With the publishing of our Synopsis with red flags article, I thought it was time to discuss what exactly a red flag is and why they should be looked for when identifying and eliminating potential investments.
At its core, a red flag doesn’t mean that the investment is bad. It just means that you are more likely to lose money on the long position than you are to make a profit. There are of course the exceptions, and there are trades you can make a lot of money on no matter the number of red flags, but at that point you are really just throwing darts at a dart board.
Going back to the Red Flags score that we discussed in the synopsis with red flags article, there are 327 companies that have more than 2 red flag indicators. Over time this strategy performs incredibly poorly, but not all companies perform extremely poorly.
“Good” red flags are indicators that result in no more than a 3%, and in many cases, negative performance. On top of this, the majority of the positions taken on by the screen should result in a loss. An indicator that has 100 positions that made 1% and two positions that lost 99%, you would still likely have lost money, but the majority of the positions were still winners. We want to identify indicators that would assist in singling out bad possible investments.
In this example it is pretty obvious that over half of the positions taken on by this strategy were losers. Diving further into the world of red flags, let’s create a brand new red flag indicator.
To start, a red flag should be a single true/false parameter that greatly affects how a company performs.
People always talk about how momentum is able to drive an already rising stock even higher. The question I have is whether or not a large share price increase over time is really beneficial or if it turns out to be more of a red flag. On a single line let’s look for companies whose share prices have increased by over 100% in the past year.
Extremely basic, yet it will likely be extremely telling by offering a large sample of companies for us to check. In the past year, 296 companies increased doubled their share price. There is a range of big and small names from AMD to MOCO, but how does this range perform over the past 10 years?
To be honest, I thought the momentum argument at this scale would ring a bit more true. I know that if you do some tinkering with the parameters you can get a fully functioning screen that is profitable over this same time span, so it comes as a surprise that the results are so poor.
Better (Worse?) yet, we have an even larger percentage of losers than we did in the original demo screen. This new potential red flag only has a 35% win-rate with the highest return being just under 700% and there being quite a number of companies which fell to -100% and went bankrupt.
At the end of the day, a red flag is just a warning. It is by far from a be-all-end-all when it comes to choosing which stocks to eliminate from your potential portfolio, but it is a great place to start. As stated earlier, almost any red flag can be tweaked ever so slightly to become a strong component of a well-balanced screen, so be sure to never judge the company book by its cover and instead do a little digging. If you’d like to ensure that none of the default red flags are located within your screen simply put red flags = 0 in your editor and all of your results will have a clean flag record. Happy Investing.