Investors and traders are always on the hunt for alpha – gaining excess returns on an investment relative to the benchmark index. But managing a portfolio that delivers this magic consistently, and over a period of time is something very few investors/traders are capable of.
Why is this so difficult? A lot of factors come in the way of consistent alpha. A rising dollar may force foreign investors to temporarily exit the market, and cause indices to fall. Stocks in entire industries may fall as the sector struggles. Trading volumes may decline with changes in government regulations, or with a sharp economic downturn.
Investors also differ from traders, in seeking returns over a longer period, while investing in fewer stocks. These investors don’t like bear market periods as a result, as even sound investments can see share price declines. Traders on the other hand, take advantage of both rising and falling markets to enter and exit positions over a shorter period, and take smaller and more frequent profits.
Using DVM scores to deliver alpha on investments
Trendlyne’s durability (D), valuation (V), and momentum (M) scores allow investors to evaluate all aspects of a stock. By choosing from curated screeners or by creating your own, users can make use of these stock scores to devise a high-return trading or investing strategy. One can also backtest these screeners on Trendlyne to see how a particular strategy performed in the past. The backtests also have various filters that let you change the frequency of portfolio review, control for the number of stocks invested in each period, etc.
There is no one-size-fits-all strategy in investing or trading. A Momentum Score strategy, which looks for stocks with bullish technicals, is more suitable for traders with an appetite for higher risk, who are very active in the stock market. While the Valuation Score strategy is suitable for value investors who are always looking for stocks that are undervalued, a Durability Score strategy which selects financially healthy companies, is for those looking for lower risk and in it for the long game.
Finally, combinations of these scores help investors identify high-quality stocks that may favor one approach over another.
Let’s look at strategies that use these three DVM metrics individually, evaluate the results and then move on to combining these parameters in search of a better strategy.
A Momentum Score strategy favours traders, but comes with caveats
This Momentum Score screener helps select high-momentum (technically bullish) stocks with sufficient volumes, so that it is easy for investors to enter and exit. This strategy outperformed all others as it delivered the highest CAGR over a shorter time frame (one to three years). This is optimal for short-term traders who are active in the stock market. Surprisingly, it also performed the best even in volatile markets, as it focuses only on stocks with the highest momentum score. With weekly portfolio reviews, this strategy delivered a stellar three-year CAGR of 301% against Nifty 50’s CAGR of 16%.
The period analysis, which shows the returns every week, is also mostly in green. However, the maximum drawdown over longer investing time periods.
Maximum drawdown is the biggest observed loss from a peak to a trough of a portfolio before a new peak is attained. This did not have a stop loss, so the drawdowns show the maximum possible with this strategy.
Things to watch out for while employing this strategy:
- A weekly portfolio review is essential since the momentum score is sensitive to share price changes, and can cause higher stock entries and exits. A stop loss can also reduce negative return periods.
- Some stocks hit the upper/lower circuit as soon as the markets open–sometimes even before the market opens–in pre-market trading itself. Hence, in some cases, it can become difficult to enter/exit the stock when required.
- For longer term investors, other strategies are more optimal as weekly portfolio reviews may not be feasible for everyone. In those cases, valuation and other strategies perform better.
A Valuation Score strategy delivers stellar long term returns, but has the highest drawdown
The Valuation Score trading strategy performs best in a longer time frame (10 years). This could be due to markets taking time to discover the stock’s true value and price it accordingly. The screener includes high valuation score stocks with sufficient volumes so that it is easy for investors to enter and exit.
Since the stock's Valuation Score changes with share price movement, it is necessary to review the portfolio every quarter. In fact, a quarterly review (as opposed to a yearly review) allows investors to select optimal stocks based on the screener and get maximum returns. In addition, limiting the number of stocks selected during each period keeps this number manageable (stocks can be limited under the ‘Advanced’ option in the screener - see image below)
Under these conditions, the strategy delivered a staggering 93.7% CAGR over 10 years.
However, investors will have to endure a high drawdown when following this strategy. Another important thing to note is that a single stock could be responsible for a significant portion of the returns.
In the top valuation score strategy for instance, Sunil HiTech Engineers (now delisted) delivered over 5,400% returns. So, missing a key stock could lead to lower-than-expected returns. In addition, not all low-valuation score stocks are undervalued stocks. There could be several reasons for low share price relative to earnings–litigations, distorted earnings due to one-time gains, etc. So, there is a chance that affordable stocks can plunge further in share price. In this strategy for example, Gitanjali Gems lost big as long-hidden fraud came into view –95% of its value.
Good for low risk investors: With lower drawdowns, the Durability Score strategy delivers results when combined with other metrics
The Durability Score strategy is most effective in relatively short terms (three years) for investors, as it delivers higher returns during this period, compared to others. Like the other two strategies, a quarterly review of stocks and controlling the number of stocks to five shows high returns for investors.
Compared to other strategies which are heavily dependent on the share price, this has a relatively lower drawdown. This could be due to the presence of fundamentally strong companies in this screener. However, it becomes more effective when combined with other metrics like valuation score.
One such strategy can be devised, by using a screener that lists high DVM-score stocks with tradable volume. Another option is to use one of Trendlyne’s expert screeners–DVM - High Return, Highly Durable Companies. This includes companies with high DVM scores with rising stock prices and strong fundamental growth. When this expert screener is used, returns increase significantly, compared to the high DVM strategy that only uses stock scores.
This is particularly effective for a long term (10 years), with quarterly portfolio review, and controlled for five stocks. The top strategy in this category delivered 85.4% CAGR with a maximum drawdown of 53%. In addition, filtering for Nifty 500 stocks made marginal changes in the returns, but reduced drawdown. But filtering for Nifty 50 stocks led to underperformance, mainly because of the low number of stocks selected due to stringent parameters.
Not surprisingly, period analysis is mostly in the green as the stocks selected here are fundamentally strong.
The DVM expert screener performs the best, when accounting for drawdowns
When mid to long-term strategies across different categories are considered, high-valuation stocks deliver the highest returns. But when we consider the maximum drawdown along with the CAGR, the expert screener comes out ahead as it has a lower drawdown.
The expert screener (DVM - High Return, Highly Durable Companies), delivered returns at a whopping 85% CAGR–meaning an investment of Rs 10,000 10 years ago is now worth over Rs 38.2 lakh. All an investor needed to do was to review the portfolio quarterly and shuffle it according to the entry and exit of stocks in the expert screener and stay invested.
This is just the tip of the possibilities available to investors. Investors can use several different parameters such as PE ratio and ROE to create screeners and backtest it to calculate the returns that particular strategy has delivered over a selected period. Combining these with Trendlyne’s stock scores can, as we saw above, substantially increase your alpha.
Investors can also choose several expert screeners encompassing different parameters and investment philosophies and backtest them to come up with a trading strategy that works for them.