How to spot future stock market stars

A factor strategy allows the investor to spot Amazon.com and other Nvidia futures at their first signs of outperformance.

The ambition of any investor looking for higher than normal capital gains consists of developing tools to detect very early the next stocks like Amazon.com or Nvidia, whose performances1 since their first listings in 1997 and 1999 have reached +213,500% and +228,000%, corresponding to respective average annual returns of +32.8% and +35.8%.

To do this, financial research into predictive factors of outperformance has evolved significantly in recent years, after the emblematic ‘momentum’ factor documented by N. Jegadeesh and S. Titman in 1993 in their publication “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.

In this reference study, these academic researchers demonstrate that a strategy consisting of repeatedly selecting, twice a year, the stocks displaying the best returns over the previous six months and keeping them for six consecutive months, generates annual profitability. average surplus to that of the market of +12.01% between 1965 and 1989.
Since then, other predictive factors of outperformance have been documented and considered statistically significant in academic circles and in quantitative research departments of financial institutions.

Among these, the best known is undoubtedly that of value, thanks to which Warren Buffett, at the head of Berkshire Hathaway, has produced an average performance of +18.9% per year since 1980, i.e. + 207,831% in total, compared to +9.6% per year for the S&P500, or +4,912% in total.

W. Buffett’s predictive factor at work

Source: FactSet and Starvest Capital

Other known factors predicting outperformance include company size, profitability, and the degree to which cash flows are reinvested in the company – the latter two falling under the umbrella of quality factors.
And as demonstrated in 2023 by Dr. David Blitz et al., head of quantitative research at Robeco, in his research called “Factor Zoo”, there are around fifteen statistically significant predictive factors of outperformance.

The investor looking for greater than normal capital gains, potentially exceeding those of Warren Buffett and comparing himself to those of Amazon or Nvidia, is thus faced with the major challenge of selecting the best factorial approach to construct his portfolio. The question then arises: rather than exploiting a single predictive factor of outperformance, would it be relevant to combine a certain number of them to increase the expected profitability of a portfolio?

There is a concrete answer to this question. Indeed, after conducting a series of rigorous tests over several years, we discovered at Starvest Capital that a synergy between four key outperformance factors generates the best results:

  1. Momentum;
  2. The size of the company (size);
  3. A quality factor; And
  4. A proprietary hybrid factor2.

The illustration below allows you to visualize the conceptual process consisting of combining these four factors.

Four key factors for a winning formula

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Source: Starvest Capital

By applying this methodology to the 2,840 stocks in the MSCI AC World index over the last 15 years and by reconstituting each quarter an equally weighted portfolio with the 30 stocks most exposed to these four predictive factors of outperformance, we obtain an average annual profitability of +28.2%, compared to +10.3% for the MSCI AC World, +14.3% for the S&P 500 and +19.4% for the Nasdaq 100. Over the entire period, our factor strategy generates a capital gain of +4,053%, more than three times that of the best performing index over the period, the Nasdaq 100.

The 4-factor strategy offers +28.2% per year

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Source: FactSet and Starvest Capital, pro-forma performance (backtest)

In view of this result, it seems legitimate to wonder whether the strategy would have effectively captured Amazon.com and/or Nvidia before these companies gained their reputation on Wall Street. The answer is affirmative, Amazon appearing in the portfolio during its first formation, in May 2009 and Nvidia, during its 33rd formation, in May 2017, that is to say from the moment its stock price began its first phase of exponential rise, as the graph below highlights.

An approach integrating Nvidia before it takes off

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Source: FactSet and Starvest Capital

Today, while the 30-stock portfolio constructed in the manner described above includes companies mostly unknown to the general public, it may well contain the Amazon.com and Nvidia of tomorrow. Often founded by great visionaries, like Jeff Bezos or Jensen Huang at the time, these future Wall Street stars market some of the most innovative services and products.

1 According to their closing prices on 05/02/2024

2 This factor has been identified as statistically significant in benchmark studies, which examined different variations of the denominator of the ratio it encompasses. It is derived from elements of the profit and loss account, as well as the balance sheet of the companies considered. After tests carried out over several years, we have retained the most convincing form.

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