My Top Ten Factors–for Going Long and for Going Short
When I invest in a company, I try to look at it from every angle I can. But obviously, some angles are more important than others. In this article I’ll discuss the factors that are most important to me.
I’m not really a buy-and-hold investor. I like to buy companies with strong earnings reports, and if the next quarter’s report isn’t very strong, I’ll often sell the stock. This practice may not work for everyone, but it’s worked for me: with a portfolio of between twenty and fifty stocks, I’ve made a compounded annual return of 48% since late 2015, when I started using factor-based ranking systems to choose stocks, with lower drawdowns during stock market downturns than those of the major indices. Like Peter Lynch, I believe in investing in boring, little-known companies rather than cutting-edge, exciting, controversial, highly hyped, or turnaround companies. This strategy has proven to be especially strong lately: after my portfolio went up 105% in 2020, it went up another 73% in 2021 and 27% so far in 2022.
In this article I’m going to spill my secret sauce, as it were, and tell you the factors most important to me in my investing decisions. I’ve intensively tested all these factors using Portfolio123, where I have created ranking systems based on them in order to choose the stocks I buy and sell.
Part One: Going Long
Here are my top ten factors, in order of importance:
- Strong earnings growth. Every company has periods during which earnings are improving. It’s a good idea to ride that wave. I’ll break earnings growth down into the six components I examine: a) compare the most recent quarter’s operating income to the same quarter last year; b) compare the most recent quarter’s net income, adjusted for special items, to the same quarter last year; c) compare the current fiscal year’s EPS estimate to last fiscal year’s GAAP EPS, adjusted for special items; d) compare the most recent fiscal year’s net income, adjusted for special items, to the previous year’s; e) compare the estimate for next quarter’s EPS to the GAAP EPS of the same quarter last year, adjusted for special items; and f) count the number of quarters out of the last six in which the EPS was higher than the same quarter the previous year.
- Low share turnover. Share turnover is basically volume divided by shares outstanding. I wrote a long article that explains why this measure is so important. I use both a one-year and a three-month measure.
- Low volume. The lower, the better, within limits. You want to favor stocks that are essentially flying under most people’s radars. But don’t buy stocks whose volume is so low that buying them will result in major market impact.
- Strong analyst sentiment. There are a lot of ways to measure sentiment, but I use a ranking system that Portfolio123 developed many years ago. It includes measures of analyst EPS revisions, EPS surprises, and recommendations. There are plenty of other sentiment measures that you can throw into the hopper: they can’t hurt.
- High earnings yield. I favor looking at the current fiscal year’s EPS estimate divided by the price, but I’ll also look at the next twelve months’ EPS estimates and the actual EPS of recent quarters.
- Low market cap. I favor small companies for both going long and going short: they’re the ones with the most potential to grow—and the most potential to collapse—and their performance tends to be less affected by what Robert Shiller calls “noise.”
- Accelerating sales. This is measured by the sales growth of the most recent quarter over the same quarter last year divided by the absolute value of the sales growth of the last twelve months over the twelve months before that. It’s a bit of a weird and counterintuitive measure (developed, I believe, by Marc Gerstein, to whom I take my hat off), but it works.
- High cash flow to enterprise value. I use several different measures here: a) unlevered free cash flow to enterprise value; b) estimated free cash flow to enterprise value; c) unlevered operating cash flow to enterprise value.
- Volume increase. I’m looking for stocks with a recent increase in volume, and use a combination of measures to determine that.
- High free cash ROA. This is the ratio of free cash flow to total assets; I use a slightly different formula than what you might expect, which is the sum of the most recent quarter’s cash flow from operations and cash flow from investments (the latter is usually negative), all divided by the total assets of the company.
Part Two: Going Short
I don’t usually sell stocks short, preferring to buy puts on the rare occasions they’re not overpriced. Here’s what I look for in companies whose price I expect to fall, in order of importance:
- High price volatility. Stocks with huge ups and downs in price are good stocks to bet against.
- Low market cap. See above.
- Unstable sales. I look at the standard deviation of sales over the last twelve quarters divided by their average. Companies whose sales are going up and down a lot are good companies to bet against.
- High net operating assets. Stocks with a high ratio of net operating assets to total assets have very little cash on hand and might plummet if there’s the least sign of trouble. I’ve written about this measure in “My favorite balance sheet ratio“.
- High share turnover. See “Low share turnover” above.
- Terrible momentum. I look at the relationship of the price of the stock a month ago to its price six, nine, and twelve months ago, and also to its 52-week high. If those ratios are low, the stock has a lot going against it.
- Divergent or unstable fixed-asset turnover. Take the ratio of fixed assets (gross PP&E) to sales and compare it to both a) the industry median and b) the same ratio last year. The higher the differences, the more horrible the situation you’re looking at. Companies with fixed-asset-turnovers that are far from the industry median either have too much invested in their fixed assets and low sales, or sales that are relatively unsustained by their fixed assets. And companies whose ratio changes radically from year to year are inherently unstable.
- Sales deceleration. See “Sales acceleration” above.
- Low industry group momentum. If the industry group (or subsector) the company belongs in is doing badly, it’ll help you in terms of shorting the stocks in that industry.
- Low cash flow to enterprise value. See “High cash flow to enterprise value” above.
Part Three: Stocks to Go Long and Go Short
Based on all these factors, as well as a number of others, if I were to confine myself to US-listed stocks with a minimum daily dollar volume of $50,000 and a minimum price of $3, I would suggest going long the following ten stocks: DLH (DLHC), Valhi (VHI), P.A.M. Transportation Services (PTSI), Summit Financial (SMMT), StealthGas (GASS), BGSF (BGSF), Investar (ISTR), Hudson Global (HSON), Radiant Logistics (RLGT), and Metrocity Bankshares (MCBS). I own shares of all these stocks myself.
Given the same restrictions, I would suggest shorting or buying puts (if the price is right) on the following ten stocks: Arcimoto (FUV), Ebet (EBET), Danimer Scientific (DNMR), GrowGeneration (GRWG), Toughbuilt Industries (TBLT), Renalytix (RNLX), DermTech (DMTK), Purple Innovation (PRPL), Intrusion (INTZ), and Vapotherm (VAPO).
9 Replies to “My Top Ten Factors–for Going Long and for Going Short”
What formula do you use for ‘standard deviation ‘ of sales, if you do’nt mind sharing.
I have trouble coding this.
LoopStdDev(“Sales(Ctr,Qtr)”,12,0). Play around with it: a variation might work better.
Would it be possible if you could share a public copy of your ranking system so it can be selected by other users? Thank you.
No, I’m afraid not. I think I’ve already shared too much of my secret sauce . . .
What are the strategies you usually use? straddles? buy puts?
Currently, what proportion of options do you have in your portfolio?
I only buy calls and puts, no straddles. Right now about 3% of my portfolio is in options; about 75% of that is in puts.
Bit late on this post but just wanted to thank you for your work. I’ve read a lot of articles and books on factor investing, but your level of detail is truly amazing. Thanks the insights. I’ve already order How Finance Works based on your recommendation. (Took my share of finance classes in college, but that was so long ago, it’s like another person.)
Since you mentioned the Verdad crew in another post, I was curious if you’ve updated this list to include debt reduction?
Anyway, thanks again for some very impressive work. I’m going through your webinars at the moment as well. Top rate stuff.
Thanks so much for the compliments. I have included debt reduction as one of my factors for quite some time, but it’s not in my top ten . . .
Ha. Makes sense. Thanks for letting me know.