Cheap Stocks on the Mend
Combine broad valuation evidence with positive momentum to find improving bargains.
- Difficulty
- Moderate
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 95%
The method begins by estimating relative cheapness through a composite of valuation measures, such as price to cash flow, price to sales, and EBITDA relative to enterprise value. Combining measures reduces dependence on any single accounting statistic or historical sample. The investor then applies momentum as a confirmation signal, looking for inexpensive companies whose prices have turned upward. Momentum represents the net effect of heterogeneous investor opinions expressed through actual transactions, so improving prices suggest that the market may regard a stock as excessively cheap. The resulting portfolio focuses on bargains that are recovering rather than mechanically buying the most distressed securities. Both the valuation composite and momentum definition should be tested over rolling rebalances and many market cycles before use.
Origin
Extracted from Masters in Business, where Jim O'Shaughnessy described a model developed through long-horizon quantitative testing.
Core principles
- 01Use multiple valuation measures instead of trusting one ratio.
- 02Seek inexpensive stocks that also show improving market sentiment.
- 03Treat price momentum as aggregated investor evidence.
- 04Test factor combinations across rolling periods and market cycles.
- 05Avoid stocks with persistently disastrous momentum merely because they look cheap.
How to run it
- 1
Build the Investable Universe
Define the stocks eligible for selection using consistent liquidity, listing, and data-quality requirements. Remove securities that cannot be implemented reliably.
Pro tip Keep universe rules stable so changes in results reflect the factors rather than shifting eligibility.
Watch out An unrealistic universe can make a backtest impossible to reproduce.
- 2
Calculate Multiple Value Factors
Measure each company with several valuation ratios rather than relying on price-to-earnings alone. Standardize the measures so they can be compared and combined.
Pro tip Include factors tied to cash flow, sales, and enterprise value.
Watch out Earnings can be manipulated and may be distorted by temporary accounting effects.
- 3
Create a Value Composite
Combine the standardized valuation rankings into one broad cheapness score. Use the composite to identify the attractively priced portion of the universe.
Pro tip Test whether the composite remains effective across rolling rebalance dates.
Watch out Do not select one ratio merely because it won over a particular historical interval.
- 4
Measure Momentum
Calculate price performance over a fixed period, such as six or twelve months. Rank candidates consistently by the magnitude and direction of their price movement.
Pro tip Use the same momentum window and calculation at every rebalance.
Watch out Buying the worst-momentum stocks can turn apparent bargains into severe losses.
- 5
Select Recovering Bargains
Choose stocks that rank well on the value composite and also demonstrate positive or improving momentum. Diversify across qualifying names rather than relying on one turnaround.
Pro tip Treat momentum as confirmation that investors are committing money to the recovery.
Watch out Positive momentum does not eliminate company-specific risk.
- 6
Rebalance Systematically
Recalculate the rankings and refresh the portfolio on a predetermined schedule. Apply the same buy and sell rules without discretionary overrides.
Pro tip Review implementation costs when deciding how frequently to rebalance.
Watch out Ad hoc trading can undermine both the evidence and behavioral discipline behind the strategy.
In the wild
A company ranks cheaply on price to cash flow, price to sales, and enterprise-value measures. Its shares have also risen over the prior six months after a long decline. The framework admits it as a candidate because both valuation and market behavior indicate that the earlier pessimism may have become excessive.
→ The portfolio gains exposure to a potential turnaround without relying on cheapness alone.
Another company appears inexpensive on several ratios, but its six- and twelve-month momentum remains among the worst in the universe. The investor excludes it until price behavior improves rather than assuming that a low valuation guarantees a rebound.
→ The screen avoids a stock whose falling price may reflect continuing deterioration.
Common mistakes
Using Price-to-Earnings Alone
Earnings are comparatively easy to manipulate, and a heavily targeted measure can lose efficacy. A composite reduces reliance on that weakness.
Buying Cheapness Without Confirmation
A low valuation can persist while the business or market view continues to deteriorate. Momentum helps identify bargains that have begun to recover.
Chasing Momentum at Any Price
Momentum alone can lead investors toward extremely expensive securities. The framework requires both attractive valuation and favorable price movement.
Is it for you?
Best for
It is best for systematic equity investors who can screen a broad universe and hold a diversified factor portfolio.
Not ideal for
It is not ideal for concentrated investors who require a detailed discretionary thesis for every company.
From the transcript
“Cheap stocks on the mend is a really interesting way to look at the market”
“using rolling rebalances and multiple value factors, it alone was outperformed by a value composite.”
“the price movement is an excellent indicator of the net net net sentiment of investors.”
From the episode
At the Money: Benefits of Quantitative Investing