. Overvalued according to several metrics,

3. Not so high volatility,

4. High trading liquidity

To find these stocks I ranked stocks with market cap above $2 billion on several valuation metrics, 11-months momentum (excluding the most recent month) and trading liquidity. I exclude the stocks with only a few years of financial history. I took the worst stocks according to the this ranking and sorted them on my smoothness metric for momentum, information discreteness. The lower this smoothness metric the smoother the chart. I picked the worst 15 stocks as the first 15 stocks with information discreteness below -0.1.

See this table:

For an example of how a chart with strong and smooth negative momentum looks like see the chart of Grupa Lotos. Since I have to compare stocks traded in different currencies I convert all stock prices to US dollars. Also in the chart below the stock price has been converted from PLN to USD:

US-listed stocks to avoid

There are 4 US-listed stocks in this table: Valero Energy Corporation (VLO), EOG Resources Inc (EOG), Concho Resources (CXO) and Suncor Energy (SU).

I think these resources and energy stocks might have their day but not in the next 3-4 months. Short term I expect further losses for shareholders of these companies. While not yet visible to many investors the coronavirus has done a lot of damage to the world economy. That should continue to affect demand for commodities.

Several other stocks can be traded on OTC exchanges: West Japan Railway Company (OTCPK:WJRYY), Kawasaki Heavy Industries (OTCPK:KWHIY), Nikon Corp (OTCPK:NINOY), Japan Airlines Co Ltd (OTCPK:JAPSY) and Deutsche Lufthansa AG (OTCQX:DLAKY).

In particular the 3 transport stocks should be avoided in the next 3-4 months because it will take time for commuting and air travel to rebound. I expect it will take 2 years before business air travel and commuting will be at pre-corona levels. See here for my article on Lufthansa.

Final words

Judging from the title of this article one may have expected to see many bubble stocks in this list. However my implementation of the above ideas excludes all stocks with good momentum, the most volatile stocks but also stocks with only a few years of financial history such as IPOs. Most bubble stocks are in one of these 3 boxes. Instead this method is looking for more established companies with a slowly spreading bear thesis. So as expected there are no modern battle stocks in this list. Instead we are looking at stocks with radically changed fundamentals such as energy stocks and airlines.

One may have expected to see IBM here. IBM is probably Jim Chanos' "best idea". But IBM's 12-months momentum is barely negative. I guess it would need a couple of extra months of declines to be smooth enough for lists like the one above. IBM might also be too cheap according to multiples based on its own reporting, but of course not according to how Jim Chanos looks at it. So far Jim Chanos' bear thesis fails to convince increasing numbers of investors. It is too early to short IBM.

So this article also provides a different perspective on short selling: not going after the well known battle stocks but start with relatively unknown stocks from a quantitative ranking. Then do your own research on these stocks. Short the names with an attractive fundamental thesis. And do not forget to cover after 3-4 months because momentum can turn around quickly.

Global Deep Value Stocks is a long only newsletter. I do not publish research on stocks like the ones mentioned here in Global Deep Value Stocks. See here and here for examples of what I do at Global Deep Value Stocks. For more information you can take a free trial here or send me a DM.