How I Beat the Market

I subscribe to a service called Portfolio123, which is ideal for analyzing data and choosing companies to invest in based on that data. It features accurate and up-to-date financial figures (most other sources are full of errors), extensive and flexible backtesting, an almost limitless capacity to work with financial formulas and ratios, helpful forum discussions, online classes, stock screeners, and, most importantly, ranking systems.

To evaluate investments, it’s best to take into account a lot of different factors, and the best way to do so is to rank your choices accordingly. No one enables this as well as Portfolio123.

I invest mostly in microcaps—companies with a market capitalization between $50 and $300 million—under-the-radar companies like Blue Bird (school buses), Fonar (MRIs, diagnostics), Cambium Learning Group (instructional technology for special needs students), and Alpha Pro Tech (protective apparel, infection control, and weatherization building products). I use a ranking system based on over two dozen factors, many of which are quite idiosyncratic, but all of which are soundly grounded in financial theory and are thoroughly backtested. I have a portfolio of fifteen to twenty stocks, and I hold my investments for an average of three to five months. If I were investing in microcaps in general, I’d be lagging the market (as a class they’ve done very poorly this year); but by investing in a small parcel of high-quality, solid-growth, and/or low-priced microcaps, I’m making money—over 23% so far this year, compared to 8% for the S&P 500.

Why aren’t more people making this kind of money by investing in these stocks? Well, plenty of people are—I’m certainly not the only investor making money from wise microcap investing, and I’m far from the only successful user of Portfolio123. But on the whole, these stocks are not very liquid and are therefore not easy to buy and sell. Trading in them with the amount of money that large funds invest would have a significant market impact and therefore diminish returns. In addition, most money managers have a conception of risk that is diametrically opposed to mine (which I’ll post about soon). And the factors I’m using are, while tested and true, not the most conventional ones.

I’m looking for companies with the following characteristics, among others (obviously, no company is going to fulfill all of my requirements: that’s where ranking comes in).

• a comparatively low stock price (see my previous post)
• healthy free cash flow
• middling but accelerating revenue growth
• good return on capital
• low and stable accruals
• strong enough earnings to cover debts
• low trading volume
• comparatively high earnings growth

In addition, I avoid companies with very low share liquidity or whose stock price is below a dollar or two per share, master limited partnerships, real estate investment trusts, utilities, and companies from countries that rank high on corruption indexes.

How do I know my investment success is not just a fluke? I engage in robust backtesting, varying my tests over different time periods, with different numbers of holdings, over different holding durations, and using different stock universes. I can see how different strategies might have performed in the past using simulations, and can thus compare them to choose the one that will be most likely to perform best in the future.

There are perils in backtesting, of course. One should never expect one's out-of-sample results to approach one's optimized in-sample results, for instance. But I'm happy with my returns.

My ten largest holdings right now: LNTH, FONR, EMMS, PCMI, BLBD, APT, GSOL, FSI, DGICA, JOUT.

YTD CAGR: 43%

Comments

[S]

How do you reconile "low trading volume" and "very low share liquidity"?

[Yuval Taylor]

I set a limit below which I won't go but favor stocks close to that limit. My limit is around $50,000 traded daily. I also don't trade in stocks with a float of less than five million. I get a few big bid-ask spreads from time to time, but using only limit orders helps. I also favor stocks with low share turnover, which has nothing to do with liquidity.