How Should You Pick Stocks?

How should you pick your stocks? Well, much of it depends on the size (and sector) of the stock.

Our Research Department has completed exhaustive research regarding stock selection criteria and what has been the most successful as it pertains to various sizes (capitalizations) of domestically-traded corporations.

Next month, we will conduct comparable research – but measure the various stock picking criteria against the ten primary stock sectors.

We have measured over 250 various stock selection criteria representing the various styles of investing:

  • Price Momentum

  • Historical Growth

  • Volatility

  • Valuation

  • Earnings Quality

  • Capital Efficiency

We have broken down the returns of each criterion into quintiles from the highest 20% to the lowest 20% and have measured the performance of each criterion per quintile as applied to Small Cap, Mid Cap, and Large Cap domestically-traded stocks.

Our calculations assume equal weighting and an annual re-balancing scheme.

Below are the top 10 stock picking criteria per capsize (designated by Standard & Poor’s indices). Definitions for each are provided at the end of this blog.

Small Cap Stocks

The following table shows some of the top stock selection criterion as applied to the S&P 600 Small Cap Index since January, 1996:


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As you can see, Valuation and Price Momentum constitute all of the top stock selection criteria. Surprisingly, small companies with the lowest 6-month trailing returns outperformed stocks with the top trailing 6-month returns by nearly 9% per year for the next 12 months. Although not on this list, a similar trend was noted with trailing 9-month returns.

Mid Cap Stocks

The following table shows some of the top stock selection criteria as applied to the S&P 400 Mid Cap Index since January, 1996:

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Price momentum indicators overtake Valuation indicators as applied to the Medium-sized companies. Of interest is the Tobin’s Q Ratio which measures the market value of a company as compared to its “replacement value” of a company’s assets. This is a true Capital Efficiency measurement in which the lower the ratio, the better a stock has performed over the next 12 months.

Large Cap Stocks

The following table shows some of the top stock selection criteria as applied to the S&P 500 Large Company Index since January, 1996:

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For the first time in our analysis, Earnings Quality stock selection criteria play an important role in the predictability of future returns. Whereas Valuation and Price Momentum criteria were the most important in selecting small and mid-sized corporate stocks, Earnings Quality criteria such as low Accrual Ratios and high Depreciation to Capital Expenditures are second only to Valuation criteria in selecting future large company winners.

Summary

It is important to reiterate that this study assumes utilizing the aforementioned stock selection criteria to purchase a stock and hold it for one year. If we were to change the holding period to one month or one quarter, the results would be much different – leaning towards Price Momentum and Capital Efficiency criteria such as Share Buyback. However, Valuation criteria would still play an important role regardless of holding duration.

As the average size of the companies in each dataset increased, we noticed that Fundamental-based criteria such as Earnings Quality and Capital Efficiency became more important. As noted above, the one constant investment style was Valuation-based criteria.