A Hybrid Technical-Fundamental Stock Trading System

This is the third in a series of three articles outlining the stock trading models described in Grant Henning’s book “The Value and Momentum Trader” (John Wiley & Sons, 2010). The first article outlining Henning’s technical-momentum trading model was the August 2010 CI Online Exclusive, and the second covering his fundamental-value trading model was the September 2010 CI Online Exclusive.

Grant Henning, a college professor turned full-time trader, believes that following a quantitative, mathematical ranking system to select stocks is a good way to remove emotions from the investment process. Depending on where we are in the market cycle, either fundamental-value or technical-momentum strategies tend to outperform. To help alleviate the need to time the market, Henning developed a “hybrid” trading model that merged both fundamental-value and technical-momentum elements into a single system, which he discusses in his book “The Value and Momentum Trader” (John Wiley & Sons, 2010).

Qualifying Variables

Just like with his other two models, Henning begins his search by creating a watchlist of roughly 200 stocks (depending on market conditions). To isolate the stocks in his watchlist, he applies three “qualifying variables”—share price, volume, and price gain (three-month and one-year):

• Current price is greater than $5;
• Daily average trading volume is at least 10,000 shares;
• Share price gain over the last 52 weeks is at least 100%; and
• Share price is at least 30% higher than the low price of the last three months.

Watchlist

For the Spreadsheet Corner article beginning on page 1, we used the SmartMoney Select website to screen for companies meeting the minimum share price and average trading volume requirements and that have also seen their stock price at least double over the last 52 weeks. We use this same watchlist of companies for this discussion, keeping in mind that it does not eliminate stocks whose prices have risen at least 30% off their low prices of the last three months. A portion of this watchlist is presented in Table 1.

Technical-Momentum Variables

Henning prefers to begin with technical variables, which he believes to be more restrictive, because they undercover stocks that are already under accumulation.

52-Week Price Multiple

The 52-week multiple column in Table 1 represents the number of times the share price has multiplied from its 52-week low over the same period. It is calculated as follows:

Current Price ÷ 52-Week Low Price

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Since one of the qualifying variables required the stock price to have doubled over the last 52 weeks, every stock in your watchlist should have a 52-week multiple of two or more.

Percentage Lag

The next column in Table 1 is percentage lag (% lag), which measures the degree to which the current share price lags the 52-week high price. It is calculated as follows:

(52-Week High Price – Current Price – $0.02) ÷ 52-Week High Price

To avoid the problem of dividing by zero if the current price and the 52-week high are both the same, Henning arbitrarily subtracts $0.02 from the current share price. Doing so, we discovered, also leads to the potential for a negative percentage lag value. Keep this in mind while performing your own analysis.

When evaluating the percentage lag, the smaller the value the better. This means that the current price is

close to the 52-week high. For Henning, anything above 3% presents an “overhang problem,” where investors who bought the stock at prices higher than the current price are waiting to sell their shares at a minimal loss. Therefore, while the price may increase, Henning believes it is reasonable to expect this rate of increase to be lower than shares without an overhang problem.

Investment Value

The next column in Table 1 is investment value. It is a variable Henning created, which is a weighted rate-of-ascent (increase) value (52-week multiple) divided by a weighted percent lag value. The formula is as follows:

(3 × 52-Week Multiple) ÷ (2 × % Lag)

Based on this calculation, stocks with high 52-week multiples and smaller percentage lag values benefit relative to stocks with lower multiples and higher percentage lags. For his own trading, Henning prefers stocks with investment values over 100.

Once he started trading his models, Henning discovered a “flaw” with his investment value calculation: It could be unduly influenced by a large price, only to have the price stagnate for the remainder of the year. Likewise, a stock may decline during the middle of the year only to rebound quickly to its pre-decline value but go no further. Henning realized he needed a way to “smooth” the rate-of-ascent curve and give priority to those stocks that continued to experience strong price gains throughout the year. He does this by using two other variables—three-month gain and investment value rank.

Three-Month Gain

The three-month price gain is the same variable we used when arriving at our watchlist. It is slightly different than a simple percentage change in price over the last three months. Instead, Henning uses the lowest intraday price over the last three months and calculates the percentage increase from that point to the current price. The calculation is as follows:

[(Current Price – Three-Month Low Price) ÷ Three-Month Low Price] × 100

For our calculations here, we do not use the intraday low price. Instead, we use the lowest closing price over the last 65 trading days, which approximates 90 calendar days. Again, since Henning is interested in averaging a 10% gain on his investments per month, he eliminates any stocks that have not increased by at least 30% from their low of the last three months. However, our analysis does not make these exclusions; but this should not impact the final results.

Investment Value Rank

The last technical-momentum variable Henning uses involves the rank function in Excel. Henning describes this rank calculation as his primary technical stock selection variable; all of the variables we have covered thus far are needed to generate the rank data.

Using the rank function, Henning first puts the companies on his watchlist in ascending order by investment value. The rankings are then “smoothed” by the three-month price gain to give priority to those stocks experiencing strong upward price movement over the last three months.

Within Excel, the function is as follows:

Rank = (RANK (G2, G2:G50, 0) * 2 + 100) / H2

Where:

• RANK is the Excel RANK function;
• G2 is the first data cell of the Investment Value column, which is the column to be ranked;
• G2:GXX is the range of investment values to be ranked;
• 0 signifies that investment values in the designated range will be ranked in ascending order (smallest to largest); and
• H2 is the first data cell in the three-month gain column, which is used to “smooth” the rankings.

Scoring the Technical-Momentum Variables

After calculating the variables in Table 1, Henning’s next step is to assign points based on the level of each variable for each stock.

Henning assigns points in the following fashion:

• One point is awarded for percentage lags of 0.03 (3.0%) or less;
• One point is awarded for investment values greater than 100;
• One point is awarded for three-month gains above 100%; and
• One point is awarded for investment value ranks less than 1.5.

The Spreadsheet Corner article beginning on page 1 in this issue outlines how you can build a spreadsheet to automatically retrieve the necessary data for Henning’s technical-momentum analysis.

Additional Technical Analysis

After performing the “quantitative” analysis of his watchlist using these technical-momentum variables, Henning uses two websites to perform additional technical-momentum analysis of the stocks on his watchlist.

First, he analyzes point & figure charts for the stocks on his watchlist using the StockCharts website (www.stockcharts.com). When you pull up a point & figure chart for a given stock, the site sometimes provides green buy signals or red sell signals based on common point & figure chart patterns. If a stock has a green bullish point & figure signal, Henning awards it one point. When there is a red bearish signal, one point is deducted.

Lastly, Henning uses the “Opinion” section of the BarChart website (www.barchart.com). Here you can get estimates of a stock’s short-, medium-, and long-term technical prospects based on over 13 different technical indicators. Henning awards a point to stocks with an overall average rating of 96% Buy to 100% Buy. For stocks with an average rating of 25% Buy to 95% Buy, zero points are awarded. Any stock with a rating below 25% Buy loses one point.

To learn more about how Henning uses these sites as part of his analysis, visit the Computerized Investing website, see the box at the end of this article.

Fundamental-Value Variables

The second half of Henning’s hybrid model involves using fundamental variables that—based on his statistical analysis—have performed well as indicators of future price growth.

Earnings

Henning describes strong earnings performance as being the “hallmark of any value-based approach.” Henning prefers stocks with earnings per share that are 10% or more of price per share. This translates into a price-earnings ratio of 10 or less. However, he assigns points on this basis:

• Two points are awarded for a price-earnings ratio less than five;
• One point is awarded for a price-earnings ratio greater than or equal to five but less than 12;
• Zero points are awarded for a price-earnings ratio greater than 12 but less than or equal to 25; and
• One point is deducted for a price-earnings ratio above 25 or negative earnings for the trailing 12 months.

Earnings Growth

For Henning, strong earnings are only one piece of the puzzle. He also seeks out companies with records of strong, consistent earnings growth quarter to quarter.

To evaluate the earnings growth of a company, he compares the quarterly earnings history to forecasted or future earnings. To do this, he compares the current price-earnings ratio based on earnings for the trailing 12 months (last four fiscal quarters) to the forward price-earnings ratio based on estimated earnings. Ideally, the forward price-earnings ratio will be “substantially lower” than the historical price-earnings ratio. This indicates growth in earnings going forward.

Henning also compares the company’s price-earnings ratio (P/E) to the average price-earnings ratio for the companies in the S&P 500 large-cap index. Following the market analysis of Yale Professor Robert Shiller, we use his S&P 500 price-earnings ratio of 19.8 as of August 31, 2010.

Henning awards points based on the fundamental-value variables as follows:

• One point is awarded when the future P/E is lower than the current P/E and is lower than the average P/E for the S&P 500;
• Zero points are awarded when the future P/E is less than or equal to the current P/E but is higher than the average P/E for the S&P 500 (we also award zero points if no earnings estimate is available for a company or if trailing earnings are negative); and
• One point is deducted when the future P/E is higher than the current P/E or future earnings per share is negative.

Book Value

Henning recognizes that there are numerous ways to estimate the value of a stock—price to earnings, price to sales, price to cash flow, etc. However, he chooses to use book value because he feels it most closely approximates the liquidation value of a company and, thus, offers a measure of safety.

When examining the price-to-book value of a stock, Henning awards points as follows:

• One point is awarded when the price-to-book (P/B) value ratio is less than two;
• Zero points are awarded when the P/B is greater than or equal to two but less than four; and
• One point is deducted when the P/B is greater than or equal to four or book value is negative.

EPS-P/E Divergence

Henning views a positive divergence between rolling 12-month earnings per share (EPS) and the price-earnings ratio as a strong indicator of future price growth. Henning defines this type of divergence as an increase in earnings per share that does not lead to an increase in the price-earnings ratio or an increase in share price. Holding all else equal, an increase in earnings per share would lead to a decline in the price-earnings ratio. However, watching the price action of many stocks around earnings announcements illustrates that many investors tend to buy stocks with recent positive earnings announcements, which could offset the increase in earnings and cause the price-earnings ratio to increase.

Henning awards points based on EPS-P/E divergence in the following manner:

• One point is awarded when the rolling 12-month EPS is increasing and the P/E is flat or declining, where the price is below the level seen prior to the increase in EPS;
• Zero points are awarded when the rolling EPS is rising and the price is increasing or rolling 12-month EPS is negative; and
• One point is deducted when rolling 12-month EPS is declining.

Cash Flow and Free Cash Flow

Henning believes that cash flow is perhaps the best indicator of a company’s future earnings and, thus, price growth.

He defines “cash flow” as the net cash flowing into or out of a company. He also defines “free cash flow” as cash that is “unencumbered by operational expenses.” This seemingly corresponds to the traditional definition of free cash flow, which is often defined as cash from operations less capital expenditures and dividends paid. While Henning views free cash flow as the more important measure, he considers both because the two often differ greatly from one another.

Henning uses a unique metric to consider cash flow and free cash flow—he takes the average of cash flow per share and free cash flow per share. He awards points in the following manner:

One point is awarded when the average of the current price-to-cash-flow and price-to-free-cash-flow ratios is less than 12.5;

Zero points are awarded when the average of the current price-to-cash-flow and price-to-free-cash-flow ratios is greater than or equal to 12.5 but less than 25; and

One point is deducted when the average of the current price-to-cash-flow and price-to-free-cash-flow ratios is greater than 25 or if either current cash flow or free cash flow is negative.

Tallying the Scores

Once he has calculated the variables used in his technical-fundamental hybrid approach, Henning tallies the results and assigns a recommendation to each of the stocks in his watchlist.

There are six technical indicators and five fundamental indicators in Henning’s hybrid model. In theory, a stock can have a rating that ranges from –11 to +11. However, since he eliminates stocks with a percentage lag greater than 50% and three-month price gain of less than 30%, he rarely assigns negative values for those indicators.

Henning assigns his final recommendations as follows:

• Very Strong Buy: +9 to +11
• Strong Buy: +8
• Buy: +7
• Hold: +6
• Weak Hold: +5
• Weak Sell: +4
• Sell: +3
• Strong Sell: +2
• Very Strong Sell: +1 or lower

Table 2 shows the 17 highest-rated stocks based on our fundamental and technical analysis for Henning’s hybrid stock trading model. Out of over 120 stocks, none of them received any type of a buy recommendation. The stock receiving the highest rating—weak hold—was ExpressJet Holdings. As we can see from this listing, several stocks were rated very highly based on Henning’s technical-momentum criteria. Radcom Ltd. even received a perfect score—six out of six—but had a –3 fundamental-value rating. It is probably not surprising that even if a stock is performing well based on price momentum that its fundamentals would be weak, given the difficult operating environment over the last 18 months.

Just because a company does not receive a favorable rating now, however, does not mean you should cast it aside. Henning warns of the transitory nature of his ratings, especially considering that more than half of the variables of his hybrid model relate to price activity. For this reason, he suggests never investing more than 10% of your available capital in any one stock.

Conclusion

While stock-picking strategies are often rooted in either value and fundamentals or momentum and technicals, Grant Henning attempts to blend the two.

His reasoning is that growth-momentum approaches typically do better during bull markets, while value-fundamental strategies tend to outperform during bear markets. Instead of trying to time the market to switch between the differing strategies, Henning combines fundamental and technical criteria into a singular trading model. His goal is to identify stocks that are likely to rise in price based on both historical performance and expected future performance.