Tom Yeung here with today’s Smart Money.
In the 2000s, researchers at the University of California, Berkeley wondered, “What is the best predictor of a college student’s grades?”
They studied dozens of factors, including family education, income, SAT scores, and more.
All these studies consistently found one thing… one fact that every professor and parent already knows:
The best predictor of college grades is a student’s high school grades.
In other words, promising high school students tend to become good college students. High school grades are twice as predictive as SAT scores and almost 10 times more useful than parent education levels at forecasting performance. Senior-year grades in advanced placement (AP) courses are the best predictors of all.
The same is true for companies.
High-performing firms keep doing well once they get going.
Large cash flows can be invested in widening a company’s “moat,” providing it with even greater profits in the future. In my quantitative stock models, I’ve found one of the best stand-ins for next year’s earnings is to take last year’s profits as a baseline. (You can tell the kind of college student I was…)
This is why momentum investing works so well.
If we bought 2023’s 25 top-performing S&P 500 companies at the end of that year, we would have walked away with a stunning 47% return, more than twice the 19% average.
However, we also know that the opposite can happen.
So, in today’s Smart Money, I’d like to share why we get excited when stocks go down.
Plus, I’ll reveal the investing strategy that has been historically proven to work best… and a tool you can use to take this approach yourself.
Let’s dive in…
The Contrarian Investor
Stocks that go down sometimes create the potential for massive comebacks.
That’s because a company’s stock price doesn’t always reflect its fundamental strength. Great companies can temporarily become mispriced because markets can’t see beyond the next quarter’s figures.
We saw this in 2024 with the recovery of PayPal Holdings Inc. (PYPL), our bet on a turnaround fintech firm (featured in your Top 7 Stocks for 2025 report).
The online payments firm traded as low as 11 times forward earnings earlier this year – roughly the same multiples as zero-growth banks. Shares have surged 60% since August as the company’s AI and turnaround efforts take shape.
Well-known contrarian investors from Warren Buffett to Michael Burry of The Big Short fame have become wealthy by identifying these diamonds-in-the-rough and investing at the right time.
Momentum Vs. Value
So, how do wide-moat, deep-value stocks usually fare?
In the 1990s, hedge fund manager James O’Shaughnessy asked a similar question. Was being a value investor better? Or should investors focus on growth? And where did quality come in?
To answer this, he took data from the Compustat, at the time the largest, most comprehensive database of U.S. stocks. In a 400-page tome, What Works on Wall Street, he outlined his discovery:
The best strategy was to do everything, all at once.
Quality… growth… value…
By combining these elements into a single multifactor model, investors could outperform any single factor by a wide margin. According to O’Shaughnessy’s calculations, $10,000 invested in a blended strategy between 1951 through 2003 using…
- Return on equity (quality)
- Price-to-earnings (value)
- Relative strength (momentum)
… Would have grown into $66,146,070 over the 52 years. That compares to $5,743,706 from the S&P 500 Index, $8,189,182 for low P/E ratios, and $12,691,903 for relative strength.
Of course, these golden opportunities don’t show up often. And they usually take time to play out.
However, history tells us that multifactor investing works.
As O’Shaughnessy demonstrated, this approach can work like gangbusters over the long term. My colleague Luke Lango is showing that it can also work over the short term.
Luke’s multifactor quant system – called Auspex – has produced a market-beating portfolio five months in a row, since he launched it with a small group of his highest-level subscribers.
Luke and his team spent a year developing the system before going live, and their extensive research has already helped uncover winners like 38% in one month from AnaptysBio Inc. (ANAB) and 115% in under 60 days from Aveanna Healthcare Holdings Inc. (AVAH).
Luke unveiled Auspex to the public in a brand-new service just yesterday in a special broadcast. You can learn more about this new market-beating system – and watch Luke’s event – by clicking here.
Regards,
Thomas Yeung
Markets Analyst, InvestorPlace
