AAII Stock Ideas: Kirkpatrick Bargain Screening Strategy

Bargain-Hunting With Kirkpatrick

The market is hitting record highs this week, capping off its extraordinary recovery from the coronavirus-induced sell-off that drove it down from its previous record high back in February. After unprecedented fiscal and monetary stimulus and advances in large technology company shares, the S&P 500 index is up over 50% since its low on March 23, 2020. With frothy valuations across some sectors and the start of a new bull market, are there any bargain stocks out there?

Charles Kirkpatrick’s book, “Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell” (FT Press, 2008), seems to have been written exactly with this scenario in mind. Kirkpatrick believes that the stock market is still the best investment vehicle available, but he also thinks it is impossible to predict the market, or the economy.

Kirkpatrick is president of Kirkpatrick & Company Inc., 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.

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 methodology is based on “relative” data elements — price to sales and price strength. His analysis has led him to the bargain 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

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 Bargain model approach uses two principle methods for selecting stocks:

  • Value
  • Price strength

Value

When looking at a stock’s value, Kirkpatrick uses the price-to-sales ratio, which is the ratio between a stock’s price and the last four quarters of reported sales for the company.

Kirkpatrick’s analysis involved first calculating the weekly price-to-sales ratios for every stock over the period from 1998 to 2006. He then sorted the companies by price-to-sales ratio and ranked them into percentiles, where the companies with the highest price-to-sales ratios were in the highest percentiles. Once the companies were placed in percentiles based on their valuation, he calculated the relative price performance for each percentile for the next three, six and 12 months.

What he discovered was that there was an inverse relationship between the relative price-to-sales ratio percentile and the relative performance three and six months forward. In other words, as the price-to-sales percentile increased, the future performance decreased. For periods of 12 months, the relationship between relative valuation and price performance dissipated. Kirkpatrick took his findings to suggest that investors should not focus on periods longer than one year.

Advancing Versus Declining Markets

Kirkpatrick also wanted to see how his various relative values performed in both advancing and declining markets. As we have learned over the last few months, the direction of the overall market can play an important role in the performance of individual stocks.

He used a very simple methodology to define advancing and declining markets. He begins by adding together the closing values of the S&P 500 for each of the last 12 months and creating an average by dividing the total by 12. At the end of the next month, the oldest monthly value is dropped from the total and the latest monthly close is added and again the average value is calculated. When the S&P 500 monthly close is above its 12-month moving average closing price, Kirkpatrick considers the market as advancing; when the monthly close is below the 12-month average closing price, the market is declining.

Returning to his price-to-sales relative analysis, the relationship between the valuation and the future price performance was only about one-third as strong during advancing markets as it was over all market conditions. However, the inverse relationship between valuation and price performance strengthened by about 25% during declining markets. This indicated to Kirkpatrick that relative valuation is a more important selection criterion during a declining market.

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.

Bargain Model

The AAII Kirkpatrick Bargain model uses the best triggers found in his testing of relative value and relative price strength.

Price-to-Sales

Kirkpatrick’s testing of relative price-to-sales ratio percentile rankings indicated optimal performance in percentiles greater than 17 but not higher than the 42nd percentile. Relative valuations outside this range tended to underperform the market. Therefore, for the AAII Kirkpatrick Bargain model screen, companies are required to have a price-to-sales percent rank that is greater than or equal to 17 and less than or equal to 42.

Relative Price Strength

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

Price and Market Cap

Lastly, AAII’s Kirkpatrick Bargain 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 bargain stocks that will perform well in both bull and bear markets and will alert you to sell in time to avoid large capital losses.

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

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American Association of Individual Investors

American Association of Individual Investors

Since inception in 1978, the nonprofit AAII has helped over 2 million individuals build their investment wealth through programs of education and publications.