Goal
Our ranking system is designed to separate good stocks from bad. The objective is to pick stocks that will outperform over the next 3-12 months.
The Model
The ranking system uses a factor-based model to grade stocks. The factors are primarily financial variables and ratios (i.e. Sales / Inventory). However, the ranking system also includes price-based technical criteria. Importantly, each factor in our model has historically had a strong correlation with future stock returns. For example, one of the model inputs is operating cash flow. We have found that stocks with high operating cash flow typically outperform those with low or negative operating cash flow. Below is a sample of several financial variables and ratios that are input into the model:
* Current Assets
* Current Liabilities
* Operating Cash Flow
* Sales
* Gross Margin
* Net Income
* Return on Equity
* Return on Assets
Each stock in our database (over 7000) is evaluated against all the factors in the model. Stocks receive a score based on how well they measure against each factor. The ranking system’s recommendations depend on the strength of each stock’s overall model score. There are five possible recommendations:
1. Strong Buy
2. Buy
3. Hold
4. Sell
5. Strong Sell
Companies receiving the highest grade are labeled as Strong Buys. Conversely, those with the lowest scores are Strong Sells.
Historical Performance
In historical testing between Jan-1989 and Dec-2005 for large, mid and small cap stocks, the ranking system’s recommendations have successfully managed to forecast future leaders and laggards. Moreover, stocks classified as a Strong Buy usually outpaced those graded as a Buy, and shares labeled as a Buy typically beat those designated as a Hold etc. The three charts below highlight hypothetical portfolio performance based on the five possible recommendations.
The charts clearly demonstrate how holding a basket of stocks rated as a Strong Buy would have been far more rewarding than holding baskets of stocks found in the other four groups. This advantage is even more apparent in mid and small cap portfolios. The charts also show that investors risk drastically underperforming the broad market by buying shares rated as a Sell or Strong Sell.
What About Volatility?
Investors often assume they must take on more risk to achieve higher than average returns. This is not the case for the ranking system’s Strong Buy recommendations. True, these stocks have massively outperformed the rest of the market (see charts above). However, they have done so with lower risk (i.e. volatility). In portfolio theory, the Sharpe ratio is used to compare investment returns after accounting for volatility (the higher the ratio the better). The three tables below show annualized returns along with each portfolio’s Sharpe ratio. The results indicate that in all three capitalization groups, the Strong Buy portfolio beat the rest of the market on an absolute and risk-adjusted basis. Interestingly, Strong Sell stocks drastically underperformed the rest of the market according to both measures.
Investment Implications
By using the free ranking system tool, investors can benefit from years of our research.
The universe of publicly traded stocks in the U.S. is very large. The ranking system recommendations can be used as a starting point to narrow the list of potential investments down to a manageable number (i.e. only consider stocks marked as a Strong Buy). In addition, since the recommendations are refreshed monthly, the tool can help determine when to sell positions. We only hold stocks classified as a Strong Buy in our portfolios. However, investors preferring to limit the number of transactions in their accounts (i.e. for tax reasons), may prefer waiting for the ranking system’s recommendation to fall to a Hold or Sell.
Tags: ranking system
[...] underperform and possibly crash. For more information about the Ranking System, please visit our Ranking System’s methodology page. As of this September, Comcast is ranked as a “Strong Buy”, while Best Buy is [...]
It’s disingenuous not to publish data that is current.
Why only shoe the “good stuff” that that ends in 2005?
Good point. At the time we did our research, we had historical data until mid-2005. After this period, our Ranking System’s Buy recommendations continued to outperform the broad market. We plan to update this article in the near future to reflect this performance.
In the meantime, please see our recommended portfolio’s track record which we monitor on a real-time basis from mid-2006 until today:
http://www.superstockscreener.com/portfolios.php
Does the ranking system attempt to determine sales growth?
Otherwise, a company with good previous sales, but a dying product line, would outperform a rising star with low current sales, but explosive growth potential..
I guess the way to capture that just from financial data would be to give ‘credit’ in the ranking for a rising EPS number from quarter to quarter..
I was surprised when I did a search for stocks with a ranking of 5 (sell) that some very high quality stocks appeared, or I thought they were high-quality – such as FCX, BHI, and FSLR for example..
Certainly these have high volatility, but for example FSLR just hit the cover off the ball for earnings, and FCX is a cheap resource stock.. (though not as cheap as it was March 9th of course)..
The site doesn’t allow one to drill down on the factors that cause a stock to be ranked 1 – 5 does it?
Hello George,
The Ranking System is made up of a set of stock price and financial statement anomalies that are highly indicative of future performance. However, the system does not attempt to forecast future sales growth.
Unfortunately, we do not offer that capability to drill down on the factors that cause a stock to be ranked 1 – 5.