At the end of the day, a stock is simply a share in the ownership of a business, and market prices are reflecting a particular set of expectations about the earnings power of such a business. If the company can prove to investors that it can consistently do better than expected, then the stock price will most probably increase in order to reflect increased earnings expectations. As a matter of fact, academic research has proven that companies announcing better than expected earnings tend to outperform the market over time.
With this in mind, the following paragraphs will be presenting a quantitative investing strategy that selects companies producing consistently better than expected earnings. The backtested performance numbers are quite strong, with the strategy outperforming the market by a considerable margin over the long term.
The strategy is not intended as a list of portfolio recommendations but rather as a source of ideas in stocks with interesting characteristics for further research.
To begin with, we exclude companies with a market capitalization value below $250 million to guarantee a minimum size for the companies in the portfolio. After that, the strategy requires companies to have delivered earnings numbers above Wall Street expectations in each of the past four quarters. In addition to this, earnings expectations for the current year need to be higher than they were 4 weeks ago and also 8 weeks ago.
The main point is focusing on only companies that are consistently beating earnings expectations over the middle term and also generating improving expectations for future performance.
Among the companies that meet the requirements above, the strategy selects the 25 stocks with the strongest metrics according to the Stocks on Fire ranking algorithm. This algorithm is a stock-picking tool based on two main return drivers: price momentum and fundamental momentum.
Winners tend to keep on winning in the stock market. Besides, money has an opportunity cost, and when you buy a stock with subpar performance, that capital is not available for investing in stocks with superior strength. You don't just want to buy stocks that are performing well, you want to buy the stocks that are also performing better than others.
The price momentum metric in the Stocks on Fire algorithm measures price performance over different time frames - the past three months, the 3 months period three months ago, etc. - in order to identify consistent price winners.
The fundamental momentum factor in the Stocks on Fire algorithm measures the adjustment in sales and earnings expectations in order to find companies that are generating rising expectations about future performance. The bigger the percentage increase in earnings and sales estimates, the stronger the ranking in terms of fundamental momentum.
The Stocks on Fire algorithm has delivered market-beating performance over the long term. The chart below shows backtested performance numbers for companies in 5 different Stocks on Fire buckets over the years.
Companies with high rankings tend to produce superior returns, and stocks in the strongest bucket materially outperform the market. This shows that the system is not only effective but also consistent.
Wrapping up, the quantitative strategy is looking to buy only companies delivering earnings numbers above expectations and enjoying upward revisions in earnings forecasts. Among those names, the strategy selects the 25 names with the strongest rankings in terms of both price momentum and fundamental momentum together.
The backtested performance assessment assumes that the portfolio is rebalanced monthly and trading expenses are 0.2% per transaction. The benchmark is the Vanguard Total Market ETF (VTI).
Since January of 1999, the strategy gained 527% versus 288% for the Vanguard Total Market ETF. In annual terms, the strategy Alpha was 3.7% per year.
The strategy has significantly outperformed the market in the long term, but it also has higher volatility, and it has underperformed in the past year. This is to be expected since even the strongest strategies with the best long-term performance tend to go through periods of underperformance from time to time. Besides, the strategy is more concentrated than the benchmark, and it has a bigger exposure to growth stocks, which explains the higher volatility levels.
The table below offers more information regarding returns for different periods and risk metrics for the quantitative strategy.
The table below shows the 25 stocks currently picked by the quantitative strategy. Data in the table also includes market capitalization in millions and the magnitude of the most recent earnings surprise in percentage terms.
|APPS||Digital Turbine Inc.||$538||75.13|
|RNR||RenaissanceRe Holdings Ltd.||$8,379||30.25|
|FCN||FTI Consulting Inc.||$4,011||78.96|
|OTCPK:HMCBF||Home Capital Group Inc.||$1,097||11.85|
|WRB||Berkley (W.R.) Corp.||$13,230||28.03|
|SPNS||Sapiens International Corp NV||$917||11.76|
|ELF||e.l.f. Beauty Inc.||$819||127.13|
|GH||Guardant Health Inc.||$9,422||62.84|
|AEM||Agnico Eagle Mines Ltd.||$14,004||295.26|
|LAD||Lithia Motors Inc.||$3,007||4.78|
|TDG||TransDigm Group Inc.||$28,249||14.52|
|OTC:WJAFF||WestJet Airlines Ltd.||$2,678||539.56|
|ACGL||Arch Capital Group Ltd.||$16,094||14.92|
|CMG||Chipotle Mexican Grill Inc.||$22,656||6.07|
|SSRM||SSR Mining Inc.||$1,892||40.93|
|SAH||Sonic Automotive Inc.||$1,164||31.77|
|MEDP||Medpace Holdings Inc.||$2,820||27.56|
|PG||Procter & Gamble||$298,516||4.64|
It's important to keep in mind that the strategy does not include any criteria for sector diversification, and it also leaves aside other important considerations such as valuation for the stocks in the portfolio. This is to keep the strategy simple and straightforward.
However, investors considering any of these names should take a deeper look at the particular business from both a qualitative and quantitative perspective. The fact that the company is consistently beating expectations is a good reason to take a deeper look at it but not enough reason to buy the stock without further research. In other words, the research process starts with the quantitative strategy, it does not end there.
That being acknowledged, investment ideas supported by hard data tend to produce superior returns in comparison to buying stocks based solely on subjective opinions and emotions. When a company is consistently beating market expectations, this says a lot about its fundamental strength and the quality of its management team.
Statistical research has proven that stocks and ETFs showing certain quantitative attributes tend to outperform the market over the long term. A subscription to The Data Driven Investor provides you access to profitable screeners and live portfolios based on these effective and time-proven return drivers. Forget about opinions and speculation, investing decisions based on cold hard quantitative data can provide you superior returns with lower risk.