In James P. O’Shaughnessy’s book, he shows a systematic approach to build a 50-stock portfolio based on multifactor ranking. With the advance of internet and online brokers, now the historical data and back testing tools are at affordable price for individual investors.
Multifactor stock ranking systems are superior than stock selection systems using subjective judgment or lagging technical indicators, such as chart reading, trend lines, Eliott waves, Fibonacci retracements, or moving average, etc. But multifactor stock ranking system is probably the most complicated one to master.
AAII offers a low-cost system with complete database, but requires customization to do ranking back testing. Zacks and valuengine offer similar tools. Portfolio123 offers customized ranking capability as well as a powerful back testing simulator. With these types of tools, individual investors are at tremendous advantage over mutual funds because of market inefficiency. Good investment opportunities can be bought well before institutions spend m(b)illions of dollars piling them up.
To show the power of multifactor ranking, portfolio123.com is used to run a 40-stock portfolio simulation from 2001 to 2002 with the following
- ranking factors:
- 34.2% – Price to Cash Flow Per Share Ratio, Quarterly
- 34.2% – Price to Sales Ratio, Quarterly
- 5.1% – Short Interest, Percent of Shares Outstanding (%)
- 26.4% – close(0)/((close(120)+close(121)+close(122)+close(123)+close(124)+close(125)+close(126)+close(127)+close(128)+close(129)+close(130)+close(131)+close(132)+close(133)+close(134)+close(135)+close(136)+close(137)+close(138)+close(139)+close(140))/20)
- $0.005/share commission cost
- 0.2% slippage
- 25% stop loss
- minimum $3 stocks
- minimum market cap $50 million
- average 20 day trading amount above $200,000
The ranking system is a typical value style ranking system because it ranks stocks by low price to cash flow and low price to sales.
As we can see the performance graph of the simulation below, the ranking system was doing very well during the very bad bear market period.
With different ranking systems to find different types of top-ranked stocks, one would be able to build a diversified stock portfolio.