1. Re-Cap
The important takeaway was this:
market participants and analysts are good at pricing in (discounting) the past 12 months of data but "forget" about the past 5 to 10 years' performance of the stock. So, the current stock price reflects short term fundamentals but does not take into consideration the longer term perspective.
The book "Quantitative Value" and the whole methodology used by Alpha Architect in their systematic ranking system is based around this idea: relative strength in long term fundamentals works. If you can filter stocks based on:
5-10yr Gross Margin
5-10yr Return on Assets
5-10yr Return on Capital
5-10yr Free Cash Flow/Total Assets
etc.
then you will have a much better idea of what kind of long term performance a stock has. Here is an illustration of the point. Compare the performance of these 2 strategies:
Buy and hold for 12 months 10 stocks that make new 52Week Lows.
Buy & hold for 12 months 10 stocks that make new 52Week Lows
AND have a 5yr avg. Gross Margin > 40%.
As you can see, the results are enhanced in a material way.
So the first takeaway is that the "value" of a stock can be assessed
via the long term key fundamentals. And relative strength in long term
fundamentals is a winning proposition.
But having been first and foremost a "coin flipper" I couldn't help but ask myself: can I not make my life easier? After all, trading is all about participating when the conditions are most likely to produce positive outcomes. Trade when the odds are in your favour. Not just anywhere and anytime you feel like it.
2. Making life easier: when is it easy to find value at a good price?
Using portfolio123 I did a simulation. Reading books on "value stocks", it appears to me that a value stock is priced at an EV/EBIT value equal or less than 5, and that a deep value stock is priced at an EV/EBIT value of 3. So I simply tested how many stocks, out of the entire universe of US stocks, were priced at "value" or "deep value" each year for the last 10 years. Here are the results.
So the "deep value" stocks go from 4% to 10%, but the "value stocks"
also illustrate better the timing of the exercize. And of course, as a "coin flipper"
trying to make life easy, that's what I was really looking for. When can I find
stocks priced at value? When is the search "easy"?
From the chart above, which echoes the more detailed work done by O'shaughnessy (below),
it appears that between 2001 and 2003 it was easier to buy value at a discount.
And then again from 2009 to 2011.
So what do these zones look like on a chart?
S&P 500 - FXCM Marketscope
Logical is it not? Stocks get "pulled" down to a cheap price, relative to their "value", by an externality. Broad market declines, as indicated by 52 week declines, where we break or test the prior year's lows, are the best place to look around for value stocks to pick up.
3. Testing a dip-buying strategy
However, I could not test this kind of pullback on Portfolio123. So what I did instead was imagine that the stock price had declined, and that now the daily chart is heading back up. So I'm buying dips on a longer term daily chart. Here's the progressive equity curve this simple strategy can produce.
Buy stocks on a daily pullback in any kind of market, outperforms
buy & hold.
Buy stocks on a daily pullback, in an upwards trending market,
outperforms the simple strategy.
Buy stocks on a daily pullback, in an upwards trending market,
in stocks that have a lower accrural buildup than the industry median,
5yr avg. Gross Margin > 40% and 5Yr avg. ROA > 10%.
As you can see, buying daily dips on quality stocks makes a huge difference
not only in the overall performance, but also in the drawdown and hence
in the sharpe ratio of the strategy.
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