Well known with the MTA, Kirkpatrick is becoming a prolific author. This is his second book. The first, Technical Analysis: The Complete Resource for Financial Market Technicians, was co-authored with Julie Dahlquist, and is now a part of the CMT reading list.
This book shares some similarities with his first. Kirkpatrick exhaustively details his subject, ensuring the reader fully grasps each point before moving on to the next. The logic underlying each principle is also fully explained.
Beat the Market also reflects Kirkpatrick’s candid personality. Everything needed to emulate this technique is included in the book – all formula, all rules. In that respect, the book is similar to the 2001 Dow Award winning paper submitted by Kirkpatrick.
Kirkpatrick spoke at the MTA Symposium after he was recognized with the MTA Annual Service Award. At that time, he presented some of the research which is included in this book. He demonstrated that his stock selection technique is a complete methodology that could be implemented by any investor. In the book, he adds risk management strategies that can be adapted by any portfolio manager to improve performance.
As he has explained in the past, Kirkpatrick had managed stocks since the early 1980s using a technique that combined RS with strong earnings growth. He was looking at methods to reduce risk when he read James O’Shaughnessy’s book, What Works on Wall Street. Combining that work with his own, Kirkpatrick came up with a simple screen to identify stocks with the potential for future gains, which is summarize in Table 1. This technique was explained in that Dow Award paper. The complete paper can be downloaded from the MTA web site.
Kirkpatrick’s Stock Selection Criteria
Table 1: Stocks meeting all of these tests are bought.
Kirkpatrick immediately implemented this strategy and to prove its effectiveness, his results were reported in real-time rather than being obtained through back-testing. These results are shown, as he reported them, in Table 2.
Performance of Stock Selection Lists as Reported by Kirkpatrick’s Market Strategist
Table 2: These results were reported on a weekly basis and could have been duplicated by an individual investor.
The returns shown are astounding, and the method is simple. Usually there are only fifteen to twenty stocks that meet the investment criteria and are held in the portfolio at any given time. In order to appear on the buy list, a stock must meet all of the criteria listed.
- Relative Strength > 90: Kirkpatrick defines RS using the Price to Moving Average Ratio method first described by Robert Levy in a 1967 Journal of Finance article, “Relative strength as a criterion for investment selection.” He divides the weekly closing price by a twenty-six week moving aver age of the price. This calculation is completed for all stocks in his database, and the results are then sorted into percentiles. To pass this test, the stock must show a RS rank that is at the ninetieth percentile or higher.
- Relative EPS Growth > 90: The percentage change in earnings per share is calculated for each stock, and these are then sorted into percentiles. Only stocks with earnings per share growth in the top ten percent are considered to be potential buys.
- Relative PS Ratio < 30: In this step, Kirkpatrick calculates the PS Ratio of each stock in his investment universe and then rank orders the ratios into percentiles. He is looking to buy only those stocks which have a PS Ratio in the bottom thirty percent.
- Market Cap > $500 million & Price > $5 per share: These filters prevent speculative penny stocks from being bought and ensures that any stock in the portfolio is an investment that institutional investors would be able to hold.
One problem that value investors confront is the reality that a cheap stock can get cheaper. Sometimes the market assigns a stock low fundamental ratios because it is in a declining industry with faint prospects for growth in the future. At other times, a stock has a low valuation because it is in a cyclical industry and is simply experiencing a regular downturn in business, with earnings expected to pick up as the business cycle turns. The screen developed by Kirkpatrick is able to differentiate between the low valuations that the stock market would assign to both a company plunging into bankruptcy and a company with improving business prospects. Only a company with solid future prospects will usually exhibit high relative strength measured over a six-month period. By adding RS to the investment selection process, the value trap of buying a stock headed for new lows is avoided.
Relative strength investors also face stock selection problems. One difficulty they encounter is that the market can become irrational and prices will rise solely because of investor’s emotions. The winners in this type of market environment will be
identified by high RS rankings. In the days of the Internet bubble, this problem affected a large number of stocks which soared to stratospheric levels of price and valuation before declining as quickly as they rose. Table 2 demonstrates that Kirkpatrick’s model easily sidestepped the problems of that time and performed extremely well as the Internet bubble unwound.
This performance is due to the fact that the fundamental filters he used identified bubble stocks and rejected them from the portfolio. Many of those high-flying stocks had no earnings at all, which means they failed the EPS growth screen. But some would see earning grow from one cent per share to three or four cents per share, demonstrating a high percentage growth, and placing them at the top of the EPS growth rankings. This highlights the importance of the Relative PS Ratio filter. Requiring that the stocks have strong fundamentals with a low PS Ratio, high fliers likely to suffer severe declines are eliminated as potential buys.
Stocks with low Relative PS Ratios represent companies with actual revenue, and are more likely to have well defined business strategies than startup companies taking advantage of easily obtained venture capital which would allow them to develop a profitable operating company assuming their business model works. Including this ratio in the stock selection process was largely responsible for the great returns achieved in 1999 and 2000 as the Internet bubble popped and inflicted a great deal of harm on the portfolio of the average investor.
The sell rules for this strategy rely only on the EPS growth rate and the RS ranking. Whenever these factors decline below a cutoff level, the stock is sold. The specific criteria Kirkpatrick defined in his work are to sell when RS falls below 30 or the EPS rank falls below 50. Whenever either of these events occurs, the market is telling you that something has changed for the worse in the company and the stock is unlikely to recover any time soon.
By setting these cutoff levels so low, Kirkpatrick is trying to ensure that he will hold the winning stocks long enough to enjoy large gains without being shaken out during normal market reactions.
Each week, Kirkpatrick runs this stock screen. If a new stock passes all of the tests, it is added to the portfolio and bought at the open on the following Monday. If one of the current holdings falls below the sell criteria, it is sold at Monday’s open. Orders can be placed over the weekend, and no further monitoring of this system is required during the week.
Not content with his astounding success, Kirkpatrick has continued to analyze his method and presented the latest research at the meeting. Looking at data from 2000 through 2006, he analyzed each relationship to identify what factors had the
most impact on subsequent stock performance. He found that over six months, relative price strength offered the most predictive insight into stock price performance, while earnings growth had little predictive power.
These new test results led him to redefine the parameters for stock selection detailed in his 2001 paper. The new rules are presented in this book. The initial results have been even more impressive than the previous criteria. The book is a must read for anyone looking to profit in the stock market.
Letter from the Editor
The Financial Management Association (FMA) at...
