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The Curious Case of Sudden Past Growth

The Curious Case of Sudden Past Growth

With every screen that is released into the Equities Lab system, we go through a verification process to make sure that the results aren’t just because of some random fluke. This process contains a six steps, and is how we check each of our screens. You can learn more about that process in the dedicated stock screener validation article.

 

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At face value this screen looks incredibly promising, returning over 1250% in the past 17 years. But we should never take anything at face value. Let’s first figure out what this screen is actually looking for.

 

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1) The standard deviation of the company’s net income 1q over the past 5 years has to be ranked in the top 80% of the market.

2) In that time, the net income 1Q should not have grown more than 6%

3) Can’t be a financial service company

4) There has been an 8% growth in net income 1Q over the past 2 years.

5) In the past year the net income 1Q should not have grown more than 6%

6) The share price must have increased in the past year.

What sort of companies does this screener return? Are they small caps with lots of volatility?

 

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It’s surprisingly the exact opposite. To be honest these were not the results that I was expecting. I don’t see a single company on this list that I don’t recognize.

 

The primary line item that I want to mention and the primary determining factor for the companies that are returned in this screen is the very first line item. Though it looks a bit complex, it is nothing more than a way to insist that the screener look for companies that are large and variable. How is that? Well the standard deviation is a number, and the larger a company’s net income is the higher that number is going to be regardless. But even still, there are many large companies that have large variations in their earnings over time due to any number of reasons, and this screen flushes them out.

 

You could, for example, adjust this line to normalize across the entire market through looking for the standard deviation of the change of net income over the past five years, but that completely destroys your returns as it is returning all companies that have a large variation in their earnings.

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Does the end justify the means?

When it comes to quantitative investing it isn’t difficult to find a strategy that makes massive gains and looks like your portfolio is more of an exponential graph than an investment portfolio. This is because a lot of these “strategies” are based on pure luck and just entered and exited positions at the right time throughout history. These strategies tend to be extremely volatile and reliant on one year or position for their success.

 

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Here is the same backtest as pictured at the beginning of the article. The only difference is that we have log scaled this backtest to give us a better understanding of how this strategy moves year after year. If a strategy is actually investable it will look fairly close to a linear line in this test – ensuring that the strategy isn’t relying on any one year for its gains.

 

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Now, the standard deviation of this strategy is over 7%, while the benchmarked S&P has a much lower deviation of 4.74%. Our strategy has almost double the risk of the benchmark – something we usually try to stay away from. So how do we test whether or not this added risk is worth it, by running a Sharpe ratio test? This test is actually run automatically within the Equities Lab system. If you are unfamiliar with the Sharpe ratio you can read about it here. In short, it compares the strategies return to the overall risk and the higher the ratio the better the strategy.

 

Overview

This article doesn’t highlight the entire validation process, but it did allow us to explore some interesting characteristics of a screener that seemed to just fall from the sky and work fantastically. In the event you’re interested in using this screener for your own portfolio you can find it under “The Curious Case of Sudden Past Growth” within the Equities Lab software system.

Do you have a screener idea that you want us to try out or write about? Maybe you have an idea of how to improve this or one of our other screen? If so, comment below or email us and we will do our best to put your idea into the queue.

Tyler McCain
Tyler McCain
A student of finance at Georgia State University, Tyler has had a passion for the world of finance for as long as he can remember. Joining the Equities Lab team in 2015 he attempts to juggle the perfect mix of school, work, and giving back to the community. When he isn't working at Equities Lab he can often be found helping teach programs at the Rosen Family Foundation - a non-profit that teaches financial literacy to middle and high school students.

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