How would you like to outperform the market by 20% per year?
That’s what Eugene Fama and Kenneth French found in their 1992 study, The Cross-Section of Expected Stock Returns. Low price-to-book stocks outperformed the highest group by 1.5% per month, or 20% annually.
In other words, cheap stocks do better than expensive ones.
But like most other good things on Wall Street, such exploits were bound to end. Since 2000, cheap stocks have outperformed by just 4.5% per year, likely as a result of more quant-based hedge funds playing in liquid markets. Penny Stocks Continue to Outperform
But what about the world of penny stocks? Surely, the illiquid market would scare off the largest and most sophisticated of these high-powered traders?
It turns out, the answer is “yes.” When the same price-to-book test is applied to stocks under $5, the outperformance doubles to 9%. It’s still not as high as the 20% returns that Fama and French found, but it’s a start.
Today, we’re going to look into quant-based penny stock investing, and see if we can regain the 20% edge that hedgies arbitraged away long ago. Using Quant to Gain an Edge
One of my favorite ways to pick out winning penny stocks is about as far from rocket science as you can get:
> Momentum. Fast-moving stocks outperform slow-moving duds.
Quality. High-performing companies with real value.
Cheapness. Cheap companies priced under intrinsic value.
And guess what?
To illustrate, I’ve taken data from Thomson Reuter’s DataStream service and tested the following penny stock universe from 2000 to present. Specifically, I looked at stocks whose: Stock price. Less than $5.
Equity value. Greater than 0.
Location. U.S. based company.
In each of these tests, qualifying penny stocks are divided into five quintiles and their past performances are ranked against each other. Cheapness
Low price-to-sales companies win. There’s long been an argument between growth and value investors. Are cheap stocks trading at low price-to-sales (P/S) ratio the best investment? Or do high-flying tech stocks offer more bang for your buck?Using data from Thomson Reuters, we find that… drumroll please…The former group is right. Cheaper is better.Low price-to-sales stocks beat high ones by 22% per year, and do particularly well in low-growth industries. In other words, you want to buy up companies like Gamestop (NYSE: GME ) when they’re trading at 0.04x P/S, not when they’re at 4.5x P/S. Cheap Stocks to Check Out Helix Energy (NYSE: HLX ). With its 0.3x price-to-book value and 0.86x price-to-sales, this offshore energy services company is a potential 5x winner on rising oil prices. The $4 stock once traded at $40 during the 2006 oil boom. Transocean (NYSE: RIG ). Much like Helix Energy, Transocean is a key beneficiary of high energy prices. And though its earnings quality is lower than HLX’s, RIG’s 0.2x price-to-book value gives it a much higher 15-20x return potential. Momentum Fast-moving stocks outperform. Next, there’s price action. Running the same test with 6-month performance figures, we find that both high-return and low-return companies do well.This makes sense when you consider the Momentum Master strategy. Certain asset classes (crypto, tech stocks) are momentum-seeking , where past gains suggest future growth. Other assets (consumer cyclicals, commodities) are mean-reverting , where price dips are usually followed by recoveries. Taken together, that means assets that have moved more in the past six months tend to outperform those that have moved less. A Momentum Stock You Can’t Miss Genworth Financial (NYSE: GNW ). GNW’s 40% rise over the past several months reflects a growing realization that higher bond rates are on their way. With GNW stock at a cheap 0.15x price-to-book, investors are looking at 2-3x upside. Quality High-quality wins — with a twist. Finally we have quality, a seemingly obvious element to Moonshot investing.The word “quality,” however, is a slippery concept — one that single-metric values often struggle to gauge. For instance, is Apple (NASDAQ: AAPL ) a higher-quality company than Tesla (NASDAQ: TSLA )?Consider cash flow to sales, one of my favorite accounting metrics. The figure does a solid job when it comes to traditional companies with long operating histories. But it falls flat when analyzing 1) zero-revenue startups and 2) dying companies that are cashing out what’s left of their assets. That means companies with both very […]