Quantitative stock trading strategies

My goal was to determine the basic factors that drive future stock market returns, from an empirical point of view, using only historical data as our raw material balance sheet, income statement, cash flow statement, and pricing data. This data-intensive approach to investment analysis yielded clear results. Certain strategies consistently outperformed the market over the two-decade test period, while others consistently underperformed.

In it, I present a wide variety of investment strategies that predict excess returns, and I show investors how to combine individual investment strategies into more complex screens and models. These can be used to generate strong potential investment ideas, create quantitative portfolios, or simply help investors better understand the market from a quantitative point of view.

In structuring our backtests, we kept in sight one basic principle: If a backtest is not constructed quantitative, or if too few years of data are used, backtest results will be unreliable. Statistical bias can cause the results to be flawed.

The two most common are look-ahead bias and survivorship bias. Look-ahead bias is when information that would not have been known or available during the trading is analyzed. For example, reported fourth-quarter earnings are not available for most companies as of December 31 of any given calendar year. Our database protected our tests from both look-ahead and survivorship bias. And a clear backtest universe must be defined: Each test divided the companies in our backtest universe into quintiles five equally sized groups based on their rank on one or more investment factors.

Portfolios were formed every quarter over our test period, and the holding period for each portfolio was 12 months. Returns for all portfolios in each quintile were then calculated, averaged over the year test period, and compared to the average return over the same period for the overall universe.

I like to use the idea of a mosaic to describe the results of our quantitative tests. A mosaic is a picture or pattern made by putting together many small-colored tiles. In a real mosaic, each tile is meaningless when viewed alone.

However, when put together by an artist, a beautiful pattern emerges. The second point is critical. Data mining—the search for correlations between items in a database—can uncover investment strategies that work fabulously during the test period and fail to work thereafter. By basing the investment strategies we tested on sound investment theory, we ensured that the results represent fundamental principles and tendencies in the investment markets and not statistical anomalies. Strategies goal was to put various stock strategies together to identify what characteristics to look for or to avoid in the stocks in which we plan to invest.

So, what can investors learn from quantitative analysis? Quantitative important discovery we made was that most investment strategies that are predictive quantitatively fall into seven major categories. I call these categories the basics, precisely because they are fundamental to achieving excess returns in the stock market. They consist of profitability, valuation, cash flow, growth, capital allocation, price momentum, and red flags risk.

There are likely more basics than the seven we identified and the seventh, red flags, is somewhat of a catchallbut investors looking for primary market drivers need look no further than these. From a quantitative point of view, valuation, cash-flow generation, profitability, and price momentum are the most important basics.

In particular, valuation and cash-flow factors should be included in almost all quantitative models, screens and analysis.

The relative valuation tests we used were simple e. It seems obvious, but investors often forget to check the price they are paying for an asset.

One of the strongest valuation ratios we tested is enterprise value to EBITDA. Enterprise value EV is the theoretical price it would cost stock buy the entire corporation.

We calculated it as the market value of common stock price times shares outstanding plus the book value of long-term debt minus cash and equivalents. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Roughly speaking, it represents operating income before depreciation. To calculate it, begin with month income from continuing operations and add back the items listed above. Generally speaking, companies with EV-to-EBITDA ratios of 8x or lower outperformed over our year test period, and trading with EV-to-EBITDA ratios of 11x or higher underperformed.

Figure 1 shows the average excess returns i. Companies in the first quintile have the lowest EV-to-EBITDA ratios, while companies in the bottom quintile have the highest ratios. Cash flow tests also generated strong and consistent excess returns. Why is cash flow so important?

One reason is that cash represents a reality—purchasing power—while accounting earnings are at strategies one step removed from that reality. Another is that a company with excess cash has financial flexibility; it can use that cash to expand its business, pay dividends, repurchase shares, acquire other businesses, and so on.

Figure 2 shows average excess returns by quintile for the cash ROIC strategy. Companies in the first quintile have the highest quantitative ROIC ratios, while companies in the fifth quintile have the lowest. When looking for stocks likely to trading, the investor should also favor profitability factors. Figure strategies shows average excess returns by quintile for the return on equity strategy. Price momentum simply refers to the speed with which a stock goes up or down over a given period of time.

A simple way to measure price momentum is to consider the proximity of a stock to its week high or low. The formula I used for this was current price minus week low divided by week high minus week low.

Figure 4 shows average excess returns by quintile for the week price range strategy. One major conclusion of our study was that fundamentals matter, valuations matter, and technicals i. The investor strategies to achieve strong stock market returns over a six-month to an month investment horizon would do well to consider all three of these factors. The seven aforementioned basics presented provide investors with strategies that work in all three of these important areas.

Another important conclusion is that quantitative analysis, qualitative analysis, and technical analysis were not only far from being unrelated subject areas, but form mutually complementary disciplines.

Investors who learn the lessons taught by each are apt to increase their ability to make money consistently in stocks. To put this all together, I suggest running a screen that incorporates the four individual investment factors mentioned in this article. These four factors cover the basics of valuation, cash flow, profitability, and price momentum. The four screening criteria would be:. You might be better served using PROFIT MARGIN rather than ROE, along with only stocks that are within 95 perdcent of their 52 week high.

Stock Selection - Strategies and Rules At least ten hands shoot into the air as the discussion turns to stock selection. The speaker smiles, responds to each, and observes: Most of the confused indecisiveness is due to constant media hype and an endless bombardment of data, news, software solutions, electronic tools, and expert opinions.

But most actual investment errors are caused by invalid expectations, fear, greed, and lack of discipline. Here's an overview, and it is expected to provide structure and provoke thinking while skimming over most of the detail and explanation that can be found in the "Brainwashing" book. For the rest of the story: The Book that Wall Street Does Not Want YOU to Read".

Does anyone know what Steve's point was? This comment just looks like an advertisement. I liked the article, even though after 30 years of doing it, I am fading out of the stock picking game for a safer indexing strategy, because frankly I'm just not convinced that even the "average" expert can get this right in the long run.

I like this approach, which is confirmed by realistic backtesting. An important part of the analysis is that takes into account the dividends, spinoff values and cash payouts, which can be a significant part of the overall return, but which are not always reflected in many databases. This review confirms my belief that an investor makes his gain on the buy side; usually by recognizing an undervalued entry point for a quality company.

Unfortunately, the ratios employed here are not obtainable in any of the simple stock screens I have at hand. Why not offer this method as one of the Stock model portfolios?

I am in a similar situation as Dan from Texas. I would quantitative a difficult time obtaining most of the ratios used in the article and would think it would be nice to see this method as an AAII model portfolio. Can AAII add the above criteria in the model stock portfolio and help us in screening stocks.

There's always the X-Factor nothing is for sure, world events even national events, nature, management changes, new stock and so on things change. Then there the unforseen surprizes that are in our favor. Controling risk is paramount. Don't concentrate in to few sectors of the economy. Mr Tortoriello's book is in my library along with many others that I have collected over the past 40 years.

Investing professionally and personally for most quantitative that period I can attest to the value of disciplined approaches such as the one outlined in this article.

In my opinion there isn't one best way to solve the investing puzzle. Lots of things work. You just need to keep doing it. And keep it simple. In my group's professional operation,we spend a great deal of time and money testing strategies and methods. After all is said and done, however, much of our stock selection process is still driven by basic inputs similar to those in this article and which were developed decades stock based on accepted and time-tested analytical techniques.

Does someone have a simple Stock Investor Pro screen worked our for this concept? If quantitative, please include in your response. Is this a "buy and hold" strategy.

Probably not, so what criteria do you use to determine when to sell? I have some stocks where PM has dropped to. Can't someone at AAII come up with a model stock portfolio for these strategies??? What can I do to spur this on? We have added the screen criteria and custom fields for use in Stock Investor Pro to the companion First Cut column on the Tortoriello approach: As Jean noted, we posted the criteria for creating a Tortoriello approach in our Stock Investor Pro program.

The First Cut article http: If you just want to see the criteria, you can download the excel file at: Liked this article a lot. Hope this isn't too ignorant of a question, but does Tortoriello, great Italian name by the way, advise holding onto stocks that fit this criteria and perhaps others for that matter for approximately 1 year? I would assume that's the optimal holding period here trading the portfolios formed over the course of the screen were held for 12 months.

It would seem that price momentum and value are counterveiling measures, and almost mutually exclusive; e. Ben, if a stock has previously been out of favor with investors or has strong earnings growth, it can have both good momentum and a low valuation. It is more common than you might think. The concept that value matters although it isn't determinative should NOT be a shock. As was rightfully pointed out Graham figured that out back in the s or was it earlier.

Bart DiLiddo, PhD in the s developed a VST Value, Safety, Timing model that was and is the basis of Vector Vest. Finally, the real problem is HOW does one determine value as one of the key factors to stock picking. In the late s, Copeland et. The Copeland model was widely adopted in stock Financial Analytics community. Finally, to simple say that stock valuation methods should be based derived from the company's financials and cash flow statements Strategies a key point.

Without making proper accounting adjustments to PUBLISHED 10K financials, one is not able to make one to one performance comparisons between different companies. The accounting NOTES to a set of financials are where the "gold" is found in analyzing a company's financials. That "gold" and it's uses can only be understood by someone with a working knowledge of accounting policies, choices and adjustments. Get AAII membership FREE for 30 days! Get full access to AAII. PLUS get unbiased investor education with our award-winning AAII Journalour comprehensive ETF Guide and more — FREE for 30 days.

Return on Equity Strategy. Fifty-Two-Week Price Range Strategy. Practical Tips Here a few suggestions for screening or analyzing a stock: Make sure you understand each ratio you are using. Ideally, you should understand not only what trading ratio represents, but how predictive it is.

Certain ratios work better than others with particular industries, so a more focused sector-based analysis may yield better results than a screen or analysis designed for use on the entire stock universe. Avoid screening or conducting analysis on a quantitative factor. It will provide too narrow a view of a stock and its stock keep in mind the idea of an investment mosaic, described here.

Never look at growth without also considering valuation! Our research found that growth factors alone are not predictive. There are two possible reasons for this: If the screening tool that you are using does not allow sophisticated screening, substitute less sophisticated ratios for more sophisticated ones.

For example, the price-earnings ratio can be substituted for enterprise value to EBITDA, and relative strength for week price range. When screening, use values for each ratio that provide a sufficient number of results, but be more restrictive with valuation ratios than with other ratios. Quantitatively, valuation ratios are most predictive and provide the strongest results.

He is author of "Quantitative Strategies for Achieving Alpha" McGraw-Hill, Patrick from MO posted over 6 years ago: You might be better served using PROFIT MARGIN rather than ROE, along with only stocks that are within 95 perdcent of their 52 week high Steve from SC posted over 6 years ago: The Book that Wall Street Does Not Want YOU to Read" Dave from WA posted over 6 years ago: Dan from TX posted over 6 years ago: Fred from PA posted over 6 years ago: Bruce from CO trading over 6 years ago: I am with Dave and Dan and would welcome an easy way to obtain these ratios.

Nash from GA posted over 6 years ago: Like Dan, Fred, and Bruce I will need more help to capitalize on this artical. John from FL posted over 6 years ago: I also would like an easy referral source for ongoing updates for the data. Choudary from MO posted over 5 years ago: Donald from PA posted over 5 years ago: Nishesh from IL posted over 5 years ago: Paul from OH posted over 5 years ago: John from LA posted over 5 years ago: Melvin from VA posted over 5 years ago: John from FL posted over 5 years ago: I would be pleased to pay for this trading, if it is ever available as an AAII portfolio.

John from MD posted over 5 years ago: Jim from CA posted over 5 years ago: Strategies from IL posted over 5 years ago: Charles from IL posted over 5 years ago: Thanks, Dom Benster from NY posted over 4 years ago: Charles Rotblut from IL posted over 4 years ago: Sorry, you cannot add comments while on a mobile device or while printing.

What is a quant trader?