Written by Liam Flavelle on 11 May 2017
- We’re live!
- Can selecting stocks based on a mix of earnings, dividends and cash flow factors lead to a profitable trading strategy?
- We’ll show you a simple yet powerful trading strategy that returns 25% a year.
Finding Your Edge
Welcome to the inaugural blog of InvestorsEdge, the internet platform that brings your trading ideas to life.
Our platform has been built to answer one question: How do I turn my investment idea into a robust trading strategy that I can trust will keep on making me money in the future?
The platform has access to millions of price, dividend, fundamental accounting and analyst estimate records stretching back almost two decades that you can draw on to design and test your trading ideas.
When you become a part of the InvestorsEdge community, as well as this huge volume of data you also get access to a slick, easy to use yet powerful web-based platform to describe and refine your trading ideas, together with a powerful calculation engine that backtests your strategies and tells you how they would have worked in the past.
Why are we unique? We think our process for designing trading systems that really work is pretty slick and special. We reckon that our enthusiasm for bringing our users the best toolset with the highest quality data is unparalleled. But the biggest reason we think we are unique is that our data is global, allowing you to broaden your horizons and design trading strategies that are truly diversified.
Let’s jump straight in and design a really simple model to show you what the InvestorsEdge platform can really do.
Our First Model
Let’s start off with a simple trading idea. A company's Price to earnings ratio (PE) is an often-quoted figure that measures its share price relative to its earnings, with lower numbers indicating that a company may be undervalued.
Let's see how that works in real life; what would happen if we invested $10,000 and once a month bought the top 20 US and UK stocks with the lowest PE ratios that have increased their earnings and dividends from the previous quarter?
Here’s the answer (click on the picture to view all the model results):
You can see that our idea would have given us a return of 6% a year, which is a bit disappointing when simply investing in the SPY (the S&P 500 ETF that tracks the index) would have returned us almost 11% annually. More worrying still is the drawdown (Max DD in the picture) - even though we ended up doubling our money the value of our holdings would have dropped by 73% before recovering, whilst the S&P 500 dipped by only 57%!
Perhaps we should conclude that companies with strong earnings and growing dividends aren't a great investment, buy an ETF index tracker fund and go and do something else with our time?
Since you are still reading I'm going to assume that we are in agreement - we're not going to be purchasing the ETF index tracker any time soon and we are comfortable with the premise that companies with decent earnings and dividends are good investments. What the above results really tell us is that we need to be smarter at picking stocks to beat our benchmark.
Let’s make one more refinement to our trading idea and add a ranking factor. We have one of those already as we are ordering our universe on those with the lowest PE.
We’ll add another factor to rank our universe of stocks by their current quarterly Price to Free Cashflow ratio. This ratio is simply the security's current market price divided by its latest free cashflow figure taken straight from its Cash Flow accounting statement.
A company’s free cashflow is an important metric that represents the cash a company generates after its capital expenditures. The price to free cashflow ratio allows us to compare different stocks against each other, with smaller numbers indicating that a stock might be being undervalued by the market.
So now each security in our universe will be given a rank for its position in the list based on both its PE and its price to free cashflow ratio. These scores are then added together to give us a final score out of 100. Once again, we will simply take the top 20 of these and buy them each month.
We'll leave the rest of the strategy unchanged. Here’s how this new version performed (click on the picture to drill down for more details):
Things haven't improved much - our returns are up to 6.1%, which is hardly an awe-inspiring number. Let's make one final change, which should show the magic of the InvestorsEdge platform.
Last Twelve Month figures
Sometimes we find comparing quarterly data can be hit and miss - many companies have business models that don't just go up in a straight line; they may be cyclical where certain quarters are traditionally stronger than others or their earnings may just be 'lumpier' than their peers.
So let's change our strategy slightly so that at each rebalance point our universe contains companies that have increased their last twelve months (LTM) earnings and dividends over the previous quarter's LTM figures.
Now that we’ve refined our strategy, let’s see how it performed. Here’s the summary (click on the picture to drill down for more details):
This latest version of our strategy would have made almost 15% a year returns. Drawdowns were still an issue though:
You can see on the drawdowns chart that the main drops in value of the portfolio were in 2007-8 and 2016. During both of these years the macroeconomic headwinds we all faced as investors were stronger than usual - the 2007-8 financial crisis is still a distinct memory whilst 2015-2016 saw oil prices tumbling whilst the fed raised interest rates for the first time in over a decade.
When assessing if we can live with a trading strategy this is the chart we tend to examine first - it's here that we can see how volatile the returns have been historically. If we can live with a model that frequently drops by up to 10% and in exceptional circumstances drops by 25% before recovering then we can start looking at how such a portfolio fits with our other holdings.
This article was more about showing how drilling down into a company's fundamentals can be used to improve your investing returns than in generating a model that we could use to trade with.
This is however a really good starting place for creating great strategies. It shows that the application of a handful of trading rules together with the use of a small number of factors are all you need to build a strategy that beats the market, and hopefully does a great job in giving you an understanding how the InvestorsEdge platform works and how it will help you improve your investment returns.
Think you can improve on the model? You can create a copy of the strategy and add your own ideas - it's free to sign up. See if you can beat us!