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Buy high quality stocks at a good momentum.
Buy high quality stocks, but not at any price.
Stock Selection US – March 2022 🇺🇸 ➡ These are the stocks making the top
What defines the quality of a company? A quality company to invest in needs to have a good balance of these 3 elements.
1. Healthy debts: A company should generate cash in order to repay its debt. The Free Cash Flow to Debt ratio (FCF2D) is a good indicator of how quick a company pays back its debt. The lower this ratio the better.
* For companies without debt, this ratio is 0. Companies with negative Free Cash Flow are excluded.
2. Profitability: We use here simply the Return on Assets (ROA). We rather use the ROA instead of the Return on Equity (ROE) because we have taken into account the factor debt in the first point. The higher this ratio the better.
* Companies with negative Net income are excluded. We require at least a ROA > 1%.
3. High Margin: We look for companies that generate free cash flow compared to its price. The Free Cash Flow to Enterprise Value ratio (FCF2EV) tells us how many years of cash flow would be needed to return the 100% of the investment. Again, the lower, the better. A really high FCF2EV ( > 25) indicates that the company is overpriced and most likely will show an extremly high PER as well. On the other hand, a FCF2EV < 1 would mean almost “free lunch”.
* Companies with negative Free Cash Flow are excluded.
For whatever reason, we know that stocks have a mid-term trend. Let’s take that into account. This phenomenon has been studied for years and it’s one of the most persistent facts in the Stock Markets.
We use the Generic Intermediate-Term Momentum of as explained by Gray & Vogel.
$$MidtermMomentum = \prod_{m-2}^{m = -12} (1+Rm) – 1$$
We calculate the monthly momentum variable as the cumulative returns over the last 12 months, ignoring the last month to avoid any short-term reversal effect.
Following Motto 2, we want to avoid pricy companies. We know that most likely a “high quality” company will be expensive, and we should accept that. But we know as well that sometimes the Stock Market gets fully irrational.
So, let’s define a defensive constrain.
$$PER < 40$$
By doing so, we are filtering out the hottest companies and most likely the short-term top performers. But keep in mind that the RQM is a long-term conservative (relaxed) selection system.
Sometimes there is no such thing as a “good” or “bad” investment, only good or bad timing. We hold the conviction that high quality stocks are better investments than others. However, buying even the best stocks at the wrong moment can make investors lose a lot of money.
So, let’s define a clear, objective and transparent buying signal and stick to it.
We use 3 elements, the current price (P), the Simple 30 weeks Moving Average (SMA30) and its Slope (θ), such that:
1.09 * SMA30 < P > SMA30
&
θ > 0.2
We can learn from one of the fathers of modern chartism: “Don’t hold onto a stock simply because it is high quality. So called quality stocks have cycles too”. (Stan Weinstein)
The other side of the coin. Learning to drop on time, selling at the begining of the bearsish trend, can make investor save a lot of money and hold up the long-term average returns.
Using the same elements: P, SMA30, θ:
P < 0.99 * SMA30
&
θ < – 0.2
Stop-Loss trigger – In the RQM strategy, we set Stop-Loss triggers to avoid getting trapped into downside cycles and to get rid of wrong stock pickers.
Make cash – Sometimes you are all invested and need cash to reinvest. Then, selling the one with the poorest performance last 12 months and/or, with the poorest quality ratios and buy a promising winner, can boost your portfolio.
Our goal is to keep in our portfolio only winners and as for new entries, pick the best stock considering all the information above.
Step 1: Assessment of our portfolio to get rid of the fishy stocks using exclusively the price signal. If one stock enters in a bearish cycle, better stay away from the beginning. Of course, this criteria will lead us to some missing opportunities, but we should take it like an insurance policy.
Step 2: Add new entries to our portfolio.
So, how do we aggregate the different factors? Simply order them from best to worst and select the top ones.
Imagine that we have 8 stocks in our universe
| Stock | FCF2D | ROA | FCF2EV | Factor 1: Quality | Momentum | Factor 2: Momentum | Final Ranking | PER |
|---|---|---|---|---|---|---|---|---|
| AAA | 8.1 | 9.8% | 11.2 | 1 | 1.93 | 3 | 1 | 33 |
| 4 | ||||||||
| CCC | 32.1 | 3.8% | 39.24 | 5 | 0.5 | 5 | 3 | 15 |
| DDD | 31.5 | 2.2% | 39.85 | 6 | 0.8 | 4 | 3 | 22 |
| FFF | 16.2 | 9.2% | 22.5 | 3 | -0.1 | 6 | 4 | 19 |
| GGG | 5.4 | 6.2% | 10.1 | 2 | 2.1 | 2 | 1 | 15 |
| HHH | 8.6 | 0.2% | 59 | 7 | -0.8 | 7 | 5 | 6 |
| JJJ | 45 | 0.8% | 48.2 | 8 | -0.9 | 8 | 6 | 3 |
The 3 elements of the Factor quality are ranked from best to worst and we get a final “Quality Ranking”. The same with “Momentum”. Then we sum up both ranks and reorder again, getting a final ranking. Finally, we discard those stocks with PER > 40.
At the end, each time we want to add a new stock to our portfolio, we will have at hand something like that.
| Stock | Factor 1: Quality | Factor 2: Momentum | Final Ranking | Price Signal |
|---|---|---|---|---|
| AAA | 1 | 3 | 1 | HOLD |
| CCC | 5 | 5 | 3 | BUY |
| DDD | 6 | 4 | 3 | HOLD |
| FFF | 3 | 6 | 4 | BUY |
| GGG | 2 | 2 | 1 | BUY |
| HHH | 7 | 7 | 5 | HOLD |
| JJJ | 8 | 8 | 6 | SELL |
In this example, we have a clear winner GGG and maybe a second candidate CCC. BBB has already put it aside because it’s demanding PER. Most likely AAA and DDD are already too expensive, above our range. FFF and HHH rank lower than the others and they are not worthy of paying a look. JJJ seems to be a bearish stock.
Most likely a bit of additional investigation will be needed to choose between GGG and CCC, with higher odds always for GGG.
Remember: You have the last word and the responsibility of your investments is up to you. The RQM System “only” suggests a set of stocks with a high probability of being long-term winners.
But the SIQM method has already provided an excellent subset of winners.
The Sleepy Investor is devoted to the transparency and reproducibility of all the content of this website. The source code of the RQM strategy and all the results are publicly available on GitHub.
The RQM strategy is a Quality-Momentum based stock selection system for those who want to see their portfolio growing a steady path while investing in the best companies in USA and Europe.
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Stock Selection US – March 2022 🇺🇸 ➡ These are the stocks making the top
