Outperform The Market With This Growth Screening Strategy

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The Kirkpatrick Growth stock-picking strategy is a purely mechanical process that depends on facts instead of predictions to help you avoid your own biases that can ultimately cost you money. AAII’s Kirkpatrick growth screening model has shown impressive long-term performance, with an average annual gain since 1998 of 15.5%, versus 6.2% for the S&P 500 index in the same period.

Growth-Hunting With Kirkpatrick

Charles Kirkpatrick’s book, Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell (FT Press, 2008), outlines stock-picking and portfolio management strategies that he believes individual investors can follow to outperform the market while reducing the risk of capital losses. Although Kirkpatrick thinks it is impossible to predict the market, or the economy, he considers the stock market to be the best investment vehicle available.

Kirkpatrick is president of Kirkpatrick & Company, which specializes in technical research, and he publishes the Kirkpatrick Market Strategist stock advisory newsletter. Kirkpatrick is a former board member of the CMT Association, former editor of the Journal of Technical Analysis and former board member of the Technical Analysis Educational Foundation, responsible for the development of courses in technical analysis at major business schools. He is also the only person to win the annual Charles H. Dow Award twice, for excellence in technical research.

Market Behavior and Investor Emotions

After investing for over 45 years, Kirkpatrick came to believe that markets trade on facts, the anticipation of new facts and emotion. As he puts it, the stock market is “the sum of all information known and anticipated, interpretation of that information, and emotional reactions to that information, right or wrong.” However, he points out that individual investors are competing against institutional investors, who are more knowledgeable and better equipped to capture and analyze that information. As a result, Kirkpatrick doesn’t believe it is possible to beat the professionals at their own game. Instead, he advocates for developing a mechanical process that depends on indisputable facts to minimize the effects of emotions.

Kirkpatrick believes that investors face several “biases” that have an adverse impact on their financial success: These include impatience, the fear of being wrong, the need for perfection and a lack of discipline.

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Philosophy and Style

Kirkpatrick believes a mechanical approach to investing will help investors avoid their own biases that ultimately cost them money. He further believes that it is impossible to predict market movements. Instead, he follows the STRACT (setup, trigger and action) technique that helps him react to individual stock movements. His growth methodology is based on one “relative” data element—price strength. His analysis has led him to the growth investment model. By following his approach, Kirkpatrick feels that individual investors can outperform the market by investing in individual stocks with a minimal time commitment.

Prediction Versus Reaction

Kirkpatrick reiterates his opinion several times in Beat the Market that it is not possible to predict markets. Instead, he feels that a more successful alternative to predicting the markets is a strategy of “reaction.”

Reaction, for Kirkpatrick, means waiting for the market to indicate what it is going to do and then (re)act accordingly. Kirkpatrick reacts when his data—either fundamental or technical—show a pattern that has proven successful in the past. When he sees such a pattern, his reaction follows three steps, which he terms STRACT: setup, trigger, action.

To illustrate the STRACT method, Kirkpatrick offers the following example: Say a study shows that when stocks advance to new 52-week highs, their chances of advancing an additional 10% are 70%. Any stock you are following that nears its 52-week high enters the setup stage. However, at this point, no action is taken as you wait for the trigger—in his example, the stock hitting a new 52-week high. Once the trigger is initiated, your action would be to buy the stock.

Meeting the Relatives

Kirkpatrick states that the first investment problems we face are deciding what to buy and how to do so without having to predict anything. The AAII Kirkpatrick Growth model approach uses two principal methods for selecting stocks: Growth and price strength.

Kirkpatrick begins his analysis by collecting data from the immediate past. Growth investing requires accurate fundamental data for each stock in his investing universe. His price strength analysis requires a history of prices for each stock; it measures how a stock price behaves against its immediate past—if a stock is high versus its immediate past, it is said to have price strength.

Relative Growth

When looking at growth factors, Kirkpatrick prefers to look at growth in reported earnings, not predicted earnings. While he admits that reported earnings are not error-free, Kirkpatrick does question the validity and accuracy of forecasted earnings.

In Beat the Market, Kirkpatrick describes the way in which he calculates the reported earnings relative rankings for each stock: “I take the last four quarters of reported earnings for each company and calculate a ratio of this total to the four-quarter total one quarter earlier.”

Kirkpatrick’s goal is to avoid seasonality, which is why he uses reported earnings over a full four quarters. Also, by using operating earnings, he eliminates the impact of special charges or nonrecurring items.

He calculates the relative reported earnings growth for all companies with positive earnings over both four-quarter periods and then ranks them into percentiles, with the companies having the highest growth being in the highest percentile.

Kirkpatrick’s research suggests that reported earnings growth is an effective stock selection tool during advancing markets. During bear markets, he found no statistical relationship between reported earnings growth and price performance.

Relative Price Strength

Kirkpatrick’s research indicates that relative price strength is the most reliable short-term stock selection technique. There are a number of ways to calculate relative price strength. Some calculations compare the percentage change in stock price over a defined period to the percentage change in a stock index, such as the S&P 500, over the same period. However, these measures do not necessarily protect you in a down market, as a stock can be falling and still have “strong” relative strength if it is not falling as rapidly as the index.

Kirkpatrick is concerned about capital loss, so his relative strength calculation involves dividing the current weekly closing price by the 26-week moving average of closing prices. He adds up the week-ending closing prices for each of the last 26 weeks and divides this total by 26. For each subsequent week, the oldest price is dropped and the latest weekly close is added to calculate the moving average. He then ranks all the stocks so that those with the highest relative strength are in the highest percentile rank.

To attempt to capture the essence of Kirkpatrick’s measure, AAII calculated the ratio of the current stock price to the average of the last six monthly closing prices. The numerator fluctuates with the weekly closing price but the denominator only changes with the end of each month.

Once again, Kirkpatrick found that there is a very strong positive relationship between relative price strength and forward price performance. As Kirkpatrick writes in “Beat the Market,” “Relative strength seems to breed more relative strength.” However, over time, this relationship gradually deteriorates. Eventually, moving forward 12 months, the relationship between 26-week relative strength and subsequent price performance all but evaporates.

During both advancing and declining markets, Kirkpatrick found that relative price strength should be your primary selection criterion.

Growth Model

The AAII Kirkpatrick Growth model uses the best triggers found in his testing of relative earnings growth and relative price strength.

Reported Earnings Growth

Kirkpatrick uses a non-standard calculation for earnings growth, which compares operating earnings over the last four fiscal quarters to the four-quarter total in operating earnings one quarter earlier. His goal is to eliminate the impact of seasonality on a company’s earnings.

Kirkpatrick uses operating income to avoid the special charges or adjustments to earnings. Furthermore, since Kirkpatrick only considers companies with positive earnings, our approach eliminates those firms with negative operating earnings over either four-quarter period.

Relative Price Strength

The AAII Kirkpatrick Growth model approach selects stocks with relative price strength in the 90th percentile or higher.

Price and Market Cap

Lastly, AAII’s Kirkpatrick Growth model strategy seeks companies with market capitalizations of at least $1 billion and share prices of at least $10.

Conclusion

Kirkpatrick takes an extremely mechanical approach to selecting stocks. To him, stocks are merely symbols. He does not concern himself with what the company does. He merely allows his data analysis to dictate when to buy and sell stocks. By basing his selection process on relative variables that have tested very well over an extended period of time, Kirkpatrick believes he has found a strategy to identify growth stocks that will perform well in advancing markets and will alert you to sell in time to avoid large capital losses.

Stocks Passing the Kirkpatrick Growth Model Screen (Ranked by Relative Price Strength)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

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