Probability Rules Us - Investment Ideas

Believe it or not, the laws of probability always have and always will rule everything we do. From interpreting the meaning of that Neanderthal girl's smile she flashes while collecting berries, to the French soldier who loads his musket on that Belgium plain in 1815, to the pedestrian attempting to cross 4 lanes of traffic on a busy 21st Century street, the likelihood of an event has governed our thinking and actions from the beginning of time. That rings true for the stock market as well because probabilities are heavily involved in any investment process. And, I imagine, that's why you're reading this article.  

With respect to stock investing, the main prospect we concern ourselves with is picking the winners over losers. So if, for example, you throw darts or use your pet monkey to pick stocks, you’re basically using a random process, and may expect the number of winners and losers to be approximately equal over time. Indeed, that would be true if there were equal numbers of winners and losers. However, in reality the average stock tends to go up over time, so a purely random process would still pick winners about 52.8% of the time on a monthly basis.

That means, just by default, your simian companion is really going to be right almost 53% of the time for any given month. But, if you have a stock-selecting process that actually adds value, then, over time, you hopefully have a winning percentage above 52.8%. The higher, the better, obviously. And let's get this straight right now; while everything in life is theoretically possible, the odds that yours or anyone else's win ratio will be 100% or anywhere near that are infinitely small. That's perfection and we all know nobody's perfect.

What's a "good" win ratio?

So, you might ask "what's a reasonable win percentage that we should strive for?" Let's take a look at a couple of examples. I looked at the monthly win ratios for the Strong Buys of both the Zacks Rank and the average broker rating from 2002-2011. The average broker rating was picked because it's a representation of the "value" provided by Wall Street analysts.

The Zacks Rank Strong Buys showed a monthly win ratio of 55.1% while the broker rating Strong Buys were winners 52.1% of the time. So while brokers' Strong Buys, on average, picked winning stocks, your dart throwing would have found winners more often. (I guess that's why they used to have that contest of analysts versus the dart board, which apparently painted a too painful reality to continue.) The Zacks Rank is a proven stock picker, so anything with a win ratio at or above 54-55% on a monthly basis is pretty darn good. Remember, stock investing has a thin line, so monthly win ratios above 55% are very rare.

What else matters?

The win ratio is only one side of the investment return equation, however. The magnitudes of the wins and losses are also very important. For example, if you have a strategy that picks winners two-thirds of the time, yet the losers lose more than twice as much as the winners do, you'll have a losing strategy. So the average gain to a strategy is just as important as how often it selects winners.

Let's look back at the Zacks Rank and average broker Strong Buys. The average winner and loser for the stocks with Strong Buy broker ratings was 10.9% and -9.6%, respectively, per month. That means if you pick a broker Strong Buy that subsequently turns out to be a winner, you could expect an average monthly return of 10.9%. However, if that broker Strong Buy turns out to be a dud, you could lose -9.6%. The Zacks Rank #1s showed a 9.3% monthly return for winners and -7.9% for the losers. So while you might gain a little more with a broker Strong Buy winner (10.9% v 9.3%), the odds are lower (52.1% v 55.1%) that you would actually pick one, and, therefore, you are more likely to pick a worse loser (-9.6% v -7.9%).

Let's see what happened when we put both the win ratio and return magnitude together and look at average monthly returns to the broker Strong Buys and the Zacks Rank #1s. The average overall monthly return was 0.94% for the broker Strong Buys and 1.44% for the Zacks Rank #1s. This annualizes to 11.9% for the brokers and 18.8% for the Zacks Rank. You can see that the winning percentage and magnitude of the Zacks Rank clearly outperforms the average broker rating and you don't have to win much more often than average to have very profitable returns.

Another win ratio

The Zacks Research Wizard provides another way to calculate a win ratio, defined as the percentage of winning periods over the total number of periods. For example, from 2002-2011, the S&P 500 had a positive monthly return 61% of the time, while the strategy that uses the Zacks Rank I outline below won money in 64% of those months. Here's more detail on the performance comparison:

Read on for a screen that uses the Zacks Ranks to find winning stocks:

• First, select only those stocks with a Zacks Rank equal to 1. (We want only the Zacks Rank Strong Buys.)
  
• Over the last four weeks, the company should have a positive increase in the current year's earnings estimate. (Increasing annual earnings are good.)
  
• Finally, the four week change in the current quarter's earnings estimate should be positive. (Increasing quarterly earnings are a good thing as well.)

Here are five of the stocks that passed our screen this week (6/22/12):

ISLE – Isle of Capri Casinos, Inc.

Isle of Capri Casinos, together with its subsidiaries, develops, owns and operates gaming facilities and lodging and entertainment facilities in the United States. This company rates as a Strong Buy on the Zacks Rank and has experienced an over 50% improvement in estimates over the last 4 weeks for both its current quarter and annual earnings. On June 7, the company beat expectations on revenues and earnings by 27%, which attributes to the top Zacks Rank.

RJET – Republic Airways Holdings Inc.

Republic Airways provides scheduled passenger services on approximately 1500 flights daily to 133 cities in 42 states and North America. With a Zacks Rank #1, this company has seen quarterly and annual earnings estimates increase by over 21% and 10% respectively. Republic is also looking to offload Frontier Airlines, which makes good sense because of Frontier's losing ways and diminishing prospects.

TM – Toyota Motor Corporation

Toyota engages in the design, manufacture, assembly, and sale of passenger cars, minivans, and commercial vehicles. The company has had its ups and downs over the last couple of years, but is on the rebound now with a top Zacks Rank, a 36% increase in quarterly earnings estimates, and nearly a 7% increase in annual earnings estimates.

PDC – Pioneer Drilling Co.

Pioneer Drilling, through its subsidiaries, provides contract land drilling services and major oil and gas operators in the United States and Colombia. This company is the master of surprises because, over the last five reported quarters, they've averaged a 59% EPS surprise. No wonder the stock is a Zacks Rank #1 and analysts have finally gotten the point and are increasing their earnings estimates for this company.

USCR – US Concrete Inc.

US Concrete, a Houston-based company, engages in the production and sale of ready-mixed concrete, pre-cast concrete products, and concrete-related products for use in commercial, residential, and public works construction projects in the United States. Within the last four weeks, this company's annual earnings estimates have increased by 19% and the current quarter's has improved by 12%. The stock is also rated a Strong Buy by the Zacks Rank.

Improve your prospects

Probabilities are evident in love, war and very much all aspects of life be they exhilarating or mundane. Lucky for us, the stock market is a very thrilling place where win ratios can be improved to increase your investment returns.

I encourage you to use the Zacks Research Wizard to test your current strategy and see if you could improve its winning percentage. The Research Wizard contains hundreds of different data items available for you to test or use one of our pre-built strategies.

Starting today, you are invited to use it free of charge. You'll have 14 days to create, tweak, and backtest your strategies. At the same time, you can see the latest picks from pre-loaded winning strategies with average gains of up to +67.4% per year.

Learn more about your Research Wizard free trial >>

Let’s make some money!

Kip

Kip Robbins is a Quantitative Analyst with Zacks.com. He analyzes screens and strategies for Zacks customers and for use in Zacks Research Wizard which empowers individual investors to use market-beating screens, build their own, and backtest their results.

 
ISLE OF CAPRI (ISLE): Free Stock Analysis Report
 
ISLE OF CAPRI (ISLE): Free Stock Analysis Report
 
PIONEER DRILLNG (PDC): Free Stock Analysis Report
 
PIONEER DRILLNG (PDC): Free Stock Analysis Report
 
REPUBLIC AIRWAY (RJET): Free Stock Analysis Report
 
REPUBLIC AIRWAY (RJET): Free Stock Analysis Report
 
TOYOTA MOTOR CP (TM): Free Stock Analysis Report
 
TOYOTA MOTOR CP (TM): Free Stock Analysis Report
 
US CONCRETE INC (USCR): Free Stock Analysis Report
 
US CONCRETE INC (USCR): Free Stock Analysis Report
 
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