Financial services is a constantly evolving and changing industry, where money-making strategies grow, reach maturity, and decline. With few exceptions, like Julian Robertson or Warren Buffett, many outperforming institutional investors and asset managers find that they need to change their investing approach as the old ways yield less returns than they used to. When new opportunities, like HFT or macro investing come about, the savviest investors will embrace those new opportunities for only as long as they outperform.
The theory that different strategies will outperform at different times remains controversial and hotly debated, but everyone agrees that investors constantly need to find new ideas. This is easier today than it has even been in human history, which may also explain why outperforming the market is getting harder and harder.
One way of generating ideas is to gather together a variety of stocks to invest in based on a fixed criteria. The “fixed” is important here; creating rules and then making exceptions will allow investors to introduce emotion and bias into their strategy, which will lead to diminished returns.
With those fixed rules in mind, investors can apply them to a stock screener and then begin the process of stock selection, due diligence, valuation, and asset pricing. For example, let’s build a growth portfolio based on the following criteria:
- High revenue growth of 25% or more in the past 5 years
- Stocks that are down 10% or more in the past 13 weeks
- Market caps between 2.5 billion and 5 billion
- U.S. based, in any sector
Before we look at what this yields us, let’s first examine why we’ve made each criterion. First, we want revenue growth because we want to find companies that will grow into greater value in the future, which is likelier if they’ve already seen high revenue growth in the past. Second, we do not want to overpay, so we do not want stocks that are at high prices relative to the past—especially since most momentum stocks have fallen substantially in the past few months. Thirdly, we want to limit risk, so we do not want to go to very small cap stocks; likewise, we don’t want large companies unlikely to grow further, so we’ll limit our options to under 5 billion in market cap. Finally, we want to stick to the U.S., because this will make due diligence easier thanks to stricter and more familiar reporting requirements in the U.S.
While this is sector-agnostic, we would expect the results to skew towards tech, but the result is surprisingly varied:
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Here we see 17 companies that fit each of these requirements; two are Chinese ADR stocks and one is based in Argentina, so we can immediately discount them, leaving 14 remaining. Of those, six are tech (DATA, YELP, ZNGA, UBNT, AWAY, and GWRE), two are medical (ATHN, SGEN), one is consumer goods (SFM), one is financial services (PSEC), two are solar (SCTY, SWI), and two are gold (NGD, EGO).
This is a diversified bunch of recent losers, so the next step will be to find any correlations that could make for a good pair trade. A quick graphing of some of these names doesn’t show much, though:
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The next step, then, will be to do some due diligence to graph out exactly why these companies have been selling off for the past three months. Some of these names are very uncorrelated, suggesting that a basket of the most valuable of these could offer some intriguing short-term swing trading opportunities.
But at the same time, they have fallen steeply in recent weeks, which may mean many of them are just plain dogs that aren’t worth putting money in at all. How can you tell which is which? Charts and stock screeners can only do so much—this is the first step. The next step is that due diligence process that can be so messy, difficult, and confusing for many investors. But it is also the process that separates professionals from amateurs and ensures that you don’t put your money in an asset that is only going to go down further and further as the market slowly realizes it is a loser.