This week I learned a great lesson of life in my tennis class. I found myself pitted against a better player and we were to play just one set. After the first two games, I was getting blown out while barely winning a point. I was down 0-2, and thought, "This guy's good and it's gonna be ugly." I imagined him winning six straight games. Then something in my mind shifted perspective. Just as easily as I pictured the impending doom, I had a moment of clarity. I envisioned, "No, get yourself together and make it hard for this guy. You can play better, so do it!" I rallied back to win six out of the next eight games to take the set. True story.
Needless to say, I've been bounding around since then and feel I have a new outlook on life. When you undergo something like that, it becomes crystal clear that success takes perseverance and determination. And for some reason, the taste of victory is always a little sweeter when you've had to struggle for it. I often try to keep learning from my experiences and apply learned perspectives to other aspects of my life.
So my experience made me think of how this particularly rings true for the stock market today. Since May 1, the market's down over 3% and down nearly 4% since April 2. I wrote about potentially tough times and the Sell in May effect about a month ago. Now Ive formed an idea on how to find stocks that outperform in down markets.
Best Stocks for a Down Market
Like life, investing also requires equal measures of skill, luck and perseverance. So we need to find a way to find profitable stocks and continue to swim upstream even when the market's current is against us.
We don't have any control over luck, so let's ignore it in our winning formula. What we can control is the ability to endure and our skill. Each person's ability to persist is unique, so you need to find what works best for you. Paying less attention to daily market moves, taking meditative breaths and having a stiff upper lip are some examples, but find something--anything--that works specifically for you.
Where I can help you the most, though, is to point you to a tool that can improve your stock-picking skill. I'm going to use the Zacks Research Wizard to devise a strategy to pick stocks that tend to perform better than the market, specifically when the market is losing money.
Let's Take a Look
Since the Research Wizard contains hundreds of data items, I narrowed the list to a set of the one hundred that I thought would be helpful in this study. Those factors were selected based on my own experience and also knowing how others have addressed this in the past. I then conducted tests from 2002-2011, using monthly holding period returns for each factor to find the five that performed best during down markets. Drum roll please... The best five indicators are Beta, Coefficient of Variation, Pretax Margin, Return on Equity and Forward Earnings to Price Ratio.
Building a combination strategy using these five indicators provides very interesting performance results. First off, the strategy outperforms the market 76% of the time when the market is down and the average excess return during a down market is +2.1% per month. For example, if the market returns -1.1% for a month, this strategy, on average, would return +1.0% for that month.
Also, this five-factor strategy is less risky than the S&P 500. Its annualized volatility and average losing stretch in terms of number of periods and returns are all less than the S&P 500. But what's most remarkable is that this strategy also outperforms the S&P 500 over the ten-year test period!
The average annual compounded return is 13.3% for the strategy versus 2.7% for the S&P 500. $10,000 grew to $35,004 for the strategy and $13,094 for the S&P 500. This combination also beat the S&P 500 in average return per month, average number of positive months and highest number of positive months. Thus, we kind of have the Holy Grail of a strategy: one that outperforms the market, yet has less risk. It's not too often you discover something that special!
Here's the method for a market-beating strategy with less risk:
- First, start with only US stocks.
- Next, create a liquid, investible set of the stocks with the largest 3000 market values 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 the 250 stocks with the lowest Beta. (Let's minimize our exposure to the market by selecting low Beta stocks.)
- From this set, select the 100 stocks with the highest Coefficient of Variation. (CoV is the ratio of the consensus annual earnings estimate divided by standard deviation of the estimates. So we want a high earnings estimate and a low variation of these estimates.)
- Pick the top 50 stocks with the highest Return on Equity. (Companies with a high ROE perform well on average and this holds true for market slides as well. Think "flight to safety.")
- Next, opt for the 25 stocks with the highest Pretax Margin. (Profitable companies tend to perform well in down markets.)
- Finally, choose the 10 stocks with the lowest price-to-earnings ratio. (Lower means you want to pay less per unit of earnings.)
Here are five of the stocks the strategy produced this week (5/11/12):
CPB - Campbell Soup Co.
Campbell, a New Jersey-based company, together with its subsidiaries, engages in the manufacture and marketing of branded convenience food products worldwide. This company has a Beta of 0.3, a high consensus earnings estimate with little variation, a whopping 71% ROE, a Pretax Margin of 15% and a P/E ratio of 14. "Soups on" when the dark clouds of the market loom.
BCR - C.R. Bard, Inc.
C.R. Bard and its subsidiaries design, manufacture, package, distribute and sell medical, surgical, diagnostic and patient care devices worldwide. This stock has an attractive P/E of 15, a solid Pretax Margin of 18%, a 31% ROE, a high and agreed upon annual earnings estimate and a low Beta of 0.34. That all adds up to a fairly safe and consistent company, and the market generally rewards those companies in times of despair.
FRC - First Republic Bank
First Republic, together with its subsidiaries, provides personalized relationship-based preferred banking and business banking, real estate lending, trust and wealth management services to clients in the metropolitan areas of the United States. This company has an excellent P/E ratio of 12 and a fabulous Pretax Margin of 41%. Also, the 0.22 Beta is the lowest of these five stocks. "Solid and stable at an inexpensive price" best describes this stock.
APOL - Apollo Group Inc.
Apollo, through its subsidiaries, provides online and on-campus educational programs and services at the undergraduate, masters and doctoral levels. With a high ROE, high Pretax Margin and a low P/E ratio, this stock is a good way to economically buy into solid corporate profits.
HTS - Hatteras Financial Corp.
Hatteras Financial operates as an externally-managed mortgage real estate investment trust (REIT). In terms of its P/E (8), this company is the least expensive of the bunch. Coupling that with the low Beta and the high Pretax Margin creates a good stock to hold when the market heads south.
Pick Yourself Up, When the Market Kicks You Down
Just as easily as I was able to turn my tennis game around, you can turn your investing fortunes around. I know you can. If you possess a winning strategy, you have to persist with it even if you suffer a few losses along the way. That's one of the attributes that separates the great investors from the poor investors. When faced with adversity, you have to find a way to work through it if you want to be profitable in the end. Remember, investing is a marathon not a sprint.
Want to find more stocks that outperform when the market takes a dive? Have your own ideas for selecting stocks in a down market and want to test it? These questions are very easy to answer with the Zacks Research Wizard.
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 that average gains of up to +67.4% per year.
Learn more about your Research Wizard free trial >>
Let's make some money!
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.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks portfolios and strategies are available at: https://www.zacks.com/performance.