The following article is adapted from Dr. Carr’s forthcoming new book, Stop Trading, Start Investing: the 6 Keys to Building a Winning Long-Term Portfolio. If you want to be alerted when the book is ready for purchase, click here: Sign Me Up!

The 6 Keys to Building a Winning Portfolio of Stocks – Part 3 of 6 “Relative Weakness”

By Dr. Thomas K Carr

In my previous two articles in this series, we looked at how “organic growth” that can be sustained over time and “fair value” as measured by the price to sales ratio are essential to finding great long-term investments in the stock market. In this article we are moving on to key number three.

The third key to finding the best stocks for investment is to look for stocks that show relative weakness. Okay, this one may have you scratching your head. Weakness? Really? Let me explain.

Relative strength in a stock is a function of the stock’s price per share. Relative strength measures the amount of change in share price over a given period of time relative to a benchmark index (typically the S&P 500). When a stock compared to its benchmark is moving up at a faster rate or down at a slower rate, it is said to have relative strength. When a stock compared to its benchmark is moving up a slower rate or down at a faster rate, it is said to have relative weakness.

Stocks with relative strength can be great trading stocks. Unfortunately, they make lousy candidates for long-term investing. The reasons for this are numerous and complex. But I don’t have to explain them to you. I can simply show you.

Let’s take our base screen as we have set it up so far: • Price to Sales Ratio < 1.0 • Earnings Per Share growth this year > 10% • Earnings Per Share growth the past 5 years > 0% • Sales Revenue growth the past 5 years > 0% • Sales Revenue growth quarter over quarter > 10%

Now let’s add a relative strength filter to it. Here, we will set up as our first filter that all passing stocks must be in the top 50% of all stocks based on relative strength. Remember, without the relative strength filter, and running the scan at the beginning of each year, we saw our original $10,000 investment balloon to $469,074 in just 15 years. Now watch what happens when we add the requirement that all stocks passing through the scan must be in the top half of all stocks for relative strength (Fig. 1):

Fig. 1: Growth + Value + Top 50% for Relative Strength

We are still way ahead of the S&P 500, but we have now reduced our overall returns from nearly $470,000 to a mere $70,000. See what I mean? While you can make money investing in stocks with relative strength, you are actually better off eliminating it as a category altogether. Simply stick with screening for stocks showing good long-term growth and current value and you’ll have a much more productive set of stocks to work with.

But wait a minute! Let’s think this through. If requiring that our stocks be in the top 50% of all stocks based on relative strength actually lowers our returns, what would happen if we reversed that filter? What about all those stocks down in the bottom 50%, the ones showing relative weakness? How did they do once we require that they also show strong long-term growth and current value? The results may shock you.

First let’s take our basic screen as we have it set up so far and add a relative weakness filter to it. Now it will look something like this: • Relative Strength = Bottom 50% of all stocks • Price to Sales Ratio < 1.0 • Earnings Per Share growth this year > 10% • Earnings Per Share growth the past 5 years > 0% • Sales Revenue growth the past 5 years > 0% • Sales Revenue growth quarter over quarter > 10%

Note that you will not be able to add this kind of relative weakness filter to Finviz, only to Research Wizard and Stock Investor Pro. What you can do, however, is set the Relative Strength Index (RSI) filter in Finviz to “< 50” which will give you something close to what you need.

So how did this revised screen do? Let’s take a look (see Fig. 2):

Fig. 2: Growth + Value + Top 50% for Relative Weakness

Wow! With this screen in place, and all else remaining the same, we would see our original $10,000 investment skyrocket to a whopping $897,819 over 15 years. Hey...to read the rest of this article, you can go here: http://www.myinvestingbuddy.co.uk/blog/

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