Finding Quality Stocks with the New Old School Value Stock Ratings
The big project my team and I’ve been working on this year is the development of the web version for the OSV stock analyzer.
Additionally, a vital piece that I always felt was missing with the current stock analyzer was the lack of a fundamental, value based, grading and ranking system.
Not anymore.
For close to 3 months, I’ve been working with a mathematician to work out a simple and effective method to rank, rate and then backtest the performance of the stock universe based on;
- Quality
- Value
- Growth
The QVG method is nothing new. It’s already used widely throughout the investment community.
But the results obviously differ based on how quality, value and growth are defined.
And so far, my backtest is producing a 27.1% compounded average returns when the best of all three are combined. I call this the “Action Score” to reflect the idea that the stocks scoring the highest for all three should be the ones you should be focusing and spend time “acting” on.
Whether that be reading, learning, tracking or buying, the high Action stocks are the ones that should be at the top of the list.
In dollar terms, using this rating system to help buy and sell stocks over a 16.5 year period would have resulted in $587k from an initial $10k investment.
That’s a hypothetical return though.
Only if everything goes perfectly will the performance reach 27%. In reality, this will likely return 17% after fees, slippage and not being able to get enough of the required stock.
But 17% is still impressive.
The complete rating formula isn’t finished, but it’s certainly close and I’ll be writing a 3 or 4 part series going into each aspect of the rating system and how I intend to use it.
Have a Big Picture of What Type of Stocks You Want to Find
This is an important section.
There are two ways to find companies to invest in.
The first method is to look for stocks without any expectations or knowing what you are looking for. This method is the same as reading every annual report starting with the A’s.
Pros to this method:
- It’s Warren Buffett’s advice
- Build up in your brain a huge database of companies
Cons to this method:
- You must have a ton of time and not get distracted with anything else
- Likely won’t get past A
The second method is to first understand and identify what you like in a company and then to look for companies that fit the description.
Pros to this method:
- Efficient and focused
- It’s checklist based
Cons to this method:
- You immediately rule out a lot of stocks to begin with
I like and use the second method for most of my stock picks. Only about 10-15% of my stock picks come via the first method where I randomly come across a stock and it happens to be something I like.
However, a lot of people will try and apply the first method to a free screener like Google or Yahoo Finance.
Low PE and PB stocks with high ROE.
Sound familiar?
I’m guilty of it myself, and to date, I haven’t bought a single stock based on that type of search. It’s like trying to find a needle in a haystack.
So I applied method two in creating the OSV rating system.
How the Quality Score Was Created
Quality is a broad term and what I wanted to do was focus on metrics that clearly define quality from a value investors perspective.
To see what I mean, answer this question.
Is debt good or bad?
It’s neither. It’s ambiguous.
Apple has debt, but I have no problems with that. On the other hand, a company that is loaded with debt makes up the majority of the balance sheet is horrible.
So to decide whether debt is good or bad boils down to what type of company is using it.
On the other hand, what about something like FCF?
Yes, you can make the same argument for FCF as debt, but if a company has a lot of FCF, the clear indicator is that it’s a money generator. There is no ambiguity.
Introducing The Old School Value Quality Score
Based on 5 years of backtesting experience, I’ve noticed that having a lot of criteria doesn’t produce good results. That’s why I wanted it to be limited to around 3 main criteria, offer stability and focus on returning positive absolute returns.
For the Quality Score, stocks are ranked based on:
- CROIC – signals competitive advantage, management effectiveness. CROIC between 23-40 is the best range to be in.
- FCF/Sales – signals cash generation ability, how efficient a company is. FCF/Sales has to be positive.
- Piotroski score – signals fundamental strength. Highest is best.
Each company in the market is ranked for each of the above quality factors. The best stock gets a 1, the worst gets last place. These numbers are then transformed into a percentage scale and then a weighting is applied to get the final quality score.
Initially, horrible stocks with a CROIC of 1,000% or more made the list which is obviously incorrect. So stocks falling outside the accepted ranges are penalized to prevent it from making the top 20.
It sounds a lot more complicated than it is. Essentially, it’s a composite weighted formula based on the 3 metrics above.
The backtest result of 16.78% is based on a portfolio of the top 20 stocks each year.
The stocks are then held for one year.
The top 20 Quality Score stocks under-performed the market 2 times so far but the most impressive part is that it has only lost money in 2008. Even in 2008, the Quality Score was able to limit the damage to -28%.
The 16.78% CAGR return is based on the entire stock universe.
When the stock universe is limited to exclude the industries and sectors that skew results (OTC, miners, energy, financials, utilities) the performance drops to a CAGR of 13.68%. However, it still outperforms the market by 8.83% over the same period.
Overall, the Quality Score with OTC, miners, energy, financials and utilities excluded under-performs the market 5 times over the 16.5 years and is negative a total of 3 times.
It still clearly limits the damage during tough years which is a true sign of quality.
This is a Ranking System and NOT a Screener
One thing to make clear is that this is NOT a screener. A screener displays a list of stocks that meets all criteria whereas the scoring system is centered on how the stock is ranked in the entire stock universe and how the weightings are applied.
e.g. lets say stock ABC has a CROIC of 40%, FCF/Sales of 10% and Piotroski score of 8.
A screener won’t display this stock but the Quality Score could list it in the top 20.
A screener is also being built for the web version of the old school value analyzer, but the details of that will have to wait for another time.
Top 20 Quality Stocks from 2015
Here is the list of top 20 stocks that make up the Quality Score portfolio starting from Jan 1, 2015 so that you get a sense of how the Quality Ratings are applied.
When Will the OSV Ratings Be Officially Released?
Originally, the release date for the working beta was set for the end of the year, but with so many moving parts in the software development cycle, it looks like it will be a 2016 Q1 release with the ratings and screener feature will only be available to members.
The free value stock screeners will remain available to everyone but the ratings will be only within the web app itself.
In the meantime, I’ll be sharing more about each aspect of the OSV ratings and how it’s calculated.
