Computerized Investing is a column in the AAII Journal that covers articles about how individual investors can use digital technology to become more effective managers of their assets.
Snapshot of a Stock: The Balance Sheet
Successful investing has no secret formula. Since financial statements are basic tools of fundamental analysis, it is important to be able to read and analyze them.
This market is so vast that its size is difficult to imagine. Overwhelmingly, this is an institutional market. It raises debt capital for the largest issuers of debt, such as the U.S government, state and local governments, and the largest corporations. The buyers of that debt are primarily large institutional investors such as pension funds, insurance companies, banks, corporations, and, increasingly, mutual funds. These buyers and sellers routinely trade sums that appear almost unreal to a non-finance professional. U.S. government bonds trade in blocks of $1 million, and $100 million trades are routine. The smallest blocks are traded in the municipal market, where a round...
A few years ago, I was asked to develop a series of quantitative stock-selection models for the equity research department of Standard & Poor’s.
In preparation for this project, we backtested more than 1,200 different investment strategies to determine which were predictive of future “excess returns.” (A backtest is simply a statistical look at historical data to determine whether employing a given investment factor, such as selecting stocks with low price-earnings ratios, results in excess returns over time; i.e., returns above a stock market benchmark.)
My goal was to determine the basic factors that drive future stock market returns, from an empirical point of view, using only historical data as our raw material (balance sheet, income statement, cash flow statement, and pricing data). In short, I set out to create a quantitatively drawn “road map” of the equity markets. To do our research, we used a sophisticated data-analysis program and Standard & Poor’s Point in Time database, which contains more than 20 years of “as originally reported” (unrestated) data for about 150 data items and 25,000 individual companies.
This data-intensive approach to investment analysis yielded clear results. Certain strategies consistently outperformed the market over the two-decade test period, while others consistently underperformed. The results of this research are published in the book “Quantitative Strategies for Achieving Alpha” (McGraw-Hill, 2009). In it, I present a wide variety of investment strategies that predict excess returns, and I show investors how to combine individual investment strategies into more complex screens and models. These can be used to generate strong potential investment ideas, create quantitative portfolios, or simply help investors better understand the market from a quantitative point of view.
In structuring our backtests, we kept in sight one basic principle: Numbers can lie. If...
