Watch List Selection Methodology

Beat The Market – Charles D. Kirkpatrick II, CMT

AAII has two outstanding articles on Charles Kirkpatrick’s methods.

ACCESS PT STOCK WATCH LIST: HERE!


Knowing What Stocks to Buy – Part I –Click on Images to enlarge

I’d like to begin going over the above book which will hopefully lead to some excellent screens and rules for members to profit handsomely. First I’d like to go over his value criteria for stock selection and quote a passage here and there.

I use price-to-sales as a measure of value for two reasons. It was found by James O’Shaughnessy (What Works on Wall Street) to be the best relationship to future performance, and because sales numbers are the least likely to be manipulated by management. Price-to-sales seems to be the most easily considered, readily available and accurate calculation of relative value.”.

Interestingly it is not the actual ratio that matters, i.e. low numbers are better than high numbers, but the ranking amongst all stocks. In other words once we gather the price/sales ratio it is measured against others and then put into percentile rankings for 0 to 99 as we do with relative strength.

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Let me see if I can now explain the above graph. The solid black line represents each percentile in the price-sales ratio rank. The dotted line across from 50 represents the market or the performance of the average stock regardless of bull or bear markets. The section of the solid curved line above the 50 level represents the percentile rank of price to sale that outperformed the market three months hence. That would be roughly from the 7th percentile rank to the 67th percentile rank. Remember rankings are from low price to sales to high price to sales. The dashed sloping line represents a linear regression, best fit of the overall curved graph. The slope of the line and the R squared indicates an excellent correlation to the conditions as outlined.

The results of this specific test are that the best three month relative performance resulted from a price to sales percentiles above the straight line and the 50 level at or near the peaks in the curved line at 27th and 37th percentile. When the curve rises above the 50 performance level, especially above the straight line, a buy trigger is established, and when the curved line declines through the 50 level a sell trigger is identified. You should look therefore for stocks to purchase in the 17 and 47 range including points on either side of the peaks because they have the best chance of outperforming the market over the following three months.” If a stock has too low a price to sales ratio, i.e. below 10th percentile lets say it may be indicating a problem with that stock and it should be avoided. Much like a dividend that is way too high may be reflecting a problem with that stock and should be avoided. Utilizing the same analysis but looking out six months the correlation becomes even stronger. I’ll save the graph for another time. Moving out 12 months and the correlations fall apart. This indicates that the optimal period is three to six months out for this valuation method. Bull/Bear Markets “There is not much question that the direction of the overall market has an important effect on the performance of individual stocks. For one thing, strong stocks tend to have better absolute price advances in rising stock markets versus declining stock markets. ” Using a very simple definition of up/down trends; a close above or below the 12 month moving average he then compared the performance of price-to-sales on a Relative basis for both bull and bear markets. The results are a bit astounding

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The graph is eerily similar to the one above. This means that even in declining markets the relative performance is the same. What this means is not that these stocks will advance in a declining market although some may but there declines will be less severe; i.e. relative. Of course using the simple definition above or another similar definition will help maximize your performance.

Next week I will go over the second component of this stock selection method; Relative Strength. Then the following week I’ll put it all together. During this time frame I will also work on putting the screen together for presentation purposes either in a spreadsheet or database output. The charts and the data are pretty impressive. When we go over the relative strength I think you will be even more impressed. Over the longer haul the way to make money in the markets is to maximize your gains during good times and minimize any losses during bad times. Maximizing gains means being in the right stocks at the right time. This I believe is one huge step in that direction.

 


Knowing What Stocks to Buy – Part II

 

The most reliable technique for selecting stocks is relative price strength“! There are many ways to calculate relative price strength for instance I do it against a benchmark average, the NYSE. Kirkpatrick does it by dividing the stock price by its long term (6 month) moving average. The calculation represents the percent of the six month moving average. This calculation presents a very different picture on a chart. Whether or not this will make a difference when it comes to rankings will require some experimentation.

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As you can see above INTC is virtually the same picture although Kirkpatrick’s method looks a bit smoother. MSFT however looks nothing alike my calculation; interesting. Again; it may not make a difference when it comes to ranking. However something has occurred to me that should be a benefit. We publish two relative strength figures one of six months and one for twelve. I’m eliminating the 12 month version (since from the book we can see it doesn’t work and judging from the sites stats it’s rarely used) and calculating this new relative strength in its place. I’m very intrigued by calculating a stock’s relative strength against itself rather than against the market.

Relative strength seems to work in selecting profitable stocks at least over specific periods. It tends to not to work over short periods or for periods longer than one year.

Stocks with low relative price to sales outperform the market in the relative value tests (see last weeks notes) and strong stocks outperform the market as well. This apparent conflict can be resolved by finding stocks that meet both criteria. Stocks with low valuations and high strength are those coming off price bottoms and showing the first signs of recovery from depleted levels. Logically, aren’t these the stocks you want to buy early Of course.

Another performance graph as last week:

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“Traditionally, I have used relative price strength in the top ten percentiles to time buys. With lower strength rankings you will find more stocks, but your future performance will be diluted. At the relative strength percentile of 80, the results show average relative performance almost at the 60th percentile, still ten points above average performance…When choosing a stock selection method, there’s not much question that relative price strength percentile rank should be the primary selection criterion and the highest level possible should be the buy trigger. All other techniques should be subordinate to relative price strength.”

Six month’s out performance deteriorates somewhat but the slope is still positive, out 12 months and the relationship also begins to fall apart. Again how about bear markets?

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Truly fascinating, isn’t it. I am gratified in the respect, that almost from the beginning, this site has been based on relative strength and percentile rankings of relative strength, and at the same time feel I’ve learned something significant and because of that learning am switching or perhaps I should say adding to what is already offered.

I have an initial screen posted under Watch List. The stocks in the screen fall between 17 and 42 on the price-to-sales percentile rank. Eliminated were those stocks trading under $10. Included are the stocks sector and industry group and insdustry group rank utilizing this new relative strength formula (I have not deleted any because of relative strength at this point in time).There is alaso a tab in the spreadsheet for fundamentals in that tab will be Sales/Share (highlighted) from which you can calculate the price/sales ratio.

I have highlighted in the relative strength column those stocks whose relative strength rankings are equal to or greater than the 93rd percentile rank. This is a beginning and with your help will be improved as we move forward.

Download this file to your computer and sort on the differing criteria. Get used to what you see and how to develop a diversified portfolio, how to enter and how to exit. In the future the list will be culled further as well along mine as well as others thoughts.

Knowing What Stocks to Buy – Part III – Wrap Up

The most effective way to see whether a combination of any of the methods we have discussed can produce positive results over time is to test an imaginary portfolio in real time.” I have not covered his growth model in the book simply because its performance has lagged over time so I’ve just skipped over it for this presentation.

Stop orders (risk) -“The method I used was to determine the previous support level, the previous low of importance at which the stock corrected and then reversed upward. If a stock rallies from one of these lows, buyers exist at that price level. If that level is penetrated, I know that the buyers are no longer there. If two of those levels are broken I know I have a loser and must get rid of the stock.

“I calculated the relative price to sales ratio as outlined previously and arbitrarily selected only those stocks that had a relative price to sales ratio percentile of 30 or less. The relative price to sales ratio replaced the chart pattern stop as a means of reducing risk. I then created created a new list and ran it every week. The performance:

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“This list called (the “value List” because value was now introduced in the selection criteria in place of stop orders) outperformed other lists and the averages. It was a star; it had a rought correction during the 2000 through 2003 market declines, but it never became negative from the starting point at the top in 1998,

Value List:
To add a stock; it must meet the following criteria:

  • Relative price strength greater than or equal to the 90th percentile
  • Relative price to sales ratio less than the 30th percentile
  • Relative Reported Earnings growth greater than or equal to the 90th percentile. (Note: Working on this part)
  • Market Cap greater than $500,000
  • Market price greater than $10.

Do delete a stock it must meet only one of the following criteria:

  • Relative price strength less than or equal to the 30th percentile.
  • Relative reported earnings growth less than the 30th percentile

Bargain List:
As a result of these studies or relative selection methods I decided to create a new list, called the “Bargain List” that would incorporate the best triggers found so far and would only include value and price strength.”

To add a stock it must meet all the following conditions

  • Relative price strength percentile greater than or equal to 97.
  • Relative price-to-sales percentile greater than or equal to 17 and less than or equal to 42.
  • Market Cap of $1 million or more.
  • Market price greater than or equal to 10.

To delete a stock it must meet one of the following:

  • Relative price strength percentile less than or equal to 52.
  • Relative price to sales percentile less than or equal to 7 or greater than 67.

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Therefore the screen that is now posted is price/sales rank less than 42 and relative strength rank equal to or greater than 90, which covers both value and bargain. Being in an excel spreadsheet you can easily sort to get either list.

Buying and Selling

A buying decision is not necessary you can remain in cash. “One reason for most investor behavior is that tests of successful methods are few. Smart investors prefer to keep their methods to themselves or cannot describe them adequately. When tested, the methods that are used most often such as earnings growth, price to earnings, and cash flow discount models, show mediocre results. Because these don’t work that well, you see few studies of them. Therefore, those methods thought to be logical are rarely tested in public because their success rate is poor. Even professionals are unaware of how poorly these methods work. They were taught in business school or by mentors or by professional associations, but they never questioned them because the methods seemed logical and everyone was using them..”

Unlike buying where you do not have to make a decision you must make a selling decision at the time or your purchase. How you are going to do that will depend upon many factors however consider a stop order as explained above or perhaps a change in the relative ranking of price-to-sales and relative strength percentiles.

“Another protection method is to use the 12, 26, and 52 week moving averages of your portfolio. If the current value declines below its 12 week moving average sell 25% of your portfolio, if it declines below the 26 week moving average sell another 25%. And if it moves below the 52 week moving average move to all cash.” Personally I really like this method and if everyone did this then no one would be hurting now.

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