Part 16 (1/2)
Value Line Publis.h.i.+ng, Inc. has the oldest continuous ranking service, initiated in 1965. They rank stocks by three qualities: timeliness, safety, and technicals. They boast that the returns on their timeliness ranking are in excess of 26,000% since 1965, compared with the return on the DJIA of 826%. Their web site posts a list of charges for their services.
Starmine (a Thomson Reuters company) is considered one of the high-end providers of a.n.a.lytic tools, as well as stock ranking. They offer newsletters with ”earning surprise forecasts” and those companies expected to have material or structural changes in earnings. They target a mostly professional clientele at a fee.
Other services, such as , Cramer's Mad Money, Reuters, and The Motley Fool () provide both premium and free stock ratings. Examples of the free services are shown in the next section. It is worth repeating that claims of success are a normal part of marketing a product, but whether you are buying a service or doing your own ranking, you must prove that it works.
TABLE 9.1 a.n.a.lyst recommendations provided on the MSN Money web site.
Not Quite a Rating Service.
If you can't afford to pay for a proprietary rating service, there are other options. Many web sites allow you to sort stocks by one characteristic, such as price/earnings ratio (P/E), but MSN Money offers a summary of a.n.a.lyst recommendations. Table 9.1 shows 27 recommendations for Microsoft on May 25, 2010, grouped from strongest to weakest, plus the 3-month history of recommendations. The bottom line gives the mean recommendation, which is interpreted as 1.0 = strong buy, >1.0 to 2.0 = moderate buy, >2.0 to 3.0 = hold, >3.0 to 4.0 = moderate sell, and >4.0 = strong sell.
This seems to be exactly what we would want. The only inconveniences are that: You must enter each stock individually and record its recommendation in a spreadsheet.
You will need to develop a history of performance relative to the recommendations to be sure that the best recommendations bear some relations.h.i.+p to successful performance, or at least fall in the upper 50% of performance of the candidates.
On the other hand, the price is right. MSN Money also has its StockScouter Ratings, which have features similar to other services we are discussing.
TABLE 9.2 Fromrankings for airlines.
Symbol Equity Rating ALGT ALLEGIANT TRAVEL CO B+.
CPA COPA HOLDINGS SA B.
HA HAWAIIAN HOLDINGS INC B.
LFL LAN AIRLINES SA C+.
LUV SOUTHWEST AIRLINES C+.
TAM TAM SA C.
GOL GOL LINHAS AEREAS INTELIGENT C.
RJET REPUBLIC AIRWAYS HLDGS INC C.
PNCL PINNACLE AIRLINES CORP C.
JBLU JETBLUE AIRWAYS CORP C.
Source: .
TABLE 9.3 Jim Cramer's Mad Money daily stock calls (May 24, 2010).
In addition to access to the Jim Cramer Mad Money daily recommendations,provides both premium and free ranking services. It provides individual stock rankings by sector, shown for airlines in Table 9.2, and Cramer's stock calls are shown in Table 9.3. As with many other services, how the rankings are arrived at is not disclosed.
TheStreet.com Ratings stock model compiles and examines all available financial data on a daily basis to gauge stocks' probabilities of moving up or down. The model scores stocks on various factors-including growth, financial solvency, stock price performance and volatility-which, when taken together, have shown strong correlation with future stock performance. The aim is to deliver investors with stock ideas that we feel have the best chance at delivering top risk-adjusted returns.
Investor's Business Daily also ranks stocks. In an academic paper, ”A Test of the Investor's Daily Stock Ranking System” (Financial Review 33, no. 22, March 9, 2005), Olsen, Nelson, Witt, and Mossman conclude that ”the best system provides market adjusted abnormal returns of 1.8% per month.” While not free, the cost is not excessive.
Do-It-Yourself Ranking The Morningstar Stock Quickrank offers a fully technical ranking approach applied to the major equity sectors, stock funds, ETFs, and some other investment vehicles. You can choose to rank by market cap, sales, year-to-date total return, dividend yield, return on equity, earnings growth, price/earnings ratio, relative strength, and other features. Once selected, you get a list of stocks as shown in Table 9.4.
TABLE 9.4 Sample of Morningstar's Stock Quickrank for all stocks, return on equity.
Ticker Symbol Name Return on Equity % NEGI National Energy Group, Inc. 244.19 FXEN FX Energy, Inc. 240.06 MRIB Marani Brands, Inc. 231.92 MARPS Marine Petroleum Trust 231.11 SPNG Spongetech Delivery Systems Inc. 230.45 TIRTZ Tidelands Royalty Trust 227.77 PAY VeriFone Systems Inc. 223.74 ARB Arbitron Corporation 216.63 IHG Intercontinental Hotels Group PLC 212.39 AH Accretive Health, Inc. 199.92 BJGL Beijing Logistic Inc. 198.76 AJGH American Jianye Greentech Holdings Inc. 196.74 LGBS Legends Business Group, Incorporated 196.36 SNSTA Sonesta International Hotels Corporation 195.48 SWKH SWK Holdings Corporation 194.00 PNGXQ PNG Ventures, Inc. 192.56 ESI ITT Educational Services, Inc. 184.17 IMMU Immunomedics, Inc. 183.92.
WLSA Wireless Age Communications, Inc. 183.35.
MILL Miller Petroleum, Inc. 181.59.
Return on equity (ROE) measures a firm's return on shareholder investment (the shareholders' equity or the net worth of the company). ROE is a useful gauge in determining how efficiently a company is using shareholders' investment. Unlike return on a.s.sets, it considers the amount and cost of the firm's debt.
Source: Morningstar.
The Morningstar ranking is similar to many others available on the Internet. You can rank only one feature at a time, so you'll need to copy the table and move it to a spreadsheet, which is allowed. Then you can give each stock a ranking value, probably just a sequence number where 1 is the best, 2 is next, and so on, and combine the rankings from various attributes to get a composite score. Once that is done, you need to keep a record of whether your ranking reflects the relative success of performance.
MSN Money offers a similar service called StockScouter Ratings on its web site. Enter a stock symbol, and you get a ranking from 1 to 10, with 10 being the best. You can rank sectors, but there are only a few factors to choose from: fundamental, owners.h.i.+p, technical, and valuation. You can also qualify the choices by various levels of capitalization. The actual method of ranking is not disclosed, but then a.n.a.lyst rankings are also not explained.
Rules for Using Ranking Systems To summarize the use of ranking services: Research the services that are available. Those that provide a record of the success of past recommendations may be the best place to start, but you will need to confirm those results yourself or find a review from some other source with no conflict of interest.
If you prefer to try to rank stocks yourself, then choose any of the free services available on the Internet. Decide the sector(s) and the criteria, and then rank the stocks daily. Transfer the rankings to a spreadsheet for tracking.
Record the performance of those stocks in the ranking zone that you've decided to track. That could be the top and bottom 10%, or those in the 7080 percentile range versus the 2030 percentile range. The goal is that those stocks in the upper range remain in the upper range and those in the lower range remain lower.
Choose the stocks to be bought and sold. Calculate how many shares of each stock are needed to have the same risk. This is done by measuring the annualized volatility and then finding the multiplication factor for each stock that brings the position size to a common target volatility or risk.
Enter your positions.
Monitor the ranking and either hold the stocks for a predetermined period based on your ranking success or remove those stocks that fall out of your ranking zone, replacing them with the new stocks that are now in that zone. Positions must be volatility adjusted. To avoid switching too often, if you are using a zone of 7080, then switch when the stock falls below 65 or 60. If it moves above 80, then all the better. Similarly, stocks in the 2030 zone are held below 20 but are switched if they move above 35 or 40.
NEW HIGHS AND NEW LOWS.
An interesting variation on a ranking arbitrage is to trade all stock prices making new highs and new lows, buying the new highs and selling the new lows short. At the extreme, this could be limited to historic (life of the stock) highs and lows or modified to recognize 5-year or 2-year extremes. The longer, the better. The idea is that stocks making all-time highs or lows have something structurally good or bad happening, and this method would profit from that trend continuing.
Once a position is set, you'll need an exit criteria. A reversal from the high or low by 20% could work well. Each time you add or remove a stock, you'll need to rebalance both sides of the trade. It may be important to monitor the stocks making new lows to be sure they are moving; otherwise, you will be leveraging them up in large numbers to offset the obvious price movement in those stocks at the top. That presents two risks: The first is event risk, where a low-priced stock reverses on high volatility. The second is that you effectively trade only the longs, and the shorts offer no risk protection.
MERGER ARB.
Merger arb is an interesting area of trading that some traders consider to be an arbitrage, but it's really not. We'll describe it here to remove any confusion.