Better Stock Picking
In the geeky world of quantitative equity portfolio management, there is sanity and a couple of investment professionals who love the fuzzy capital markets. That would be myself, and my firm's main investment guy, JP Tremblay. You see, I've know JP Tremblay for two decades. We've worked together during amazing bull markets and some of American history's worse bear markets. After a long period of going our separate ways, we got the band back together. We really didn't miss a beat in my opinion.
Last week we recorded a 45-minute impromptu video talking about two factors to improve stock picking. I tested these factors myself years ago and have been using them for managing separate account portfolios, but because we both have a deep-seated desire for evidence showing that it can really help us generate better returns I asked JP to replicate and validate these two factors using a different methodology. So JP proceeded to test these two factors to double-check my previous tests and behold - the results were very strong with a strong confidence in generating excess returns over the stock benchmarks. The excess returns were a solid 5%+ annually, leaving room for problems with slippage normally seen in implementation.
Not only did the factor backtest show higher returns, but it also had a significantly lower risk than the stocks in the lower-ranked quintiles. This is not normally seen with the traditional and tired value factors often found in academic literature. The information coefficient was large compared to most value factors as well. The spread between the highest and lowest quintiles were consistent and large. The stability of the information coefficient over time showed that the best results occurred in bull market and the predictability was worse in bear markets but of course the is found in many if not most factors that I personally have seen tested. So far I am concluding that this means the when the overall market is bad, it's hard to hide.
I first presented the results of a signal-test for one of these factors in a video on Real Vision. The results showed that if you analyzed the return distribution, it had a high peakedness compared to the overall random selection of stocks or buying beaten-down names, a common strategy by value investors. This means the return distribution was tighter. JP's test showed similar findings. The standard deviation of returns of the best-ranked stocks were substantially lower than those in worse ranked quintiles.
So how does all of this related to better stock picking? It relates because of the methodology. Over the years I have become a strong believer that evidence-based analysis based on rigorous research helps us keep our head on straight because it arms us with information to screen and rank stocks that have a higher potential to perform well compared to the markets. It gives us the ability to establish protocols using a scientific method, much like the medical field, and thus provided better advice for clients. Because investing is NOT a perfect science we understand the limitation of our data; however, when combined with solid portfolio construction and risk management strategies, we have a higher probability of generating good results for our clients and our own personal wealth.
So what are these two factors we tested? To learn more watch the video BETTER STOCK PICKING AND FACTOR TESTS. Spoiler alert - these factors are technical in nature and are very simple.
Louis Llanes is the founder of Wealthnet Investments, LLC, and Llanes Research and can be reached at louis@wealthnetinvest.com. www.wealthnetinvest.com
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