The key to making excess returns in the stock market is finding stocks that, on average, are expected to appreciate more than the averages. The challenge is that we do not know apriori which stock will beat the market and which will falter behind. Researchers have been searching for decades for stock factors that correlate to future returns. Those are commonly called stock factors, or anomalies, or beta factors. The research shows that the most prominent stock factors are Small Size of The Company (a.k.a. Small Minus Big, or SMB), Low Valuation (a.k.a High B/P Minus Low B/P, or HML), High Quality (a.k.a Quality Minus Junk, of QMJ), and Momentum (a.k.a Up Minus Down, or UMD). All other things being equal, investing in small-cap companies is expected to yield higher returns than investing in large-cap companies. Investing in cheap, i.e., low-valuation companies, is expected to yield higher returns than investing in high-valuation companies. Investing in the stocks of high-quality companies is expected to yield higher returns than investing in the stocks of junk companies, and stocks with a high price momentum are expected to yield higher returns than stocks with low price momentum. While overly simplistic, these should act as general rules or as a starting point for investment discovery.
After grasping the general idea of stock factors, the interested reader may continue to search papers that I referenced in our Resource Library.
The first step for finding winning stock ideas is thus knowing what you are looking for. Are you looking for Value, Quality, the combination of the two, Momentum, a combination of Value and Momentum, or a combination of all three factors?
I’ve shot an introductory video in which I list several free resources for finding investment ideas – How To Find Winning Stock Ideas, which is part of the video mini-series titled How To Become A Better Investor.
Now, let’s look at some more advanced resources.
The following table may help you reach an educated decision on the type of stocks that may fit your needs and temperament. It summarizes the top quantitative investing strategies that could be used as a starting point for finding new and compelling investment ideas. Each strategy differs in several respects. The most obvious one is – expected returns. Naturally, we will be looking for strategies that yield the highest returns. But there are no free lunches, and higher returns often come with a cost – higher volatility. An explanation will follow.
|Magic Formula||Low to Moderate||High to Moderate||N/A||High||High|
|Graham’s “Defensive Investor”||Moderate||Moderate||N/A||Moderate||Moderate to Low|
|Quantitative Value||Low to Moderate||Very High||N/A||Very High||Moderate|
|Deep Value||Very Low||Very Low||N/A||Very High||High|
|Net-net||Very Low||Very Low||N/A||Very High||Very High|
|Negative EV||Very Low||Very Low||N/A||Very High||Very High|
|Microcap Trending Value||Low||N/A||High||Very High||High|
The Magic Formula (MF)
The Magic Formula (MF) is the most well-known quantitative investing strategy. It was defined by Professor Joel Greenblatt of Columbia University and introduced in his book The Little Book That Beats The Market. The Magic Formula averages Valuation and Quality in similar weights. The Magic Formula screener that we have on our website is unique in a sense that for each stock, it displays the ranking of the Valuation metric separately, and the ranking of the Quality metric separately. It thus allows one to determine exactly how cheap a stock is and how high-quality it is. Greenblatt, as well as other researchers that studied the Magic Formula, had shown that it does beat the market. Nevertheless, investing in Magic Formula stocks can be volatile. All in all, the Magic Formula is an excellent pond to fish for individual cheap and high-quality companies, as well as a system for creating a quantitative stock portfolio.
Graham’s “Defensive Investor” Strategy
Conservative investors will value our Graham’s “Defensive Investor” (GDI) strategy screener. The screener is based on Benjamin Graham’s Criteria for The Defensive Investor described in his seminal book The intelligent investor published in 1949. We have shown that 70 years after its publication, Graham’s defensive stocks still beat the market by a wide margin. In fact, our simulation results show that a portfolio of 15 such Graham Defensive stocks has delivered a return, which is double the returns of the S&P 500 over the last 20 years. Graham’s criteria for the defensive investor select stocks which are large and prominent, have high Quality (profitable and pay dividends consistently) and moderately priced. Not only that they beat the market, but in general, they do so with relatively low volatility.
We have written about Graham’s “Defensive Investor” performance in the following blog articles:
Read more about Graham’s “Defensive Investor” Strategy Performance 1999-2019.
Quantitative Value (QV)
Quantitative Value (QV) is one of the most advanced quantitative strategies we have in our arsenal. While commonly used for the creation of quantitative portfolios, Our Quantitative Value screener is an excellent source for investment ideas for investors that select their stocks manually. The strategy works in two steps. First, we filter the universe for cheap stocks. We keep the 25% cheapest stocks in the universe and disposes of all other stocks. Then, we sort the remaining bucket of stocks for Quality, based on a sophisticated formula that consists of tens of quality metrics with efficacy proven by research. The resulting stocks are the highest-quality issues out of the cheapest stocks in the universe. Quantitative value stocks have a very high expected return with lower-than-the-market volatility. The QV screener is one of the first tools we look for when we are searching for compelling investment ideas.
Read about the design of our proprietary Quantitative Value model in our article: Quantitative Value Strategy – Design & Performance
We recommend watching the lessons about Quantitative Value in our online course “How To beat the market with confidence” – Module 3, Lessons 5 and 6.
If you’re interested in QV performance during 1999-2019, see our QV performance report.
For an in-depth discussion on the relationship between the Valuation and Quality factors in Quantitative Value vs. The Magic Formula and other strategies, read our white paper Spotlight: The Value of Quality.
Deep Value (DV)
The Deep Value (DV) investment strategy searches for the cheapest stocks in the universe regardless of the Quality of the underlying companies. In our Deep Value Screeners page, we have two deep value screeners. One based on the EV/EBIT valuation multiple, and the other based on a composite of six valuation multiples, which we call Value Composite 2 (VC2). Those are P/E, P/B, EV/EBIT, EV/Sales, P/FCF, and Shareholder’s Yield. Top investment research, ours included, shows that Deep Value stocks, especially small caps, deliver exceptionally high returns. Unfortunately, Deep Value stocks are characterized by high volatility. They are a way for aggressive investors, or as Graham called – enterprising investors, to generate exceptionally high investing returns.
Read about the design and the rationale behind our Deep Value strategy screener in the article: Deep Value – What Is It?
Also, see our article, Performance of Deep Value stocks, 1999 – 2019 (coming soon)
Net-nets are another way of finding the cheapest stocks trading in the stock exchange. A Net-net stock trades at a valuation that is lower than the NCAV (Net Cash Asset Value) of a company. We have two net-net screeners, each with a slightly different way of calculating the NCAV. Net-net stocks are hard to find during normal times and are more abundant during stock market crashes. Net-nets are also very volatile and somewhat unexpected. Yet, aggressive investors will find that some net-net deliver astronomical returns. Investing in net-nets is a game for advanced investors.
Read more about our net-nets screeners and their performance in our white paper: Spotlight on Net-nets.
Negative EV (NEV)
Negative EV stocks are those stocks that have huge cash hoard, even higher than their equity plus debt. Such companies are rare. Nevertheless, a basket of Negative EV stocks can deliver astronomical returns, similar to investing in net-nets.
Read more about our Negative EV screener and its performance in our white paper: Spotlight on Negative EV.
Microcap Trending Value (MTV)
Micro-cap Trending Value is the best-performing investing strategy listed in Jim O’Shaughnessy’s book What Works On Wall Street. The stocks that fit this model are those that are cheap and yet possess a high price momentum, meaning that they had appreciated over the previous year more than most of the other stocks in the universe. Micro-cap Trending Value stocks deliver exceptionally high returns with high but acceptable volatility. They are a good source for diversification for Value Investing portfolios since they possess an element of Momentum. As such, portfolios with Quantitative Value or Deep Value stocks will benefit from adding Micro-cap Trending Value stocks.
Read more about our Micro-cap Trending Value screener and its performance in our white paper: Spotlight on Micro-cap Trending Value.
If you’re interested in MTV performance during 1999-2019, see our MTV performance report.
Developing a System To Find Winning Stocks Ideas
The key to consistently finding new and compelling investment ideas, in our view, is having a system to do so. Such a system should define where and how you search for new investment ideas. Having an orderly system for finding ideas will save you a tremendous amount of time browsing and searching the internet in circles. As the saying goes, in order to catch big fish, you need to fish in the right pond. In addition, having a structured system that increases the chances that the stocks you find are those with the best prospects to appreciate. Once you find good sources and gain confidence in that they deliver the expected alpha, stick with them.
Learn more about our approach to building a system and investing intelligently in the following resources:
The Next Step
You have found a stock which seems, on the surface, that it is a compelling investment idea. Now what?
If you are a quantitative investor, like I am, you will invest in a bucket of 30-50 such stocks that result from a quantitative investing screener, without further judgment.
But assuming you are not a quantitative investor, you would probably wish to research the stock and the opportunity further.
To help you save time on your research, and gain deep insights on the quantitative traits of the stocks, we have designed
The Quant Toolbox lists hard-to-find metrics and insights on more than 2000 stocks.
We recommend downloading the free ebook How To Invest Quantitatively: A Quant Toolbox User Guide, which is available FREE on the Quant Toolbox webpage.