7. Relative Strength

Having substantially narrowed the potential universe of shares with the PEG sieve, and used cash flow to provide some peace of mind, we can now move on to the final stage of the selection process to discover the real high flyers. My third sieve is the relative strength of a share price against the market for both the previous month and the previous year. Although it is tempting to think that shares which have underperformed recently have the most potential for growth, in practice the best-performing shares tend to be those that have already started behaving like winners by outperforming the market.

I now regard relative strength in the previous twelve months as such an important measure that all of the tables in REFS include a column for it. In addition, we have introduced two special sets of relative strength tables covering each of the indices. I am not alone in believing in the value of relative strength as an investment criterion. In February 1996, Barrons , the American weekly investment newspaper, drew attention to a forthcoming book by Jim O’Shaughnessy, who has researched the last 43 years of data from the Standard & Poors CompuStat database. The author tested every conceivable method of investment and found that of the ten best winning strategies for buying American shares, each of them involved some element of relative strength, judged by the stock’s performance relative to other stocks during the previous year.

It is easy to determine if the relative strength of a share price is positive or negative. Say the market, as represented by the FT-SE Actuaries All-Share index, stands at 1800 and the share price of a company is 100p. If the market rises by 18 points during the month, that is 1% of 1800. Unless the company’s shares rise by at least 1p, their relative strength would be negative. If the shares rise by 1p, matching the market’s growth, their relative strength would be neutral and if the shares rise by more than 1p, their relative strength would be positive.

The way of calculating the exact percentage relative strength is a little more complex. Say a share price starts out at 100p and during a given period rises by 10% to 110p whilst the market increases by 20%. The relative strength of the share during that month would be -8.5%. The market would have risen to 120% of its former level, the shares to 110% of theirs and the 10 percentage points difference between the two represents 8.5% of 120%.

Take another example of a share that fell from 100p to 80p while the market rose by 20%. In this instance, the share would be at 80% of its former level against the market’s 120%. The difference of 40 percentage points expressed as a percentage of 120% shows relative strength of -33.3%.

As a final illustration, if the previous example was the other way around, and the share price had risen by 20% to 120p and the market had fallen by 20%, the relative strength would be +50%. The share price would be 120% of its former level, the market 80% and the difference of 40 percentage points would be 50% of 80%. Note that the relative strength percentage is always calculated in relation to the market’s performance, which in the first and second instances had risen to 120% of its former value and in the third had fallen to 80%.

The good news is that only the mathematicians among you need worry about how relative strength is worked like the one shown below. REFS makes all these calculations for subscribers and shows them in the chart in the company entry like the one shown below. As an investor, all you need to understand is that a share showing positive relative strength is outperforming the rest of the market while one with negative relative strength is faltering.

The relative strength plot is the broken line which usually floats within the shaded area which supports the plot of the share price. The relative strength plot is superimposed and rebased, so that it always starts at the same point as the share price plot.

You will also see the small box to the bottom right of JJB Sports’ chart. It shows the relative strength for the previous year, six months, three months and one month. In addition, there are monthly tables of the shares in each index with the lowest and highest strength every month and there are columns in the table of shares with the lowest PEGs showing the one-month and one-year relative strength of the shares in question.

The third sieve

There are two requirements for the third sieve of relative strength. First, it should be positive for the previous month (even 0.1% would suffice) and , second, for the previous twelve months it should be both positive and greater than the one-month figure. The June 1996 charts below show as examples Psion, with excellent relative strength, and Telspec, that is faltering and failed to qualify.

In a bull market, using relative strength as an investment measure works exceptionally well. It identifies companies that are acting like winners. If a share begins to falter in the market, it is quite possible that a number of people know of some bad news that is about to be released and are selling some of their shares.

The very least that an investor should do is to make sure that at the time of purchase the share being bought is acting like a winner and that its future in the stock market appears to be set fair.

It is time to look at the results of applying the relative strength sieve to the shares that had already survived the previous PEG and cash flow tests. As you can see from the figures below, the relative strength sieve was a massive success:

The universe of shares that qualified was reduced from about 25 to an average of only nine, but the results were spectacular. In just six months, the average increase was about 34.5% compared with 21.6% using the cash flow and low PEG sieves and only an 8.9% increase in the market as a whole.

Further proof

Further proof of the effectiveness of the sieves of low PEGs, strong cash flow and high relative strength are provided in Chapter 15 on Portfolio Management. I show there the performance of the eight shares selected using all of the sieves for a New Year’s portfolio in the Financial Mail on Sunday . By the end of June 1996, the eight shares showed an average profit of 22.4% after all expenses , and after allowing for the benefit of press comment, while the market as a whole with no expenses rose by only 3%.

Yet more proof is provided by my son’s fund, The Johnson Fry Slater Growth Unit Trust. Mark began managing this trust in July 1995 and, by 31 October, had switched the portfolio into shares with low PEGs, strong cash flow and high relative strength. By 5 June 1996, the portfolio had appreciated 36.9% after all costs including management fees compared with the market’s rise of only 11.2%. During that period Slater Growth was also the top performing unit trust in the UK growth sector.

In October 2000, Legg Mason, who acquired Johnson Fry, decided to change the management of Slater Growth by bringing it in-house. Legg Mason then changed the approach by concentrating on highly-priced technology stocks at what proved to be the wrong time.

A new Slater Growth fund is now being advised by my son Mark. It is interesting to note that using the PEG principle with all the criteria in October 2010 it is first out of 2829 unit trusts in all categories with a gain over the last year trailing of 75%.

More on relative strength

When applying the relative strength sieve for the previous month, it should be borne in mind that after long periods of heady growth, the share prices of great growth stocks sometimes pause for breath. As long as the overall trend is intact, and the company appears to be carrying on doing its thing, this is not necessarily a cause for alarm. For this reason, I sometimes relax my one-month relative strength rule if it is mildly negative, as long as the last three months’ relative strength is still positive. However, I have become such a great fan of the twelve months’ relative strength rule that I never waver from it.

It is the continued weakening of a share price over several months that should cause investors to reconsider the right of a company to a place in their portfolios. The purpose of this chapter is not to examine the courses of action open to them once a share has been bought, but it is abundantly clear that it would be nonsense to begin an involvement with a growth company when its shares are starting to act badly against the market. A value investor looking for companies at a discount to assets might disagree, but growth investors should be focused on ensuring that nothing is going wrong with the story of a stock and that the future outlook continues to be rosy.

In a bear market, the relative strength sieve will almost certainly not work so well. The kinds of shares that rise most in a bull market are those that by definition have the best relative strength. In the final stage of a bear market investors rush for cover and, irrespective of underlying value , tend to sell those shares that show the most profit. Provided you can last out the storm (fortunately bear markets tend to be relatively brief) the value highlighted by the low PEG and strong cash flow should support the share price and help it to recover. As the market goes up, these kinds of shares are usually the first to recover.

Take a typical low PEG share with a prospective year ahead PER of 15 and a growth rate of 30% per annum. After a year’s further growth, if the share price stayed the same, the PER would drop to 11.5. A year after that it would drop to 8.9 and become such an obvious bargain that even the dimmest fund manager would consider buying some.

As an investor who concentrates on the fundamentals, I have always regarded cash flow per share as a more important sieve than relative strength. On the test results so far, however, the relative strength sieve is a hands-down winner over cash flow, so I am more than happy to revise my prejudice.

Technical analysis

Chartists work on the assumption that, irrespective of fundamentals like fluctuating multiples and asset values, a chart showing the history of a share price reflects the hopes and fears of all investors. They also argue that prices usually follow a trend and that when they do it is more important to go with it than to try to estimate future profits. Chartists also attempt to establish the best moment to buy a share – a point at which the upside potential is maximised and the downside risk reduced to a minimum.

I have always been sceptical about chartists. However, in recent years I have been converted to believing that charts are an essential tool in an investor’s kit and that, in particular, the relative strength of share prices in the previous twelve months is an essential investment sieve.

To clarify my thoughts on chartism, let me itemise my present beliefs about the uses of technical analysis:

1. Charts do provide a quick overall picture of what has happened to a share price over a given period. I particularly like the REFS charts with the share price, relative strength and EPS growth shown in three separate plots. They make it very easy to recognise a good growth share. A steeply rising share price, coupled with high relative strength and a forecast of strong EPS growth beckoning the share price further ahead, is the most encouraging pattern.
2. Chartists and technical analysts use different systems, most of which are based on the well-worn phrase ‘the trend is your friend’. Disciples therefore tend to cut their losses and run their profits, which means that they are following the most important of all of the guiding investment principles.
3. A substantial number of investors believe in charts, so some forecasts by chartist become self-fulfiling. A well-known buying signal encourages buying which in turn puts up the price. Conversely, a widely recognised bearish pattern has the reverse effect.
4. The month of the year can be an important factor in deciding when to buy shares. There is no doubt that historically some months have been better for investors than others. January is well known as being one of the best months and June as one of the worst. I can see how ‘sell in May and go away’ became such a well-known stock market maxim. There is no doubt that electoral cycles, budgets, the weather and enthusiasm at the beginning of a new year all play their part in making certain months better than others for the stock market. I do, however, part company with those extreme enthusiasts, who would claim, for example, that 19 February is likely to be better or worse than 18 February, just because it has always been a good or bad day in most previous years.
5. 5. The Coppock Indicator is perhaps the single most reliable signal of a bull market. It has not given a false signal since 1948 and the average gain based on the last ten buy signals was 30%. As the Coppock Indicator is calculated on moving averages, it is a relatively easy matter to know when there is a strong likelihood of a bullish signal being given. The Coppock Indicator does not provide reliable sell signals.
6. A break-out, a strong upward movement after a long period of consolidation, often highlights very graphically that something is afoot. Directors’ buying or news of a recent management change can provide strong corroborative evidence.
7. A share price breaking through its moving average, while the average itself is improving, is usually a reliable bullish signal. Conversely, a break below the moving average is usually a bearish sign.

Summary

1. Good relative strength in the previous twelve months was a common ingredient of the ten best winning investment strategies examined by Jim O’Shaughnessy when researching the CompuStat database over a 43-year period.

2. In REFS, the relative strength plot is the broken line in the chart of the share price. Detailed figures for one, three and twelve months are also shown in the small box to the bottom right of the chart. There are extensive tables in the tables volume showing the shares with the best and worst relative strength during the previous month and previous year.

3. I recommend as a third sieve positive relative strength over the previous month and positive and greater relative strength for the previous twelve months. The results of using these sieves over eight periods of six months lifted the average increase to a spectacular 34.5% compared with 21.6% when only PEGs of under 0.6 and strong cash flow were used as sieves. During the same period the market increased by just 8.9%.

4. Compromises can be made if the one-month relative strength is mildly negative, provided the three-month figure remains positive and all other investment criteria are fully met.

5. The relative strength sieve might not be so effective in a bear market, as investors often panic and take profits irrespective of underlying value.

6. There are a number of other advantages of technical analysis which are set out in the numbered list just before this summary, under the heading ‘Technical Analysis’.