Advanced Equity Trading - Page 2

Tests of the Efficient Market Hypothesis

The EMH has serious implications for equity traders and investors and for this reason various academic tests have been carried out to test the validity of each of the above theories.

Tests of the Weak Form

1. Statistical Tests. These tests include autocorrelation where calculations are made on the independence of stock prices to other stocks as well as tests to determine if stock prices are correlated or exhibit a general pattern over time.
2. Other tests include trading rule tests, where a specified quantitative trading rule is deployed on a basket of securities. Results show that it is not possible to beat a buy and hold policy after taking into consideration transaction costs.

Tests of the semi strong form

1. Time series tests. These are tests where the dividend yield of the stock is compared to the yield of fixed income markets and compared taking into account risk. Other time series tests include earnings surprises and calendar studies.
2. Cross sectional tests assume that all securities should like on the same risk Vs return line and if this does not hold true the specific stock does not follow the semi strong form. Tests include P/E and P/B ratio tests where stocks which exhibit lower figures on these ratio’s are expected to yield a higher return. Other tests include small firm and neglected firm effects, where the lack of analyst coverage as well as liquidity affects the ability for the stock to respond to fundamental data.
3. Event studies tests are used to examine abnormal rates of return before and after the release of information regarding a corporate action event. Tests include: stock splits, exchange and index listings, IPO’s and PO’s as well as accounting changes (e.g. changing from a conventional account principle used in a specific country to GAAP).

Tests of the strong form

These include tests on SEC insider filings, exchange specialists and security analysts.

Results have shown that the tests of the EMH work in varying degrees with respect to time as well as security classes. Many market practitioners such as Warren Buffet strongly reject the EMH claiming that if it were true “I would be a bum on the street with a tin cup”. Most often than not the markets are frequently efficient but not always which gives rise for opportunities for smart investors to use their skills in stock picking.

Alternatives to selective stock picking

Burton Malkiel one of the proponents of the EMH hypothesis maintained for the past 20 years that the best way to invest is to pour ones savings into a broad based index. He claims that on average the S&P 500 returned 12% per annum which is higher than the vast majority of hedge funds as well as mutual funds. He tested his theory on numerous stocks and finds that none of the buy sell strategies beat the return of investing in a broad based equity index. His advice is to buy as many index tracking mutual funds. Other available funds are Index ETF’s as offered by Barclays I Shares.

For those that do not believe in the efficient market hypothesis

Christopher Brown and Joel Greenblatt both managers of hedge funds have their own methods of investing in which they claims beats the index. Joel Greenblatt uses an earnings model whereas Christopher Brown uses a value or “sum of parts” approach.

Earnings Approach to Stock Picking

Greenblatt model takes a list of stocks from an index within a market cap range and creates a “multiple”.  The multiple consists of the P/E the ROE and the ROA of the stock. The basic premise is that the lower the multiple the higher the earnings potential and the likelihood for the stock to appreciate.   He tested his model and concluded that this “earnings quality” selection of stocks consistently beats the index. The only drawback is that for certain market cap ranges one has to wait a while till the returns are consistently above the index.

Christopher Browns model doesn’t concentrate so much on the earnings but rather looks at a company in terms of balance sheet value. Brown filters for stocks which have a price to book ratio of less than one indicating that a prospective buyout firm can acquire the target company, sell its assets and yield a risk free return. Brown maintains that he has tested his model, that his whole investing philosophy is based on it and has been successful for years.

Browns model does not emphasize so much on earnings but rather on value.

My strategy

Following years as an analyst, institutional sales person and interested reader of equity investing I have developed my own method of trading which takes into account the above concepts.

My methods are a combination of technical as well as fundamental analysis. Due to my experience I will use Bloomberg as a systems tool.

I will use the equity search function to pick stock with the following criteria:-

[1] IBES estimates P/E for next year > current P/E.
[2] IBES estimates P/E for next year < 40X
[3] Price to Book ratio is less than 2.0 X
[4] 20 day average value traded > 1 million
[5] Dividend Yield > 0.5%
[6] Current Price is < 60 day moving average
[7] MACD indicator has crossed in the past 2 days
[8] 30 day historical volatility >30%

I start by picking stocks which I terms as value as well as have “good earnings “potential.

To do this the first criteria above will pick stocks which a consensus of analysts believe that earnings next year will be better than this years earnings, filtering away any stocks which are considered cheap this year but could potentially drop earnings next year.

I myself do not want to buy stocks which have an earnings yield of less than 2.5% which is the reason why I picked criteria 2.

Companies which have liquid assets backing them up, are less likely to suffer a sudden long lasting crash, even if earnings announcements are worse than expected.

Liquid stocks are much easier to enter and exit and are subject to less transaction costs. Generally liquid stocks are also associated with the “Size” affect which reduces the likelihood sudden default (although one can more appropriately use market cap as a filter).

Dividend yield indicates that the company makes enough money to be able to pay a dividend.

Criteria 6 selects stocks which are potential bargains bytrading at the lower levels of the trading range ( further analysis needs to be made on an individual stock basis to affirm the validity).

Criteria 7 select stocks which have a sudden upward acceleration in price, indicated by the MACD momentum indicator.

Often stocks can have such low volatilities that even if they have reached a “high” of some standard the commissions eat up a proportion of the returns. For this reason I select stocks which have a minimum annualized historical volatility of 30%

Once the stocks have been selected I use a Relative Value screen to compare the stocks to the industry. The relative value screen has the following columns:-

IBES estimates P/E for next year,
Current P/E.
Price to Book ratio,
20 day average value traded,
Dividend Yield,
S&P LT Credit Rating.
 

I compare each stocks to the industry based on the above criteria. Furthermore I check to see what the current analysts are targeting as the stock price.

An important piece of data which is often overlooked is the “holders” of a stock. Seeing that well known hedge funds and money managers agree with your selection gives an investor greater confidence in the stock.

If I am still happy with the results I will launch my own custom graph which includes moving average lines, MACD signal line as well as 2 standard deviation Bollinger Bands.  If the technical analysis confirms the fundamental analysis I execute the trade.