Just as I was about to undertake a massive research project into what makes a stock grow quickly, I stumbled into a research paper titled, ‘The Anatomy of a stock market winner’.
It’s an indepth study published in 1988 by Marc R. Reinganum and is an examination of 222 firms whose stocks at least doubled in price during one year of the 1970-83 period. The hope was to find similar characteristics. The stocks which were termed ‘Great Winners’ by William O’Neil increased in value by an average of 349%.
The 70s and 80s were very different, but some things are timeless, hopefully this research paper is too.
Once the data had been collected they analysed the stocks based upon 5 categories.
The first category, “smart money,” includes the behaviours of professionally managed funds and corporate insiders. The second category contains valuation measures such as price/book and price/earnings ratios. The third grouping includes technical indicators such as relative strength. The fourth class consists of accounting earnings and profitability measures. The final category contains some miscellaneous variables that did not seem to fit into the other four groups.
Anatomy of a stock market winner: Smart Money.
When looking at investment advisors the conclusion was that “The past behavior of investment advisers is not apt to be a good predictor of future stock price movements.”
And when it came to managed funds “professional money managers may participate in, but do not prophesy, extraordinary price appreciation.”
And also that “ the buying and selling transactions of corporate insiders do not adumbrate the large price advances of the 222 winners.”
The article went on to say that….
“While the “smart money” variables may reflect the actions of well-informed investors, the evidence suggests that well-informed investors do not predict major price advances. The transactions of corporate insiders do not suggest either a leading or contemporaneous relation with the large price changes. The actions of professional money managers do not reveal a leading relation with the large price changes, although significant shifts in institutional ownership seem to be contemporaneously correlated with large price movements.”
You can read into this how you like, but their suggestion seems to be that when picking a great stock, looking into using or copying professionals probably isn’t the greatest starting point.
Anatomy of a stock market winner: Valuation Measures.
Within Valuation measures there were 5 different variables, the price/book ratio, price/earnings ratio, stock price level, stock market capitalization and Beta which is
a measure of the volatilitycompared to the market.
“The valuation evidence indicates that companies whose market values are less than their book values are potential winners. This is not startling or new. The more surprising discovery is that the 222 winners did not have low-priced stocks or low P/Es or small market capitalizations. While low price, low P/E or small capitalization may be an integral part of some successful investment strategies, these characteristics are not essential to every successful strategy”.
“Furthermore, while the firms as a group were slightly riskier than the market as a whole, the additional beta risk cannot account for the extraordinary returns of these winners”.
Anatomy of a stock market winner: Technical Indicators.
The first technical indicator was relative strength. The report says,“The ranks range from 1 to 99. The relative strength of a stock is the weighted average of quarterly price changes during the previous year, where the most recent quarter receives a weight of 40 per cent and the other three quarters each receive weights of 20 per cent”.
“These findings have two implications for investment strategy: First, one should seek out firms with relative strength ranks of at least 70; second, one should try to identify firms that exhibit a positive change in their relative strength rank from the prior quarter”.
The datagraph rating is based on a proprietary formula that assigns weights to “reported earnings [primary operating], capitalization, sponsorship, relative strength of stock, price-volume characteristics, group rank and other factors.” The datagraph rating can range from 1 to 99.
“Thus the set of winners was characterized by a datagraph rating in excess of 70 in the buy quarter. One might also consider incorporating positive changes in datagraph ratings into an investment strategy, although there is substantial overlap between these changes and changes in relative strength”.
Anatomy of a stock market winner: Earnings and Profitability Measures.
When looking at Earnings & profitability the evidence clearly indicates that a positive pretax profit margin should be one of the selection screens in an investment strategy.
Another investment rule suggested by the 222 winners is to seek out firms with a positive change in the change in quarterly earnings-that is, earnings acceleration.
Also sales acceleration duplicates this and you should look for companies that possess positive five-year quarterly earnings growth rates.
Anatomy of a stock market winner: Miscellaneous Measures.
Within Miscellaneous measures, the report discusses limiting your selection to companies with less than 20 million outstanding shares of stock, although nowadays these figures would have to be looked into.
Next up the findings went against the contrarian view of buying stocks when their prices have fallen. An investment strategy that selects stocks that are selling within 15 per cent of their maximum price during the previous two years would capture a characteristic common to the 222 stock market winners.
In the final section of the report they reconstructed and backtested the top factors combined with a Nine-Screen Strategy. Which over the 2 year interval outperformed the S&P 500 index by more than 50%.
And finally they tried to simplify this by only using the top four screens, which were; a price-to-book ratio less than 1.0 , accelerating quarterly earnings , a relative-strength rank of the stock in the current quarter greater than the rank in the previous quarter and fewer than 20 million common shares outstanding.
Although the results weren’t quite as great the strategy clearly outperformed the S&P 500.
The full paper can be found as a link in the description below.
In Reinganum’s conclusion despite the absence of popular characteristics, the trading strategies produce excess returns that are economically significant. And in their words, “This suggests that there may be more than one way to skin the performance cat!”
I also did a video format of this post with more visuals:
If you’ve enjoyed this post, you will probably enjoy reading about another popular investment strategy; Beating The Market With The Magic Formula Investing Strategy
The Anatomy of a stock market winner PDF:
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