Two Important Questions Investors Must Ask

Successful investors spend a great deal of time analyzing what to buy. Many investors who are less than successful also spend a great deal of time analyzing what to buy. The difference between success and failure can come down to the second question, the one less successful investors often fail to consider – the question of when to buy. Successful investors consider “when” to be as important as “what” while less successful investors may believe a good company can be bought at any price.

For example, Cisco Systems (Nasdaq: CSCO) is a great company which makes great products and records billions of dollars of profits. But it hasn’t been a great investment. The stock has consistently underperformed the market.

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This underperformance comes even though CSCO has been a value stock for years with a relatively low price-to-earnings (P/E) ratio.

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This demonstrates the importance of evaluating when to buy. Value stocks can underperform for years, delivering below average returns while some investors feel trapped in their investments because they believe value is ultimately all that matters.

Finding what to buy can be relatively straightforward. There are many techniques that help identify what to buy. In most cases, these techniques are variations of fundamental analysis. To determine when to buy, technical analysis can be useful. The combination of the two disciplines can be very profitable. In the words of one investment manager, “Fundamental analysis tells me what to buy. Technical analysis tells me when to buy.” Other investment managers have said that knowledge of fundamentals was needed for them to get hired but knowledge of technical analysis is the reason they keep their job.

These impressions are confirmed by research.

A number of studies, including work by James O’Shaughnessy in What Works on Wall Street, have shown the combination of technical and fundamental strength can help to consistently identify stock market winners. In that book, O’Shaughnessy provided results for dozens of quantitative tests. He analyzed a number of ratios based on a company’s financial statements, including the popular P/E ratio and other less popular indicators. He also tested a number of technical indicators. His data demonstrated the combination of fundamental and technical analysis provided the best results in the long run.

To determine whether or not the company is undervalued, O’Shaughnessy found the price-to-sales (P/S) ratio worked best. The P/S ratio is an appropriate metric because some companies show losses over the past twelve months and the more commonly used P/E ratio would be meaningless for those companies. Using the P/S ratio to find value overcomes the problem of no earnings and allows for an investor to analyze more companies, a benefit for investors who are searching for the best possible investment opportunities.

This week, for example, more than 55% of all companies report no earnings for the past twelve months. Using the P/E ratio would limit your investments to a relatively small group of companies.

After tests that combined indicators, O’Shaughnessy found buying value stocks (those with the lowest P/S ratio) with high relative strength (RS) performed best in the long run.

RS is how well a stock performs relative to the market. For example, a stock that gains 40% sounds like a winner but if the market gained 60% during that time, the 40% gain is below average. RS ranks all stocks by performance and highlights those that have outperformed the market.

In 2001, Charles D. Kirkpatrick II, CMT, built on O’Shaughnessy’s work and was recognized with the Charles H. Dow Award (the equivalent of the Nobel Prize for technical analysis) for his paper, Stock Selection: A Test of Relative Stock Values Reported over 17 ½ Years. The paper included results of a real-time test of stock selection criteria. Kirkpatrick published his stock picks in advance and tracked the performance of two portfolio selection techniques after making the recommendations public. The was real-world testing rather than the academic style back tests completed by O’Shaughnessy. The results were summarized in a chart:

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In the paper, Kirkpatrick described the stock selection rules and sells criteria he followed.

Each week the entire list of available US stocks (usually around 5,000 issues) was screened to find stocks with RS and relative earnings growth in the top 10% of all publicly-traded companies. For List 1 in the chart, a bullish chart pattern was also required. Any stock not already on the list that met these criteria was added to the list. Stocks were sold when RS fell below the 30th percentile; or when relative earnings growth declined below the top 80th percentile; or when the price pattern turned bearish. The results for List 1 outperformed the market measured by the S&P 500 index and the Value Line Geometric Average (VLG in the chart), a broad index that is often used as a benchmark by more experienced analysts.

List 2 did even better. For List 2, the chart pattern was not used. Instead, the P/S ratio was used. To give a buy signal., the stock needed to have a relative P/S ratio at or below the 30th percentile of all stocks. The sell rules for List 2 were the same as in List 1 but the P/S ratio was not used for a sell signal since a high level didn’t mean a stock would always decline. The sell requirement for relative earnings growth was lowered to the 50th percentile since earlier experience had shown Kirkpatrick a high threshold sold stocks too soon.

As the broad market went into a bear market in 2000, the rules for List 2 were delivering big gains.

After the paper was published, Kirkpatrick published a book that was used by the American Association of Individual Investors to create a screen that follows these rules.  AAII has run this system monthly since the book was published, providing an independent assessment of the question of whether or not the strategy still works. The chart below includes this strategy (shown as Kirkpatrick value) along with two others Kirkpatrick detailed in his book. This data extends the real-time test and provides a true out-of-sample test of his method.

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Data confirms the idea that the combination of fundamental and technical analysis can be better than either discipline by itself. By now, you might be asking how you can implement a strategy like this.

There are a number of web sites that allow for screening on fundamentals. One example is finviz.com where you can screen on different criteria. At that site, you could screen for stocks with a P/S ratio that is less than 1. To find high RS stocks, you could search for stocks that have gained at least 50% in the past six months and are down in the past month. This could identify value stocks that are experiencing short-term pullbacks during long-term uptrends.

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This screen would provide you with a list of buy candidates. You could then sort by price, for example, to find the lowest priced stocks for a buy list. Or, you could sort by dividend and buy the highest yielding stocks to generate an income portfolio.

A screen like this will help answer the two questions every investor should ask before they buy – what should I buy and when should I buy. “What” is the list of low P/S ratio stocks. “When” is answered by the other two filters which identify high RS stocks. This combination has been shown to beat the market by O’Shaughnessy, Kirkpatrick and others and could help you in your efforts to beat the market.