USING A SCREENER TO HARVEST PROFITS FROM THE STOCK MARKET

A brief guide to building a systematic value portfolio

In this Mini-Book: • • • • • • • Why most investors lose in the stock market How you can take advantage of the weakness of others Step by step example of a systematic investing strategy Building screening strategy using Stockopedia How to think about screening results How many stocks should you buy relative to portfolio size How to think about position size, rebalancing and diversification

stockopedia

Stockopedia Discount Code – CONFERENCE043

2

Why most investors lose in the market
“In the short run the market is a voting machine, but in the long run it is a weighing machine.” Benjamin Graham
In the short run stocks are driven by stories. This drives the majority of the P/E multiple expansion and contraction from year to year. Most stock market participants become wedded to the ‘stories’ behind stocks rather than the economic reality, failing to accept that over the long run reality prevails. Story stocks (glamour) often become overloved and overvalued, while the stocks that everyone loves to hate (value) are often thrown away for less than their true worth. The ‘weighing machine’ eventually adjusts to this economic reality over almost all 3 year periods and valuations revert to the mean. Understanding this can significantly help in your approach and success in the market. The trick is to learn from the greatest investors who act in a contrarian fashion, systematically rotating into good, cheap but improving stocks while rotating out of poor, expensive, deteriorating stocks.

FACT

Over the long term, value stocks outperform glamour stocks. Investors tend to overpay for glamour stocks, but underpay for value stocks.

“It’s only when the tide goes out that you find out who has been swimming naked” Warren Buffett

stockopedia

Stockopedia Discount Code – CONFERENCE043

3

Take advantage of the weakness of others
When you start understanding what works in the markets you can generate an investment philosophy to harvest profits more systematically. Reading books & papers by the greats or academics & talking to experienced investors can help you on the road to lasting success. . •

What works in the stock market? A few lessons from greats
Buy cheap – most people shun value in order to overpay for growth and glamour. People forget the power of ‘mean reversion’ – troubled companies can turnaround while an Apple may stumble. As a result cheap stocks outperform expensive stocks by a considerable margin over any 5 year period.

Buy quality – The record of Warren Buffett is stellar – a record that he built on the back of buying cheap, safe, high quality stocks. It shouldn’t be a surprise that high quality stocks (based on profits, cashflows, margins etc) outperform low quality stocks (think blue sky stocks) by a big margin.

Buy improvement – companies with recently rising share prices continue to rise. Companies with improving fundamentals continue to improve. Companies with rising broker forecasts continue to rise. Momentum is possibly the strongest market anomaly. It works. Learn to use it.

Step by Step Systematic Value Investing
Once you have an investment thesis, you’ll want to generate a portfolio with those qualities. For example to find good, cheap improving stocks we need to find some criteria to fit and reduce the universe of stocks. Your own criteria may differ, but rest of the paper illustrates our specific example.

stockopedia

Stockopedia Discount Code – CONFERENCE043

4

Building a Stockopedia screening strategy
Versions of the strategy we illustrate in this paper have been backtested by such investing giants as Morgan Stanley & Societe Generale, while a more optimised version in the recent publication ‘Quantitative Value’ returned a compound growth rate of 17.68% with a maximum drawdown of 32%. Crafting a set of rules to harvest the profits that others throw away is a personal choice, but we’ll illustrate how to create your own version of a ‘quantitative value’ strategy using Stockopedia’s toolkit.

1.
Our first filter relates to market capitalisation – as a precaution against small-cap disasters and to focus on more established names we don’t want anything valued at less than £100m (lower or higher if you prefer). Once you have entered your requirement, hit the Add a Screening Rule button to create another one.

2.
Our second group of filters relates to removing companies that have a high risk of permanent capital loss. Firstly, we want to remove the companies that have the highest risk of bankruptcy, using something called the Altman Z-Score – created by Professor Edward Altman in the 1970s for this purpose. It’s a blunt tool, but quite effective - companies with a Z-Score < 1.8 are high risk.

We also want to remove stocks that may have aggressive accounting practices as they tend to suffer in future. We have several ways of doing this at Stockopedia, but we’ll focus on using the Beneish M-Score (M stands for Manipulation) which has predicted trouble at Cupid and Supergroup. This time we choose a cut off of an M-Score less than -1.78 for the safest companies.

stockopedia

Stockopedia Discount Code – CONFERENCE043

5

Next step… Improving Fundamentals
US finance professor Joseph Piotroski wanted to find a way to separate the winners from the losers in a basket of cheap stocks. His 9 point fundamental checklist – known as the FScore for fundamental strength –has been shown to add significant value to almost any investment system it is used in and the Piotroski screens on Stockopedia have been some of the best performers since inception on the site. Importantly, the F-Score covers a range of fundamentals and ratios spanning profitability signals, leverage, liquidity and source of funds and, finally, operating efficiency. Each ‘pass’ scores one point, giving you a single overall figure at the end that indicates which companies are in the best financial shape. The additional safety filter that we will add is that we will have a preference for companies scoring between 6 and 9 out of 9 on this checklist. In his research, Piotroski claimed that by investing in companies scoring 8 or 9 over a 20-year test period through to 1996, investment returns could be increased by 7.5% each year. Stockopedia provides F-Score checklists and meters for all stocks.

3.
Given that companies scoring 8 or 9 on the F-Score significantly outperform their peers it makes sense to restrict our universe to focus on them. It should be noted that the F-Score finds companies whose fundamentals are improving not whose fundamentals are good. 6 out of 9 of the criteria focus on the trend in the fundamentals rather than on the company’s current state.

Please note that all these ratios are described on this page may seem intimidating by their labels, but really they are designed to do something very simple – filter out weak companies. You can read up further on all the Stockopedia Screening Ratios at the Glossary. http://www.stockopedia.co.uk/ratios/

stockopedia

Stockopedia Discount Code – CONFERENCE043

6

Filter for Cheap, Good companies
Finally we hone in further on quality and the all important value using a shortcut called the Magic Formula, as detailed in The Little Book That Beats The Market by US hedge fund manager, Joel Greenblatt. The formula looks for two metrics in a stock: a high return on capital (a good profitable company) and a high earnings yield (a cheap share price).

Return on capital is a measure of how effective a company is at making a profit from its assets … while the earnings yield takes the operating profit and divides it by value of the company’s entire enterprise. The screen ranks the market from high to low for each indicator and adds the two ranks together to get an overall Magic Formula. In his book he maintains an astonishing record for the Magic Formula – it’s a brilliant read that we highly recommend – and only about 150 pages long!

4.
We use the Magic Formula as a percentile rank to sort the market in descending order – from the highest ranking stocks to the lowest ranking stocks. The sort will act on our filtered universe, clear of all the distressed, low quality, fundamentally deteriorating stocks that we have diligently cleared out in the first three steps.

If you’ve been following these steps you will end up with a set of criteria that look like this:

stockopedia

Stockopedia Discount Code – CONFERENCE043

7

How to think about screening results
By tweaking the individual criteria you can raise or lower the number of results that are returned by your strategy. At the time of writing we found 55 stocks in the UK qualifying for these criteria.
Depending on personal preference and the rigour of your system, screening results could be considered individual candidates for further research or used as a systematic broad brush buy list.

Always another way

If you do intend to buy stocks that qualify for a personal system you should ensure that you have a complete understanding and have researched the risks involved. Equity investment is a volatile business and drawdowns during market routs can be very extreme – it is best to perform extra research into the candidate stocks on any list.

Handling Outliers
When searching for the cheapest stocks in the market, one can occasionally find companies with anomalous data qualify – for example stocks that have a P/E Ratio of less than 0.5. To avoid the extremes that may be due to data anomalies it can be a good idea to add some extra criteria that remove the ‘tails’ of the distribution.

Liquidity Issues
Many shares (even large caps) can be tightly held, illiquid and have very wide bid-ask spreads adding significantly to trading costs. It’s best to conservatively estimate trading costs by adding a slippage factor to the overall portfolio spread, while reducing risks by removing extremely illiquid shares and those with low free floats.

Tools for Subscribers
As a registered Stockopedia member, the screen will remain in Your Screens and will automatically update daily as company results are announced and prices move. Results can be downloaded as XLS, CSV, PDF files and transferred to portfolios for further analysis using the buttons at the bottom of the screening table. Custom table views can be created allowing any of 300 or more ratios to be analysed for each candidate stock.

stockopedia

Stockopedia Discount Code – CONFERENCE043

8

How many stocks should you buy?
Although it sounds rather obvious, it is essential to consider how the size of your initial investment pot might influence your investment strategy. Regardless of whether you intend to drip money into the portfolio over time, if your initial investment is too small the costs of investing and managing a diversified portfolio will be disproportionately high versus a managed fund or just a handful of stocks.

Mind the costs!
Costs and fees can be a huge drag, eating up your performance. By opting to invest directly in the stockmarket you will be dispensing with the conventional costs associated with buying a fund. Advertised fund charges can be as low as 0.75% per year but in reality these cosmetically low charges can mask a range of trading and intermediary fees, which can inflate the typical costs to as much as 4%! Casting off these charges is undoubtedly appealing but a self-invested portfolio does come with its own costs. These include: • • • • Stamp Duty : 0.50% - a tax on all stock market purchases Commission : approximately £10 per trade with typical brokers Bid/Ask Spread : 0.50% - the typical difference between the buy and sell price Information/Advice/Subscriptions: e.g. a Stockopedia Subscription of £179.99 per year

#Stocks 1 5 10 15 25 50

Portfolio Size (assuming 80% annual turnover and the above costs) 5,000 10,000 25,000 50,000 100,000 250,000 1,000,000 4.72% 2.76% 1.58% 1.19% 1.00% 0.88% 0.82% 6.00% 3.40% 1.84% 1.32% 1.06% 0.90% 0.83% 7.60% 4.20% 2.16% 1.48% 1.14% 0.94% 0.83% 9.20% 5.00% 2.48% 1.64% 1.22% 0.97% 0.84% 12.40% 6.60% 3.12% 1.96% 1.38% 1.03% 0.86% 20.40% 10.60% 4.72% 2.76% 1.78% 1.19% 0.90% NB - 'Red' limit is > 4% costs annually NB - 'Green' limit is < 2.5% annually

Based on these costs and assumptions, our analysis at Stockopedia shows that the optimum starting investment pot for a DIY investment strategy should be £30,000+. At that level the costs of investing and managing a portfolio of 25 shares should be less than 2.5%. That assumes that you rebalance 80% of the portfolio annually – which may be rather high, but is the average portfolio turnover rate of a typical investment fund. By comparison, the same portfolio with £5,000 to invest would attract charges of 12.40% - at this level of portfolio size, you may be better off either investing in a fund or ETF or picking your spots by owning many less shares. While the costs may be higher the education will be priceless !

stockopedia

Stockopedia Discount Code – CONFERENCE043

9

Position Size, Rebalancing & Diversification
Position Size
Indices, such as the FTSE 100, are weighted according to the Market Capitalisation of a stock. In a focused portfolio of 20 shares it is a simpler approach to equally weight all position sizes on entry – i.e. for 20 shares an initial position size of 5% would be typical. Equally weighted indices also outperform market cap weighted indices!

Rebalancing Position Sizes
Portfolio rebalancing is a way to periodically adjust position sizes to stay in line with the target allocation while selling stocks that no longer qualify & buying new stocks that do. This involves the counter intuitive action of selling investments that are doing well and buying investments that are doing poorly. “But what about running my winners, cutting my losers” or, put another way, doesn't this amount to the cardinal sin of averaging down? The short answer... if you fancy yourself as someone who can control their fear and greed response and time the selling of investments, you probably shouldn’t be running a systematic strategy. But it’s precisely because most people fail to manage their emotions that systematic strategies do so well! Some investors choose to rebalance quarterly, semi-annually or annually, while others set rules in place to rebalance positions that skew a certain percentage from the target allocation. For example some investors will set a rule to sell whenever a stock rises above a 10% weight when targeting a 5% position size.

Diversification
One of the biggest mistakes that novice investors make when using screens to build portfolios is to ignore sector weightings. Dividend strategies became heavily overweight banks in 2008 just before they collapsed – so setting a 20% cap to any single sector weighting can be a very prudent approach to minimising downside. Stockopedia provides a plethora of portfolio analysis tools that can help to manage risk, keeping position sizes and sector exposures from drifting too far from target allocations. Subscribers can analyse their portfolio style, overall portfolio valuation, risk and exposures.

stockopedia

Stockopedia Discount Code – CONFERENCE043

10

We have been tracking the performance of these “GuruModel” strategies since December 2011. As reported in the FT, 85% of our long only strategies have beaten the market – some by very large margin. It’s very important to recognize though that we are not factoring in transaction costs, and some value stocks do suffer from wide spreads. In spite of this, the evidence from all sources is that smart contrarian value investing, especially in smaller cap stocks that institutions cannot invest in does work and is a persistently profitable strategy over medium term timeframes.

Does this stuff really work? This Bottom Up: using screens as checklists

Please pick up a copy of our free e-books that

describe all of these ideas in much greater detail. We have summarized the history and philosophy of value

Taking it further – read our ebooks This Bottom Up: using screens as checklists

investing for over 10,000 readers since publication, and our summary of dividend strategies has also been extremely well received.

www.stockopedia.co.uk/courses/books/

The Stockopedia Story
Stockopedia was founded out of a belief that investors online deserve better. Better tools, better data, better analysis, better treatment as customers, better everything. We believe that it’s possible to beat the market as a private investor, but only if you can guard against scams, charlatans, herd mentality and your own biases. As founders we’ve learnt our own lessons in the market and Stockopedia has been born out of a determination to learn from errors and put in place the necessary checks and balances to ensure we maximize returns and minimize risks. We hope you’ll join us! You can read the Stockopedia Manifesto here: You can take a free trial to Stockopedia here: http://www.stockopedia.co.uk/manifesto/ http://www.stockopedia.co.uk/plans/

stockopedia

Stockopedia Discount Code – CONFERENCE043

11

Recent Press & Subscriber Buzz This Bottom Up: using screens as checklists

Still thrilled with your system ! Read many of the books before, but never dreamed I would see such in action. **Michael B** I’ve been using Sharescope since 1999 but you really trump them on the data/screening side and also I really loved little things like being able to add important dates to my calendar. **C E** As a novice investor this site is absolutely brilliant. The screens and ability to create your own are fantastic. What a simplification of all the bull one sees in the market. Keep up the great work. **Jerry** Already very impressed and have just sent an email cancelling my Sharescope subscription which I have held for the last 7 years as I plan to use Stockopedia as my data source going forward. **Chris S** I actually fell in love with your product... I have to give you guys great credit for the software design - really sharp. **David B** I am absolutely delighted with the program (and the support)! **Jon M** You guys are probably the most passionate, involved, engaged and intelligent business leaders/entrepreneurs I’ve worked with over the years. **Diego C** Hats off, what a fantastic website, hands down the best standalone resource website available. Phenomenal resource and an amazing effort. **Andrew B** I'm in love! Great, great job you guys did. Stockopedia is fine art. Thank you! **Marcelo T** It’s really good to deal with someone genuinely interested in providing such a good service **David S** From what I have seen so far I think Stockopedia is probably the best information source we have in the UK, so well done to you chaps! **Miserly Investor** Your support is probably the best in the business and I love the enthusiasm that you and Dave display and I’m sure that the product has the makings of something very special. **David S**

http://www.stockopedia.co.uk/buzz/

stockopedia

Stockopedia Discount Code – CONFERENCE043

12

Take a free trial to Stockopedia Premium This Bottom Up: using screens as Stockopedia is the UK's highest quality checklists stock analysis service on the web where
you can put everything discussed into practice. We build investment models that apply the lessons of the world's greatest investors to the finest database sourced from Thomson Reuters. If you are a serious self-directed investor looking to improve your investment returns through stock picking, Stockopedia has the toolkit you need. Take a free trial and discover how our 65 GuruModel stock screens and 2000+ UK StockReports can improve your stock selection process.

© Stockopedia Ltd. Stockopedia is a fundamental data & stock screening toolkit for self-directed individuals who have an adviser and/or are comfortable making their own decisions. We do not provide investment advice or recommendations as to whether an investment or strategy is suited to the investment needs of a specific individual. The figures quoted in the above stock report are for illustrative purposes only and should not be relied upon as they are subject to change as well as specific site terms of use. Please note that quantitative screening helps to narrow a search based on pre-defined criteria and is not a substitute for independent analysis. In addition, past performance is not necessarily a guide to the future