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There are certain things in life where the gap between the best and worst performers is immense. Then there are others where the gap is infinitesimal. Sports, for example, is something with an extremely large gap. Neither myself nor anyone I know could beat Derek Rose in a game of one-on-one even if spotted a few baskets. Tiger Woods' form has slipped a little recently, but I personally do not know any golfer that could defeat him. And, I'm a pretty good defender, but I'm 100% sure Lionel Messi could dribble around me as if I were a blade of grass. So it's fairly obvious there are some things in life where the average Joe just can't compete against the pros.

However, there are areas with much, much smaller gaps between the pros and everyone else. Poker is one of these. There have only been four repeat winners of the World Series of Poker in over 40 years. Why do you think it's so difficult for a champion to win it more than once? Most of the winners are first-timers and never win it again. Why is that? It's not because they truly aren’t good players. In reality, they are some of the best. You can only win a tournament like that by fully understanding the game.

Stock investing also falls into the "small gap" camp. I would even wager the market's gap is more narrow than poker's. You've probably heard at least a hundred times how most professional portfolio managers don't beat the market in a given year. Even though Bill Miller's 15-year market-beating streak is legendary, it ended in 2005. But you also hear the stories about how individual investors are beating the market even when the pros aren't. Clearly a very thin line exists in stock investing and an individual investor can compete against the pros!

Explaining the Thin Line

So why does the thin line exist in the realm of some activities and not others? The answer lies in the amount of skill and variance that's inherent in whatever contest you're looking at. As a child, I used to play in chess tournaments yet I'm sure Gary Kasparov would make me look silly even while lying sideways from the worst hangover he's ever had. To say it another way, even at his worst, Kasparov is better than my best. Same goes for Rose, Woods and Messi. So those guys have a lot of skill in what they do -- and very little variance.

Stock investing isn't like that. First, it's hard to actually tell which investment managers are skillful over time. Second, and this is the main reason, there's so much variance in a manager's historical return series that it's often difficult to distinguish it from noise. Therefore, statisticians would say that sports and chess, for example, have a high signal-to-noise ratio (lots of skill, little to no variance) and poker and the stock market have low signal-to-noise ratios (skill is less evident, with high variance in outcomes). This is math-speak for saying there's a lot of short-term luck involved in the market and very good investors -- as well as very bad investors -- will occasionally experience results that are at complete odds with their skill levels. The key is to greatly improve your skill so there's less doubt that you have a market-beating strategy.

Improve Your Odds

It's pretty clear that you have to find a strategy that is profitable over a long time frame and stick with that strategy through thick and thin. The Zacks Research Wizard presents you with many pre-built strategies designed to beat the market. All you need to do is find one that fits your investing style and trading frequency or build one of your own.

As an example, I tested a few of the strategies available to you via the Research Wizard from the beginning of 2000 until the end of 2011. Here are the results of the S&P 500 and five of the over 100 existing strategies:

The above results clearly show that each of the five pre-built strategies easily beats the S&P 500. It's not even close. Placing $10,000 in these strategies at the beginning of 2000 would have allowed you to make a nearly six-fold profit at minimum, and up to over 27 times your investment at the max. All this while the S&P 500 basically went nowhere.

Looking at the maximum drawdowns, you can see that risks are very similar for all of these. So how does it sound investing in a strategy with a similar potential loss as the market, yet with at least six-times the potential profitability? Yea, me too!

Here's a screen that captures a mix of the five strategies listed above:

  • First, start with only US stocks.
  • Next, create a liquid, investible set of the stocks that have at least a market capitalization of $100 million and average daily trading volume greater than or equal to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade it).
  • Because a lot of stocks under a certain price are difficult to trade, keep only those stocks trading above $5/share.
  • Add another filter by selecting only those stocks with Zacks Rank less than or equal to 2. (We only want companies that are a "Buy" or "Strong Buy".)
  • From this set, the Price/Cash Flow, Price/Earnings and Price/Sales should ALL be less than the S&P 500 median. (We want to pay a low price for Cash Flows, Earnings and Sales.)
  • The four week change in both the current quarter and annual earnings estimates should be greater than the S&P 500 median. (We want improving quarterly and annual earnings estimates.)
  • The company's Return on Equity should be greater than the S&P 500 median. (Companies with a high ROE perform well on average.)
  • Finally, the PEG Ratio should be less than the S&P 500 median. (We want a low price, high earnings and a high growth rate.)

Here are five of the stocks that passed this screen this week (5/25/12):

CSTR – Coinstar, Inc.

Coinstar owns and operates self-service Redbox kiosks that enable consumers to rent or purchase movies and video games, and self-service coin-counting kiosks where consumers can convert their coin to cash, gift cards or E-certificates. From time to time, this stock often bubbles to the top of my idea list. At the moment, the company looks very attractive by any valuation measure and has seen analysts dramatically increase their quarterly and annual earnings estimates over the last four weeks.

TKR – Timken Co.

Timken develops, manufactures, markets and sells anti-friction bearings and assemblies, alloy steels and mechanical power transmissions systems. It's been a favorite stock of mine for a couple of years now. This company has a "Strong Buy" Zacks Rank, increasing earnings estimates for both the current quarter and the year, yet still has a very attractive (9.0) P/E Ratio.

WCG – WellCare Health Plans, Inc.

WellCare Health Plans provides managed care services for government-sponsored health care programs in the United States. This company has a solid (30%) ROE, a fantastic Price-to-Sales Ratio, and, over the last four weeks, experienced nearly a 17% increase in annual estimated earnings. The latter can be attributed to first quarter earnings more than doubling. The company expects good times to continue throughout the year.

CMI – Cummins Inc.

Cummins designs, manufactures, distributes and services diesel and natural gas engines, and engine-related component products worldwide. This company has a great ROE (32%), a low P/E (9.3), a good expected growth rate (22%), and is a Zacks Rank "Strong Buy" based on the company's most recent earnings being up 36%.

ETN – Eaton Corporation

Eaton, a Cleveland-based company, provides electrical components and systems for power quality, distribution, and control; hydraulics components, systems, and services for industrial and mobile equipment; aerospace fuel, hydraulics, and pneumatic systems for commercial and military use; and truck and automotive drivetrain and powertrain systems for performance, fuel economy, and safety. The company is a Zacks Rank "Buy," has strong cash flow and sales relative to price, and a good ROE.

Take Advantage of the Thin Line

The stock market presents a unique situation for you to go head-to-head against the pros and come out victorious. There aren't many arenas in life that present you with that kind of opportunity. That's one of the things I like best about stock investing. So take advantage of that thin line!

Want to find other strategies that outperform the market and match your investing style? Perhaps you have your own ideas and would like to see how they stack up. The Zacks Research Wizard can provide a lot of answers to most of your questions.

Starting today, you are invited to use it free of charge. You'll have 14 days to create, tweak and backtest your strategies. At the same time, you can see the latest picks from pre-loaded winning strategies with average gains of up to +67.4% per year.

Learn more about your Research Wizard free trial >>

Let's make some money!

Kip

Kip Robbins is a Quantitative Analyst with Zacks.com. He analyzes screens and strategies for Zacks customers and for use in Zacks Research Wizard, which empowers individual investors to use market-beating screens, build their own and backtest their results.

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