There are certain things in life where the gap between the best and
worst performers is immense. Then there are others where the gap is
infinitesimal. Sports, for example, is something with an extremely
large gap. Neither myself nor anyone I know could beat Derek Rose
in a game of one-on-one even if spotted a few baskets. Tiger Woods'
form has slipped a little recently, but I personally do not know
any golfer that could defeat him. And, I'm a pretty good defender,
but I'm 100% sure Lionel Messi could dribble around me as if I were
a blade of grass. So it's fairly obvious there are some things in
life where the average Joe just can't compete against the pros.
However, there are areas with much, much smaller gaps between
the pros and everyone else. Poker is one of these. There have only
been four repeat winners of the World Series of Poker in over 40
years. Why do you think it's so difficult for a champion to win it
more than once? Most of the winners are first-timers and never win
it again. Why is that? It's not because they truly aren’t good
players. In reality, they are some of the best. You can only win a
tournament like that by fully understanding the game.
Stock investing also falls into the "small gap" camp. I would
even wager the market's gap is more narrow than poker's. You've
probably heard at least a hundred times how most professional
portfolio managers don't beat the market in a given year. Even
though Bill Miller's 15-year market-beating streak is legendary, it
ended in 2005. But you also hear the stories about how individual
investors are beating the market even when the pros aren't. Clearly
a very thin line exists in stock investing and an individual
investor can compete against the pros!
Explaining the Thin Line
So why does the thin line exist in the realm of some activities
and not others? The answer lies in the amount of skill and variance
that's inherent in whatever contest you're looking at. As a child,
I used to play in chess tournaments yet I'm sure Gary Kasparov
would make me look silly even while lying sideways from the worst
hangover he's ever had. To say it another way, even at his worst,
Kasparov is better than my best. Same goes for Rose, Woods and
Messi. So those guys have a lot of skill in what they do -- and
very little variance.
Stock investing isn't like that. First, it's hard to actually
tell which investment managers are skillful over time. Second, and
this is the main reason, there's so much variance in a manager's
historical return series that it's often difficult to distinguish
it from noise. Therefore, statisticians would say that sports and
chess, for example, have a high signal-to-noise ratio (lots of
skill, little to no variance) and poker and the stock market have
low signal-to-noise ratios (skill is less evident, with high
variance in outcomes). This is math-speak for saying there's a lot
of short-term luck involved in the market and very good investors
-- as well as very bad investors -- will occasionally experience
results that are at complete odds with their skill levels. The key
is to greatly improve your skill so there's less doubt that you
have a market-beating strategy.
Improve Your Odds
It's pretty clear that you have to find a strategy that is
profitable over a long time frame and stick with that strategy
through thick and thin. The Zacks Research Wizard presents
you with many pre-built strategies designed to beat the market. All
you need to do is find one that fits your investing style and
trading frequency or build one of your own.
As an example, I tested a few of the strategies available to you
via the Research Wizard from the beginning of 2000 until the end of
2011. Here are the results of the S&P 500 and five of the over
100 existing strategies:
The above results clearly show that each of the five pre-built
strategies easily beats the S&P 500. It's not even close.
Placing $10,000 in these strategies at the beginning of 2000 would
have allowed you to make a nearly six-fold profit at minimum, and
up to over 27 times your investment at the max. All this while the
S&P 500 basically went nowhere.
Looking at the maximum drawdowns, you can see that risks are
very similar for all of these. So how does it sound investing in a
strategy with a similar potential loss as the market, yet with at
least six-times the potential profitability? Yea, me too!
Here's a screen that captures a mix of the five strategies
listed above:
- First, start with only US stocks.
- Next, create a liquid, investible set of the stocks that have
at least a market capitalization of $100 million and
average daily trading volume greater than or equal to 100,000
shares (if there's not enough liquidity, it'll be hard for you
to trade it).
- 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 Zacks
Rank less than or equal to 2. (We only want companies that are
a "Buy" or "Strong Buy".)
- From this set, the Price/Cash Flow, Price/Earnings and
Price/Sales should ALL be less than the S&P 500 median. (We
want to pay a low price for Cash Flows, Earnings and
Sales.)
- The four week change in both the current quarter and annual
earnings estimates should be greater than the S&P 500
median. (We want improving quarterly and annual earnings
estimates.)
- The company's Return on Equity should be greater than the
S&P 500 median. (Companies with a high ROE perform well on
average.)
- Finally, the PEG Ratio should be less than the S&P 500
median. (We want a low price, high earnings and a high growth
rate.)
Here are five of the stocks that passed this screen this week
(5/25/12):
CSTR – Coinstar, Inc.
Coinstar owns and operates self-service Redbox kiosks that
enable consumers to rent or purchase movies and video games, and
self-service coin-counting kiosks where consumers can convert their
coin to cash, gift cards or E-certificates. From time to time, this
stock often bubbles to the top of my idea list. At the moment, the
company looks very attractive by any valuation measure and has seen
analysts dramatically increase their quarterly and annual earnings
estimates over the last four weeks.
TKR – Timken Co.
Timken develops, manufactures, markets and sells anti-friction
bearings and assemblies, alloy steels and mechanical power
transmissions systems. It's been a favorite stock of mine for a
couple of years now. This company has a "Strong Buy" Zacks Rank,
increasing earnings estimates for both the current quarter and the
year, yet still has a very attractive (9.0) P/E Ratio.
WCG – WellCare Health Plans, Inc.
WellCare Health Plans provides managed care services for
government-sponsored health care programs in the United States.
This company has a solid (30%) ROE, a fantastic Price-to-Sales
Ratio, and, over the last four weeks, experienced nearly a 17%
increase in annual estimated earnings. The latter can be attributed
to first quarter earnings more than doubling. The company expects
good times to continue throughout the year.
CMI – Cummins Inc.
Cummins designs, manufactures, distributes and services diesel
and natural gas engines, and engine-related component products
worldwide. This company has a great ROE (32%), a low P/E (9.3), a
good expected growth rate (22%), and is a Zacks Rank "Strong Buy"
based on the company's most recent earnings being up 36%.
ETN – Eaton Corporation
Eaton, a Cleveland-based company, provides electrical components
and systems for power quality, distribution, and control;
hydraulics components, systems, and services for industrial and
mobile equipment; aerospace fuel, hydraulics, and pneumatic systems
for commercial and military use; and truck and automotive
drivetrain and powertrain systems for performance, fuel economy,
and safety. The company is a Zacks Rank "Buy," has strong cash flow
and sales relative to price, and a good ROE.
Take Advantage of the Thin Line
The stock market presents a unique situation for you to go
head-to-head against the pros and come out victorious. There aren't
many arenas in life that present you with that kind of opportunity.
That's one of the things I like best about stock investing. So take
advantage of that thin line!
Want to find other strategies that outperform the market and
match your investing style? Perhaps you have your own ideas and
would like to see how they stack up. The Zacks Research
Wizard can provide a lot of answers to most of your
questions.
Starting today, you are invited to use it free of charge. You'll
have 14 days to create, tweak and backtest your strategies. At the
same time, you can see the latest picks from pre-loaded winning
strategies with average gains of up to +67.4% per year.
Learn more about your Research Wizard free trial
>>
Let's make some money!
Kip
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.
CUMMINS INC (CMI): Free Stock Analysis Report
COINSTAR INC (CSTR): Free Stock Analysis Report
EATON CORP (ETN): Free Stock Analysis Report
TIMKEN CO (TKR): Free Stock Analysis Report
WELLCARE HEALTH (WCG): Free Stock Analysis Report
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