How to Design a Fundamentals-Based Strategy that Really Works, Part Four: Strategy Implementation

This is the fourth and last article in a series: here is the first (on factor design); here is the second (on designing ranking systems); and here is the third (on principles of backtesting).

I’ve been using a fundamentals- and ranking-based strategy for stock picking since 2015, and since then my compound average growth rate is 47%. So I can attest that a fundamentals-based strategy can really work. In this series of articles, I’ve been advocating creating ranking systems as a good alternative or addition to traditional screening. I use a subscription-based website called Portfolio123 for this; ranking can also be done with spreadsheets or other data management tools, but that involves a huge amount of work and is beyond the scope of these articles.

Putting Factors to Work

You’ve created some factors and put them into a ranking system. You’ve done some backtesting and you’re pleased with the results. How do you actually make money?

You must develop a strategy that you can stick with through thick and thin. You can’t just buy the top-ranked stocks willy-nilly and decide when to sell them later. You have to be able to manage your cash, decide your position size, set limits on when to buy and sell, and so on.

Some Behavioral Rules

• Never make spur-of-the-moment decisions. Always follow a system. Modify the system slowly.
• Never panic. Always remind yourself that if something bad happens, something good might happen next.
• Accept volatility.
• Every time you make a modification to your system, keep the old version. You might want to revisit it.
• Only use several systems at once if you feel completely unsure as to which one is better. Otherwise either combine the several systems into one, or go with the better one.
• Don’t make discretionary exceptions to your system. Modify it instead.
• If your main focus is avoiding losses, you’ll never
  • a) make any big gains;
  • b) learn from your mistakes.
• Never use stop losses. Remember that the future price of a stock has absolutely no relationship to what you paid for it.
• Don’t set target prices. Sell a stock when you need the money to buy another whose probability of future gains is higher.
• Often, rebalancing involves adding to losing positions and trimming your winners. Be comfortable with that.
• Don’t worry about things being too complicated. The stock market is intensely complicated; there’s no reason why your strategy shouldn’t be too.
• Don’t follow trends.

Learning from Trading

Every time you make a trade, questions arise. For example:

• A stock appeared on my screen even though it shouldn’t have. Why?
• A stock I bought was obviously a poor investment because of something that the company did that my rules didn’t cover.
• My system is making way too many trades and I keep buying and selling the same stocks.

All of these require investigation and possibly rewriting your portfolio management rules.

Number of Positions

Diversification lowers volatility but can depress returns. A portfolio with too many holdings will be vulnerable to:

• decreased overall returns from holding too many middling stocks,
• management difficulties and too much time spent trading and placing orders, and
• oversight lapses.

A portfolio with too few holdings will be especially vulnerable to

• market impact costs,
• sudden downturns,
• missed opportunities, and
• high turnover.

I’ve found that the ideal portfolio size is between eight and thirty-two positions unless you’re using multiple strategies at once, in which case you go higher.

Position Weighting

It’s best to put more money in positions that inspire your greatest confidence (algorithmically). Mathematically, you’d want to put the most money in the position with the highest expected returns and the least in the position with the lowest. However, if you’re concerned about portfolio volatility, you’ll also want to look at the correlation of the positions and their volatility. And don’t forget to adjust for transaction costs. A stock with a very high expected return might also have serious liquidity issues.

I suggest rebalancing a position if it has radically grown or shrunk or if your estimation of the stock has drastically risen or fallen.

Trading Frequency

Trading daily, two or three times a week, weekly, or monthly is largely a matter of personal choice. Trading daily can increase your returns because you can respond quickly to price changes, earnings reports, and other news; and because it’s easier to ease in and out of positions trading frequently. But trading less frequently can increase your returns because you can drastically lower your transaction costs.

Holding Period

I would not advise you to have a fixed holding period unless you’re absolutely allergic to taxes. Some stocks you might want to hold for only a few weeks, others for more than a year.

But you might want to set yourself a minimum holding period to avoid excess churn.

Entry and Exit Strategies

Do you buy/sell your entire position at once? Or do you ease in and out of positions?

Because factors and prices are unstable, easing in and out of positions over several days may provide you with more stability than simply trusting one day’s output and buying an entire position on that day. In addition, this approach can dramatically lessen market impact.

On the other hand, buying/selling all at once allows you to fully take advantage of sudden price moves and to move quickly on earnings reports.

Hedging

Personally, I don’t hedge. I keep my volatility low by diversifying, buying low-volatility stocks, paying attention to industry trends, and buying a few put options now and then if they’re not too pricey. But if you do want to hedge, try to figure out if you want to use a

• temporary hedge—placing it only under certain market conditions;
• permanent hedge, such as a 5% or 10% short position—this can smooth your returns, but also diminish them; or
• variable hedge, such as using one of the CBOE’s volatility indexes to adjust the amount you hedge.

Margin

Margin should be used in small amounts and very carefully. It has to be closely watched. You must understand how margin works, how it turns small losses into large ones and small gains into large ones. It’s also helpful to understand the mathematical relationship between your expected drawdown, your margin debt, the market value of your securities, and your house surplus. And you should try to fathom how Reg T works and the difference between a Reg T and a portfolio margin account.

Margin interest can often be lessened by talking to your broker and threatening to move your account to a different one.

Lastly, I recommend reducing your use of margin when volatility is rising.

Cash

Lots of investors like to keep a reserve of cash on hand in case they encounter major bargains. I don’t. If I encounter a major bargain, I simply sell some other securities in order to buy it. Cash is costly: it’s one of the few asset classes that always loses value, every day, every hour (unless you’re in a deflationary environment). Stocks are much better, even if there are some trading costs involved with selling them in a hurry.

Of course, cash is necessary for paying bills, buying goods, and emergencies. I suggest putting a certain amount aside and not touching it, adding to it as need be.

Trading Techniques

The object of smart trading is to get good fills: to buy or sell exactly the number of shares you want at the very best price.

There are four major impediments to doing so:

• The bid-ask spread might be high.
• The depth might be insufficient.
• The market impact might be large.
• Your timing might be off.

For large caps and mid caps, only the very last of these (timing) is a consideration. For small caps and microcaps, however, all four are important.

Interactive Brokers has a large number of trading algorithms, as well as access to dark pools, which may be useful to reduce trading costs or to get good fills fast.

If you use another broker, you should consider how to best place limit orders.

Trading Microcaps While Minimizing Transaction Costs

First ascertain how tradable the stock is. What’s the median bid-ask spread as a percentage of the stock’s price? If it’s more than 2.5%, it’s going to be hard to trade profitably. What’s the median daily dollar volume? I sometimes trade more than 100% of a stock’s median volume in a day, but that can get quite expensive.

Never use market orders to trade microcaps. Stick to limit orders. If they don’t get filled, you can replace them or place them again another day.

If you’re after a large number of shares, it’s best to place several small orders over the course of a day or a week instead of one large one.

Don’t commit yourself to getting a complete fill every time. If the price moves strongly against you, you might be able to buy more tomorrow at a better price.

The simplest way to trade microcaps is simply to place a limit order before market open at the previous day’s close. Then forget about it. If it doesn’t get completely filled, try the same thing the next day.

I use a much more time-consuming method, involving placing orders somewhat far from the previous day’s close and then adjusting or abandoning them depending on my fills, the bid-ask spread, and how far the price has moved against me.

Portfolio Management Tools

Lastly, and unfortunately, most brokers don’t offer very good portfolio management tools. But some websites do. Portfolio123, for example, has a free “Manage” platform that offers portfolio tracking and analysis. It allows you to import transactions from any broker, send automated or manual orders to Interactive Brokers, divide your accounts into different strategies, and work with watchlists and notes. I find most of these tools very valuable in making my strategies work for me.