Guest Blog by Kip Robbins, CFA, Zacks.com.
Having worked in the equity markets for awhile now with a primary focus on finding profitable stock-picking strategies, I sometimes feel like the keeper of great stock picking ideas. That being said, as the New Year is upon us, I’m in a giving mood and would like to gift you three great ways to pick stocks in 2012.
In the previous two articles I’ve posted here, you’ll remember that I discussed the merits of Research Wizard as an essential stock picking tool for the individual investor to create and test new ideas. So today, I’m going to give you an example of how to develop a stock-picking strategy within the Research Wizard using three specific strategies:
First, it’s very important to start with a good ranking or rating system. Most of the time, there’s a lot of research already committed to a rating and starting with a good working foundation is a great way for you to save time. (Examples of these are broker stock ratings or the Zacks Rank. I’ll use the Zacks Rank since it’s more comprehensive than broker ratings and also has a great track record for selecting stocks.)
Second, look for stocks that the market judges favorably too. Nothing is more frustrating that discovering a great company, but the stock price just doesn’t go up. So, it’s a good idea for the stock to have a good price appreciation over the past twelve months. Numerous research studies have shown that winning stocks continue to be profitable in the future. It sounds a little too easy, but it’s effective and very persistent in the stock market. (Why wouldn’t this effect go away if it’s so effective? Well, that’s why it’s called the Momentum Anomaly.)
Third, I think it’s a great idea to buy stocks at a bargain or discount. So let’s add a dash of value by looking for stocks with a low price-to-sales ratio (P/S Ratio). The P/S Ratio is a measure of how much you’re paying for each dollar in corporate revenue. Obviously you want to pay as little as possible. For example, if Stock A P/S Ratio of 1 and Stock B has a ratio of 2, then you’d pay twice the amount per dollar of sales if you bought Stock B instead of Stock A.
So at this point, if you read my last article, you’re probably thinking: It all sounds good, but just how effective is this strategy? Using Research Wizard, I built this strategy and tested it monthly from the beginning of 2000 through the end of October 2011. Over this time period, the S&P 500 returned a compounded annual return of 0.1% (So people are right when they say the equity market really hasn’t gone anywhere in 12 years!)
However, the strategy I suggested returned a compounded annual return of 16.2%. So, while the overall market’s wheels were spinning on ice, there were strategies out there that moved forward and were highly profitable–you simply need to find them.
Remember also, that if you have a low number of stocks in your portfolio, you’re going to have more volatility. For example, the strategy that I outlined contained only 10 stocks, and thus had 64% more volatility than the S&P 500 with its 500 stocks. In this case, the volatility was worth it.
5 Steps to Finding Highly-Rated Stock with Good Momentum
Here’s a 5-step methodology for finding highly-rated stocks with good momentum at a reasonable price:
#1: Start with U.S. Common Stocks.
#2: Create a liquid, investable set of stocks with the largest 3000 market values and a average daily trading value to 100,000 shares (if there’s not enough liquidity, it’ll be hard for you to trade it).
#3: Add another filter by selecting those stocks with a Zacks Rank=1. (Again, let’s stick with only the best rated stocks.)
#4: Select the top 50 stocks with the highest return over the past 52-weeks. (We’re looking for stocks with great price momentum over the last year.)
#5: Select the top 10 stocks with the lowest P/S Ratio. (Lower means that you want to pay less per unit of company revenue.)
Now it’s your turn to use Research Wizard yourself to create your own stock picking strategies. You’ll be a better investor for it.
Here’s to a safe and profitable 2012!
(Disclosure: The views and opinions expressed here are those of the author(s) and do not necessarily reflect the views of the Portfolioist. Zack’s is unaffiliated with FOLIOfn Investments, Inc. but does use its services.)