Time to move on to the next quant strategy I want to highlight. This post will cover a strategy called Trending Value, aka the value stocks on the mend strategy. This strategy is the top ranked strategy by risk adjusted return (sharpe ratio) in the book What Works On Wall Street. This strategy shows the power of combining the three market factors that have been proven to outperform over time; size, value, and momentum. Actually you get two strategies out of this one since you start out with a powerful value screen. With the basics we learned in the previous posts we can easily implement these strategies now.
The Trending Value strategy consists of two parts. The first part involves doing a composite value screen on the universe of all stocks. By using the all stocks universe it opens the strategy to all companies with market caps of $200M or greater which provides a smaller cap benefit to this strategy. The value composite used for this screen, value composite 2 (VC2), is the same one I described in my last post on the Utilities strategy. It basically is a ranked list of stocks based on a composite score of P/E, P/B, P/S, P/FCF, EV/EBITDA, and Shareholder Yield. This part of the strategy is one of the most powerful strategies in the book. It’s called the VC2 high 25 strategy. It simply buys the top 25 stocks ranked by the VC2 score. From 1964 through 2009 this strategy returned 18% a year with a sharpe ratio of 0.7 and a max drawdown of 55.6%. My screen results as of June 10 are below.
Pretty compelling value scores; pe and pfcf of less than 9, pb and ps of less than 1, ev/ebitda less than 6. If you’re a tried and true value investor maybe you just stop there. You’ll do great. The only issue with pure value strategies is that they can under perform for long periods of time. Remember the late 90s? Would you have been able to stick with such a strategy when companies with no business plans, no earnings, valued on clicks were ripping higher year after year? These long periods of under performance are reflected in the base rate stats. This VC2 strategy has a base rate of 88% over rolling 3 year periods. That means 12% of the time your rolling 3 year return would not have beaten the market. These are great numbers, by the way, but just one the factors affecting an investor’s ability to stick it out. But we can do even better by applying a momentum screen to this powerful value stock screen.
The second part of the strategy takes the stocks in the top decile (top 10%) of the value ranked list. In excel you would do a PERCENTRANK function on the total composite value score column then do a custom sort for a value of 0.1 (10%) or less. Now you have the top decile of value stocks from the all stock universe. The last step is simply to sort the top decile of value stocks by six month price change, highest to lowest. The top 25 stocks on this final list would be the Trending Value portfolio. Now you can see the rational in the name of this strategy. It represents the top value stocks with the best momentum or price trends. Below are the results of my Trending Value screen that I ran at the beginning of the week.
As you can see from the table above the VC2 scores aren’t as good as the pure value screen but are still quite good. The benefit you get is higher returns, 21.08%, a higher sharpe ratio, 0.91, a lower max drawdown, -51% and higher base rates. This strategy has a 3-year rolling return base rate of 97% vs 88% for the VC2 strategy. Pretty powerful stuff. Now the hard part if you’re a value investor. Actually pulling the trigger and buying into the portfolio. Look at the last column in the table. How would you feel about buying a group of stocks that already went up 74% on average over the last 6 months? Not easy for most investors. But momentum is one of the most powerful forces in markets and it tends to persist. That’s what this strategy tries to take advantage of by buying a group of value stocks that the market has acknowledged, through price appreciation, are already on the mend. Yes, they are up big but from very low levels.
In summary, the Trending Value strategy combines the best of the three long term out performance factors (size, value, and momentum) to yield superior risk adjusted returns. Now you have all the tools you need to run the strategy yourself. I would recommend learning to run the screen, run it once a month for a while, and keep track it so you can see how it performs before committing any capital to it. I have one more screen to review, the Enhanced Dividend Yield screen, before I move on to some other quantitative investing topics.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.