The price of a stock is the number-one thing most investors look at when deciding whether or not to buy shares in a company. But maybe it shouldn’t be.
The hypothesis behind fundamental analysis is that one can compare the price of a stock to the price that, in an ideal world, it should have. The markets often “misprice” a stock, and by using fundamental analysis, one can see what a stock should really cost. One can then determine whether or not to buy the stock; one holds onto it until it’s properly priced. (The hypothesis behind technical analysis, on the other hand, is that all information is already reflected in the price of a security, but price-related signals can predict future price movements.)
I would like to suggest an alternative theory. One can be a very successful investor without ever looking at a stock’s price. Price is too often a distraction from what really matters.
The price of its stock usually has very little to do with the future performance of a company. There are exceptions, of course, particularly in companies whose executives are paid in stocks and who therefore may pay more attention to stock prices than to the overall health of the company. But in general, if you’re a buy-and-hold investor, you should buy stocks in stable companies with healthy cash flows. Their price just isn’t terribly important.
To prove my point, I’ve designed a rather simple but extremely successful investment strategy on Portfolio123 that is absolutely price-blind. You are hereby instructed to blindfold yourself to anything that reflects a stock’s price: its market cap, its enterprise value, its price-to-earnings or price-to-sales ratio, its fifty-two-week high or low, its relative strength, its momentum, etc. You have no idea what the price of the stock is now or what it was two months or two years ago, and you don’t give a hoot.
First, we need to limit what kinds of stocks we’ll invest in. We can’t exclude stocks based on market cap or price or average daily total since we’re going price-blind. So let’s first exclude over-the-counter stocks: they have to trade on one of the major exchanges. For liquidity’s sake, let’s exclude any stock with a float of less than three million shares. Let’s exclude really tiny companies: out of all public companies that issue annual reports to the SEC, we’ll remove the bottom 50% in terms of assets and the bottom 50% in terms of sales. Let’s exclude utilities, real estate, financials, and limited partnerships—these may be very good investments, but one evaluates them quite differently from other companies. Let’s limit our investments to US and Canadian companies (though foreign companies do just as well), simply because their financial reporting is better. What’s left? About 1,400 stocks right now, but over 2,000 eighteen years ago. This is a strong set of companies to start with: investing equally in them and holding for a year would net you an average annual return of 13.37% since January 1999 (the earliest date available on Portfolio123), compared with 6.34% for the S&P 500 (with dividends). It does include a half-dozen stocks with prices under a dollar (having experienced recent extreme price drops), but when you’re flying price-blind, that can’t be helped.
Next, let’s create a ranking system based on four equally weighted factors. Why equally weighted? Because I don’t want to be accused of curve-fitting.
- Stable revenue growth. I’m looking for companies with a three-year compounded revenue growth of five to ten percent (which is average for this set of stocks). The closer the growth comes to that range, the higher the ranking. I want to invest in stable rather than rapidly shrinking or growing companies.
- Balance-sheet accruals to assets. I’m looking for low or negative balance-sheet accruals, measured as follows: take the average NOA (net operating assets) over the last twelve months, subtract the average NOA over the previous twelve months, and divide that by the average total assets of the last two years, with lower values being better. (The CFA Institute recommends dividing by the average of the two years’ NOA, but in cash-rich and low-debt companies NOA can be negative, which messes up your results.) NOA are total assets minus cash and equivalents and non-debt liabilities. Companies with negative accruals are generating cash and non-debt liabilities (which are roughly equivalent to an insurance company’s “float”) relative to their total assets and are thus primed to outperform expectations.
- Cash-flow accruals to assets. Again, I’m looking for negative accruals, this time measured as follows: take the net income over the last twelve months, subtract the operating cash flow (the CFA Institute recommends also subtracting cash flow from investments, but cash flow from operations are more important in generating future income and cash flow from investments can involve large numbers that distort the overall picture), and divide by the average total assets (rather than average NOA, again, to avoid negative denominators), again with lower values being better. This means that companies with negative net income but terrific operating cash flow will rank the highest. Because investors focus so much on income, these kinds of companies will tend to outperform expectations.
By the way, the correlation between these two different ways of measuring accruals is actually rather low—about 0.18—so it’s good to use both.
- Short interest. I measure this by the number of shares short divided by the number of shares outstanding. Once again, the lower the better—high short interest can be a real warning sign. Of course, it can also lead to a short squeeze, but I’m not going to bank on that.
Now here are Portfolio123’s rolling backtest results.
If you had invested in the hundred top-ranked companies out of the set of companies I’ve described above according to these equally weighted factors every single week since the beginning of 1999 and held those stocks for one year, paying 0.6% in transaction costs when you bought and sold, you would have made an average yearly return of 25.82%. If you had bought those companies the first Monday of January every year since 1999 and held them for one year, you’d have beaten the S&P 500 in fourteen out of those eighteen calendar years. If you had invested in only the top twenty-five companies, your average yearly return would have been 33.2%, and if you had chosen only the top ten, it would have been 40.38%.
Now what kinds of companies does this system favor? Well, it doesn’t favor companies with strong earnings. People who focus on price-to-earnings ratios or outstanding EPS growth would be unlikely to invest in these companies. On January 2, 2016, for example, your top ten stocks, in order of rank, would have been Pengrowth Energy (PGH), Thompson Creek Metals (TCPTF), NACCO Industries (NC), Tredegar (TG), Taseko Mines (TGB), Agilent Technologies (A), Baker Hughes (BHI), Microsoft (MSFT), Gran Tierra Energy (GTE), and Hercules Offshore (HEROQ). Nine out of these ten stocks increased in price during 2016 (Hercules didn’t), and the top-ranked five each generated returns exceeding 75%. But nine out of the ten had seen their earnings per share fall over the previous twelve months (Agilent being the exception), eight of them experiencing a 30% drop or greater. Only Agilent and Microsoft had positive twelve-month earnings.
Are these results a weird statistical fluke? I don’t think so. I’m sure people can improve on this system. There are plenty of other ways to look at company performance. If the factors were weighted differently, or if you used eight or fifteen or thirty factors, or if you chose from more or fewer stocks, you might get much better results. What’s important here is that I’ve disproven the central tenet of investment theory. Price doesn’t have to matter.
How can the practice of investing possibly work if it’s price-blind?
The answer is easier than you might think. Stocks as a whole have a proclivity to rise in price (there are many reasons for this, but those are outside the scope of this piece). The art of successful stock selection consists in the evaluation of companies according to a variety of metrics in order to exclude stocks that are less likely to yield positive returns and include stocks that are more likely to yield positive returns. Some of those metrics involve price, but there are plenty of others. The price-blind stock selection rules and four factors I’ve proposed weed out stock shares that are less likely to appreciate over the long term: stocks in companies with overstated earnings; excessive or inadequate revenue growth; low cash flow, assets, or revenue; or too many investors betting against them. And the ranking system winnows those down to the stocks most likely to appreciate over the long term: those that are primed to beat investor expectations.
Does price-blind investing offer any advantages over value investing?
Well, it enables you to recognize that a company’s so-called value is only one out of many considerations that should go into stock-picking decisions. And it frees you from having to go through all the complicated financial analysis that goes into determining the “real” value of a company’s shares.
Have other investors taken a price-blind position? I don’t think the ironically named T. Rowe Price, the father of growth investing, looked very hard at the price of the stocks he was buying. Many other growth investors don’t either. And investors in index funds certainly aren’t overly worried about the price of individual stocks.
As for me, I do take price into account when I invest. But I sleep better at night knowing that it’s of secondary—or perhaps tertiary—importance.
I’ve made public the universe, the screen, and the ranking system on Portfolio123. Here are the links: