Label me a pessimist if you wish, but I believe we're all too
optimistic about potential outcomes regarding the stock market and
many other things in modern life. Let's not blame ourselves; it's
in our DNA. Optimism has served us well throughout our evolution.
For example, if early Homo sapiens thought they spotted a Woolly
Mammoth in the distance, it was worth checking out. If they were
right, and succeeded in killing it, their optimism would be greatly
rewarded. However, very little would go wrong if they discovered
what they thought was dinner was simply a pile of rocks. In other
words, there was little at risk in pursuing their hopefulness.
Don't get me wrong, optimism is great. After all, if you're not
willing to stick your neck out and go for something, you'll always
be faced with "What if?" And you can probably imagine what happened
to those early hominids that weren't, for the most part,
optimistic. They didn't last long, and therefore didn't pass on
those overly pessimistic genes. But I believe that the optimistic
traits, which were beneficial when we lived in caves, aren't as
well suited to a modern, high-rise society in general and the stock
market in particular. The big difference is that one has the
potential to lose a lot of money in the market, if they are acting
on optimism alone. So I believe you've got to be extremely careful
when making an investment, and that you should resist being overly
optimistic about a stock.
What initiated my thought about all this is that most stock
analysis is peppered with reasons why you should buy a stock, but
little, if anything, is ever said about why you shouldn't. Even
given the market today, the fact that 25% of analyst ratings are
Strong Buys while only about 1% are Strong Sells is a testament to
this optimism. Also, I think with most decisions, when the complete
picture isn't viewed, we tend to fill in any blanks with positive
aspects, if our initial instinct was positive. As a result, an
inaccurate picture of potential results could be constructed.
Perhaps instead of simply looking only at the positives, maybe it's
best to look at all aspects -- positive AND negative.
Leave No Stone Unturned
Too often I think investors only consider a couple things when
deciding whether to buy a stock. They might look at the
Price-to-Earnings ratio and the Price-to-Sales ratio. Or perhaps
they only look at a couple of growth rates. Or maybe they even look
at a valuation ratio and a growth rate, and if those look good,
they buy. However, I think one needs to use multiple criteria --
somewhere in the range of 10-12 considerations -- at a minimum.
You've got to create a checklist of items that indicate
market-beating investments and only buy those that pass on all
accounts. How else will you discover the negatives if you aren't
meticulous about what you're looking for?
One reason why people don't do all their homework is that perhaps
it's just too time consuming. Or maybe they don't have access to
all the data. Or possibly one just isn't sure what characteristics
of a stock or company lead to a profitable investment. But there
are fairly simple and useful tools available for removing the
illusions from your portfolio or focus list.
Discovering the "Illusions"
Zacks Research Wizard
removes all those hurdles to comprehensive stock investing by
allowing you access to hundreds of data items for thousands of
companies, the capability to backtest your ideas to determine what
really works and what doesn't, and provides extremely fast analysis
and screening. It's the perfect tool for the individual investor to
evaluate numerous different investment criteria quickly.
As an example, I used the Research Wizard to create a strategy that
removes the underperformers or "illusions" by focusing on ten
aspects I feel are important. I then tested the individual factors
to determine at what respective value for each factor indicates the
stock will underperform the market. For example, I determined that
a value less than 0.6 for Asset Utilization usually indicates the
stock will underperform the market.
I then tested the combination of all of these criteria to see if
creating a strategy designed to remove the dogs could outperform
the market. A test was conducted using the strategy detailed below
from 2002 until the end of 2011. Here are the results of the
S&P 500 and that strategy:
The above results show that strategy I created clearly outperforms
the S&P 500 over the last ten years. The total return more than
doubled that of the market! Looking at the maximum drawdowns, you
can see that risks are very similar. So there are two investment
opportunities with similar risks, yet very different return
Here's the screen that weeds out those companies that tend to
underperform the market:
- First, we're only going to evaluate
- Next, create a liquid, investible set of the stocks with
the largest 3000 market values
average daily trading volume greater than or equal to
(if there's not enough liquidity, it'll be hard for you to
- Because a lot of stocks under a certain price are difficult
to trade, keep
only those stocks trading above $5/share
- Add another filter by selecting only those stocks with a
Zacks Rank less than or equal to 2
. (Any Zacks Rank 3 or greater is either at or under market
- From this set, keep only those stocks with a
Price/Forecast Sales Ratio less than 1.25
. (My research indicates that a P/FS Ratio greater than 1.25
leads to underperformance.)
Enterprise Value/EBITDA Ratio should be greater than
zero, but less than 10.3
(We want positive EV/EBITDA ratios, anything over 10.3 tends to
underperform the general market.)
- Additionally, the
Price/Cash Flow Ratio should be less than 14.
(Any stock with a P/CF over 14 is likely to underperform.)
quarterly EPS change from the most recent quarter to that
same quarter last year needs to be better than -200%
. (While not ideal, it's OK to have negative earnings growth to a
degree, but anything major is a red flag that indicates future
underperformance for the stock.)
2-year annual cash flow growth needs to be better than
. (Again while not ideal, it's OK to have negative cash flow
growth to a degree, but anything major is a red flag that
Asset Utilization should be greater than 0.6
. (I have found that stocks of companies with Asset Utilizations
less than 0.6 are likely to underperform the market.)
Accruals should be less than -5%.
Recall, we want low accruals
and above -5% isn't good.)
- Over the last 4 weeks, the company should have had
at least one increase in the current year's earnings
. (If a company hasn't had an increase in its earnings estimates,
it tends to be a market performer or worse.)
- Finally, the
1 week change in trading volume should be
. (Increasing volume shows activity that the market is starting
to notice the stock.)
Here are five of the stocks that passed this screen this week
- Vishay Intertechnology Inc.
Vishay designs, manufactures and supplies discrete semiconductors
and passive components in the United States and internationally.
This company scored well on the entire checklist. The valuation
looks great and earnings estimates have been increasing. There's
nothing really bad about this company, but some of the cash flow
and balance sheet items look kind of average.
- Unisys Corporation
Unisys provides information technology services, software and
technology that solve mission-critical problems for clients
worldwide. This company passed on all criteria as well. Things that
look good include the basic fundamentals (good cash flow &
earnings) and improving earnings estimates. Just keep an eye on the
short interest on this stock.
- Spectrum Brands Holdings, Inc.
Spectrum Brands, together with its subsidiaries, operates as a
consumer products company worldwide. Spectrum doesn't look bad by
most criteria. Things that look good are its price momentum,
increasing earnings estimates and improving balance sheet.
Something to keep an eye on is the valuation.
- Mentor Graphics Corp.
Mentor Graphics provides electronic design automation software and
hardware solutions to automate the design, analysis, and testing of
complex electro-mechanical systems, electronic hardware and
embedded systems software. This company has been experiencing good
earnings growth, increasing estimates for this year, and the stock
price has been rocketing. As with any stock that just keeps going
up, you should be wary of the valuation you're willing to pay.
- Brown Shoe Co.
Brown Shoe, a St. Louis-based company, operates as a footwear
retailer and wholesaler in the United States, Canada, China and
Guam. This is probably my favorite stock of the bunch simply
because I have a hard time finding something I don't like about it.
The fundamentals, valuation, price momentum and earnings estimate
revisions all look good. The only yellow flag I see is a spotty
history of positive earnings surprises.
Gain Access to the Key
I wouldn't call myself pessimistic, but I would call myself
cautious. And I think when it comes to investing we should all
exhibit a little caution. Accordingly, I encourage you to fully
evaluate a company and if you find something that doesn't look
good, skip it and move on to something else.
Zacks Research Wizard
to unlock the full picture of a company before you buy. Once you
learn what works and what doesn't, you can create and save a screen
that can be run in just seconds to provide stock ideas.
Starting today, you are invited to use it free of charge. You'll
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Let's make some money!
Kip Robbins is a Quantitative Analyst with Zacks.com. He
analyzes screens and strategies for Zacks customers and for use in
Zacks Research Wizard
which empowers individual investors to use market-beating screens,
build their own and backtest their results.
BROWN SHOE CO (BWS): Free Stock Analysis Report
MENTOR GRAPHICS (MENT): Free Stock Analysis
SPECTRUM BRANDS (SPB): Free Stock Analysis
UNISYS (UIS): Free Stock Analysis Report
VISHAY INTERTEC (VSH): Free Stock Analysis
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