EFA

Eastern The
Financial
Finance Review
Association
The Financial Review 33 (1998) 161-176

A test of the Investor’s Daily stock

ranking system
Dennis 0. Olson*
Department of Economics and Finance, Sultan Qaboos University

John Nelson
Department of Economics, University of Louisville

Craig Witt
Sugar Research, Ltd.

Charles Mossman
Faculty of Management, University of ~ .
.
. nitoba

Abstract

This paper examines the profitability of trading strategies derived from stock rankings
published in Investor’s Business Daily. The best system provides market-adjusted abnormal
monthly returns of 1.81% from buying S&P 500 stocks, and a 3.18% abnormal return on an
arbitrage portfolio. Stocks selected for trading have above average volatility, but a portion
of abnormal return may be a reward for identifying stocks with short-run sustainable price
momentum. Results seem indicative of market inefficiency, but the phenomena may be
temporary since abnormal returns are lower during the second half of the data set.

Keywords: market efficiency, momentum investing, trading rules, stock rankings, relative
strength
JEL Classification: G14

1. Introduction
In recent years Investor’s Business Daily (ZBD) has emerged as an important
competitor to the Wall Street Journal in the U.S. market for a national daily business

* Corresponding author: Dennis Olson, College of Commerce, Sultan Qaboos University, Al Khod,
Postal Code 123, Sultanate of Oman

161
162 D.O. Olson, J. Nelson, C. Witf, C. Mossrnan/The Financial Review 33 (1998) 161-176

newspaper.’ It has concentrated on financial markets and its daily stock tables differ
in appearance from those in the Wall Street Journal. For example, stocks making
an annual high or up more than a point from one day to the next are boldfaced,
while stocks at a new low or down more than a point are underlined. The primary
feature that distinguishes Investor’s Business Daily from the competition, however,
is its proprietary stock ranking system? The first two columns in what is advertised
as “the world’s most intelligent stock tables” show earnings per share (EPS)and
relative strength (RS) rankings for over 6000 U.S. stocks. Since many investors use
these rankings as a guide in stock selection, an examination of the information
content of the IBD rankings should be of interest to the investment community.
Investors buying stocks with high EPS and RS rankings implicitly assume that
earnings and price momentum will continue into the future. Such trend following
systems have become popular in recent years and Hanley (1993) describes Investors
Business Daily and the Value Line Investment Survey as the leading proponents of
momentum investing in the 1990s. Beginning with Black (1973), the Value Line
rankings have been extensively analyzed and generally shown to have provided
investors with superior returns in the 1970sand 1980s.Although the IBD rankings are
similar to the Value Line timeliness rankings, little is known about the performance of
these rankings. The purpose of this paper is to test the profitability of various trading
strategies derived from Investor’s Business Daily stock rankings. The results will
also indicate how momentum investing has performed in recent years.
The next section of the paper describes the ZBD rankings and is followed by
a literature review on momentum investing. Subsequent sections describe the data
and the methodology, test some possible trading rules, and examine reasons for the
existence of abnormal returns.

2. The Investor’s Business Daily stock rankings

The EPS ranking measures a stock’s earnings per share growth and the stability
of that growth over the past five years relative to all stocks listed in the daily stock
tables. Percentile rankings range from 1to 99, with 99 being the highest. The relative
strength rankings compare a stock‘s price change relative to other stocks over the
past twelve months. Both ranking schemes are proprietary and the rankings are
updated daily. Stocks with EPS rankings of 80 or above are “companies with
superior earnings records” and stocks with an RS ranking below 70 “indicate
weaker or more laggard relative price performance.” In his book How to Make

’Investor’s Daily was founded in April of 1984 and changed its name to Investor’s Business Daily in
1992. Circulation has steadily increased to a 1996 level of over 200,000 issues.
Investor’s Business Daily also presents each stock‘s volume percentage change from day to day. In
1992, it introduced an Accumulation-Distribution rating based on accumulated changes in stock volume
over the previous 40 days. Daily data are needed to examine the value of volume information.
D.O. Olson, J. Nelson, C. Wit& C. Mossman/The Financial Review 33 (1998) 161-176 163

Money in Stocks, William O’Neil (1988), the founder of Investor’s Business Daily,
recommends selecting stocks with EPS rankings above 80 and RS rankings above 70.
The stock selection philosophy implicit behind the ZBD stock rankings is
O’Neil’s (1988) CANSLIM method. The CANSLIM acronym is based on Current
earnings, Annual growth, Size, Leader in an Industry, and Market direction. A
“good” stock will have high current earnings and annual growth, it will be a
medium sized company that is a leader in its industry, and it should have an EPS
ranking above 80 and a RS ranking above 70. These stocks should be purchased
when the general market direction is favorable and when a stock is at a “pivot
point,” which is at the bottom of a short-term correction off an interim high. The
CANSLIM system requires subjective analysis of charts, but the information content
of EPS and RS rankings can be easily tested.

3. Literature on momentum investing

Levy (1967a, 1967b) provides the first evidence that relative strength rankings
can be used to profitability exploit price trends. For the 260 weeks from 1960 to
1965, the highest 10% of stocks ranked by six-month relative strength generally
continued to out perform the market over the next six months. Subsequent comments
by Jensen (1967) and Jensen and Benington (1970) criticize Levy for testing for an
anomaly using the same data set which uncovered the anomaly. They also find that
Levy’s models do not work well for their data sets, but Arnott (1979) shows that
the differences between studies are related to the time period considered. Relative
strength investing worked well from 1968 to 1974, but not during 1974 to 1977.
Such results are consistent with Lakonishok, Shleifer, and Vishny (1994), suggesting
that there are periods where growth stocks (generally high RS stocks) outperform
value stocks (lower RS stocks), and vice versa.
Arnott (1979) identifies a potential problem with momentum systems and
relative strength investing-that stocks with abnormal one-month performance are
subject to price reversals in the next month. Subsequent work by Brush (1986)
confirms that one-month price reversals are problematic for short-term relative
strength models. The suggested solution is to measure relative strength over a six
to twelve month time interval. He also notes that momentum investing may not
work well around the turn of the year.
Jegadeesh and Titman (1993) find that a portfolio formed by purchasing extreme
winners and selling losers based upon six month relative strength rankings produces
12% annually compounded size-adjusted abnormal returns. During 1965-1 989, their
system provided generally positive abnormal returns up to twelve months and
negative abnormal returns thereafter. Hence, momentum investors face likely price
reversals if stocks are held too long.
A complex trend following system called CRISMA (CumulativeVolume, Rela-
tive Strength, Moving Average) developed by Pruitt and White (1988) selects many
of the same stocks as the CANSLIM method. CRISMA chooses among stocks with
164 D.O. Olson, J. Nelson, C. Witt, C. Mossman/The Financial Review 33 (1998) 161-176

increased trading volume and relative strength when a 50-day moving average of
prices is above the 200 day moving average. Depending upon commissions,CRISMA
provided annual returns of 6% to 15% above that for a buy-and-hold strategy for
1976-1985. Pruitt, Tse, and White (1992) report that CRISMA provided 1% to 5%
excess returns from 1986-1990, showing that a momentum system can continue to
work (though not as well) even after investors become aware of its success.
Value Line timeliness rankings, which are similar to the ZBD rankings, are
based upon relative strength, relative earnings, and unexpected changes in quarterly
earnings. Black (1973) first showed that highly ranked Value Line stocks earn
positive abnormal future returns. Subsequent research generally confirms these
findings, but Holloway (198 1) shows that abnormal returns are significantlyreduced
by transaction costs and Hanna (1983) argues that the apparent success of Value
Line rankings stems from inadequate adjustment for risk. Chandy, Peavy, and Reich-
enstein (1993) suggest that favorable Value Line reports temporarily boost stock
prices; but more recently, Peterson and Peterson (1995) find that Value Line “Stock
Highlight” reports provide new information about future earnings that is permanently
incorporated into stock prices.
The literature on momentum investing has focused primarily upon price trends,
but Jaffe, Keim, and Westerfield (1989) show that current earnings are generally
positively correlated with stock returns in subsequent periods. A possible exception,
also noted by Ettredge and Fuller (1991), is that stocks with negative earnings in
the past year out perform high earnings-to-price stocks in the next year. However,
Ali and Klein (1994) find that negative earnings stocks fail to out perform the
market after properly adjusting for risk. A subsequent note by Ettredge and Fuller
(1991) shows that the performance of negative earnings stocks varies considerably
between time periods.

4. Data
The primary data consist of end of the month EPS and RS rankings and monthly
returns for all stocks in the Standard and Poor’s 500 (S&P 500) index during the
period from May 1984 to December 1992. This period includes 104 of the first 105
months of the newspaper’s existence. April of 1984 is excluded because back issues
of Investor’s Business Daily were not available for that month.
End of the month RS and EPS rankings were copied by hand from Investor’s
Business Daily from the first issue of each month.3 Monthly returns for S&P 500
stocks listed on the New York, AMEX, and Over The Counter exchanges are from
Center for the Study of Security Prices (CRSP) data tapes. Both the NYSE/AMEX
and the NASDAQ/NMS monthly and daily tapes were used to obtain as complete

To obtain as complete a sample as possible, rankings for stocks not published in the first issue of
Investor’s Business DuiZy each month were copied from the second issue of the month, or from the last
issue of the previous month.
D.O. Olson, J. Nelson, C. Witt, C. Mossman/The Financial Review 33 (1998) 161-176 165

a sample as possible. Data for the risk-free rate of return on 90 day U.S. Treasury
bills and the dividend-inclusive return for the S&P 500 index are from Pinnacle
Data Corporation. Quarterly earnings per share, market value, and prices for S&P
stocks are from Cornpustat.
The sample of stocks for each month includes all stocks in the S&P 500 at
the end of the previous month. The list was obtained from monthly editions of the
Standard and Poor’s Stock Guide. Stocks entering the S&P 500 on any day prior
to the last day of the month do not enter the data sample until the next month.
Similarly, stocks delisted during a month remain in the sample through the end of
the month.
Since CRSP returns and ZBD rankings could not be obtained for all stocks each
month, the usable data set consisted of 49,448 observations,rather than the theoretical
maximum of 52,OO (500 x 104). The number of stocks in the data set each month
ranged from 462 to 491, with an average of 475 observations per month.
The stock rankings ideally should be tested over a longer period of time using
a broader sample of stocks; however, the rankings are proprietary and not available
electronically, nor on tape or diskette. The decision to limit the sample to S&P 500
stocks reduces the impact of confounding factors, such as the small-firm effect and
analyst neglect. Also, since O’Neil developed and optimized his ranking system
prior to founding Investor’s Business Daily in 1984, this data set provides an out
of sample test of the IBD rankings.

5. Measuring abnormal returns

Abnormal returns relative to some benchmark are commonly calculated in one
of three ways. First, market-adjusted abnormal returns (a,,) for any stock or stock
portfolio i over a future period of t months are denoted by:

a,, = R,, - Rmt, (1)

where R,, and R,, are portfolio and market returns over a t month holding period,
and q, is obtained by regressing R,, - R,, on a constant. Beta-adjusted abnormal
returns (al,)
are calculated from the empirical capital asset pricing model as follows:

where Re is the risk-free rate of return for t months, Pi, is the holding period portfolio
beta, and is an error term. A non-zero value of the regression intercept (ai,),
often called Jensen’s alpha, denotes abnormal performance. Finally, size-adjusted
abnormal returns can be calculated as sit= Ri, - Rst,where R,, is the return to stocks
of similar size to those in portfolio i. Since the S&P 500 index consists mainly of
large stocks, it is a relevant proxy for either R,, or R,, in this paper.
The magnitude of measured abnormal returns can be sensitive to the market
proxy selected to represent the ‘‘true” market. The dividend-inclusive value-
166 D.O.Olson, J. Nelson, C. Witt, C. Mossman/The Financial Review 33 (1998) 161-176

weighted return on the S&P 500 is the most frequent performance standard for
money managers and used as the relevant market proxy. Its mean monthly return
over the 104 months from 1984 to 1992is 1.38%. Possible alternative market proxies
are the equal-weightedreturn of S&P stocks in the sample each month, the dividend-
inclusive value-weighted CRSP index, and the dividend-inclusive equal-weighted
CRSP index. Mean monthly returns for these indices are 1.45%, 1.34% and 1.17%.
With the exception of the equal-weightedCRSP index, abnormal returns from trading
strategies are not significantly affected by the choice of market proxy.4
A common procedure in many studies is to sort stocks by ranking characteristics
to form equal-sized quintile or decile portfolio groups. In contrast, this study models
the likely behavior of investors by devising trading strategies based upon the magni-
tude of EPS and RS rankings. Stocks that satisfy a common ranking characteristic,
and therefore the number of stocks in a portfolio, will vary from month to month.
With this caveat, portfolio returns are calculated by equally weighting each stock’s
return within period and then equally weighting each period over time. Monthly
rebalancing is required for holding periods beyond one month.
Alternatively, abnormal returns can be calculated using individual securities,
thereby equally weighting observationsregardless of time period. In practice, regres-
sions on portfolios or individual securities yield similar measures of abnormal
returns5 Results presented hereafter are based upon regressions on portfolios because
it is a more intuitive way to calculate beta-adjusted abnormal returns.

6. Testing the EPS and RS rankings

Panel A of Table 1 shows holding period returns for periods of one to twenty-
four months for stocks in various RS decile groups. Market-adjusted abnormal
returns are positive and generally statistically significant when RS 2 80 and negative
and statistically significant when RS < 30. The top decile stocks provide market-
adjusted abnormal returns of .64% for one month and 3.28% over the next year.
Returns continue to increase slightly during the second year of the holding period
for stocks with RS 2 80, with no evidence of mean revision during this time frame.
In contrast, Jegadeesh and Titman (1993) find that trends among previous stock
market winners and losers persist for about a year and then revert toward the mean.
The differences probably arise because the data sample of S&P stocks does not
include all of the biggest winners from the previous year.

For a portfolio of RS < 20 stocks, the average month ahead market-adjusted return is a, = -.68% using
the S&P 500 market proxy, -.65% using a proxy derived from stocks in the data set, and -.59% using
the value-weighted CRSP proxy. Using the equal-weighted CRSP proxy yields a, = -.22% and it suggests
much higher abnormal returns to any trading strategy than the other proxies.
For RS t 80 stocks, a, = .38% using portfolios, and a, = .39%using individual securities. Both techniques
give identical results of a, = -.68% for RS < 20 stocks. Correcting for heteroskedasticity has only a
negligible effect on the significance of any regression parameters presented in this paper.
D.O.Olson, J. Nelson, C. Witt, C. Mossrnan/The Financial Review 33 (1998) 161-176 167

Table 1
Abnormal returns by RS and EPS decile group rankings
This table shows abnormal returns (in %) from purchasing S&P 500 stocks on the basis of end of month
RS and EPS decile rankings. Holding periods ( i ) range from one to twenty-four months. P, is the portfolio
beta over a t month holding period, and a, and eiare market-adjusted and risk-adjusted cumulative
abnormal returns. For brevity, not all values of at and PI are presented. The notation * denotes statistical
significance at the 10% level and ** indicates statistical significance at the 5% level.

Panel A. Regressions on RS decile groups

RS rank al a1 PI A3 a, a12 PI2 a24
1-9 -1.06* -1.45** 1.46** -2.36** -4.08** -5.13** 1.43** -6.25**
10-19 -.38* -.61** 1.26** -.71* -.42 -1.55 1.22** -.71
20-29 -.41* -.61** 1.10** -.48 -.96* -2.36** 1.11** -3.54**
30-39 .05 -.07 1.15** .71* .08 -1.48** 1.10** -1.88
40-49 .13 .04 l.lO** .34 -.01 .01 1.09** -.83
50-59 .08 .03 1.06** .30 .08 .02 1.05** -.49
6M9 .18 .13 1.07** .29* 0.00 .04 1.06** .21
70-79 .15 .10 1.05** .25 .56* .96** 1.08** .57
80-89 .23* .15 1.10** .19 .35* 1.28** 1.15** 2.28**
90-99 .&** .48* 1.19** 1.30** 2.62** 3.28** 1.22** 4.24**

Panel B. Regressions on EPS decile groups

EPS rank ai a1 PI A3 a, aI2 PI2 aZ4
1-9 -1.32** -1.36** 1.05** -2.60** -2.76** -5.95** 1.12** -10.32**
10-19 -.85** -1.05** 1.25** -2.05** -3.07** -4.47** 1.21** -4.35**
20-29 -.36* -.52* 1.19** -.83** -1.44** -39 1.17** -.96
30-39 -.01 -.lo 1.11** -.06 -.43 -1.15** 1.10 -1.97
40-49 .03 -.08 1.09** .37* .41 -.81* 1.06** -1.23
50-59 .16 .16 1.00** .31 .31 .96** 1.04** -.49
6M9 .16 .13 1.04** .61* .68** .84* 1.06** .21
70-79 .33** .26** 1.07** .65** .79** .56* 1.09** .97
80-89 .13 .04 1.10** .43** .35 .08 1.12** 1.28*
90-99 .39** .19 1.24** .74** .43 1.39** 1.18** .13

For stocks with RS < 30, negative abnormal performance persists throughout
the twenty-four month holding period. Lakonishok, Shleifer, and Vishny (1994) and
the literature on the contrarian investment approach show that the biggest losers
over three years outperform other stocks over the next three years. Results in this
study may not conflict with the literature, however, because low RS stocks are
selected after only one year of poor price performance.
Panel B of Table 1 displays the results for EPS decile groups. Positive market-
adjusted abnormal returns generally accrue to high EPS stocks over holding periods
up to two years, while negative abnormal returns accrue to low EPS stocks. With
the exception of EPS c 20 stocks, abnormal returns are less than for stocks selected
by RS deciles. Stocks with EPS < 20 earn statistically significant negative abnormal
returns for holding periods up to 24 months. This conflicts with earlier studies
168 D.O. Olson, J. Nelson, C. Wig, C. Mossman/The Financial Review 33 (1998) 161-176

reporting superior performance from negative earnings stocks, but is consistent with
recent work by Ettredge and Fuller (1991). Their size-adjusted one year abnormal
returns to a portfolio of NYSWAMEX negative earnings stocks of -5.81% for 1974-
1990 is virtually identical to the twelve month market-adjusted returns of -5.95%
for the lowest EPS decile stocks.6
While the average beta for stocks in the sample is 1.11, the holding period
betas of extreme RS or EPS portfolios are somewhat larger? For example, PI =
1.46 for the smallest RS decile portfolio and PI = 1.24 for the highest EPS decile
portfolio. These betas remain fairly stable over time, but beta-adjusted abnormal
returns are uniformly smaller than market-adjusted returns for high ranked RS or
EPS stocks. Investors wishing to engage in short selling the low ranked stocks face
a similar volatility risk, which significantly reduces returns on a beta-adjusted basis.

7. Combining ranking characteristics

Table 2 shows abnormal returns obtainable using trading strategies based upon
combined EPS and RS rankings. Following O’Neil’s suggestion of purchasing
stocks with RS 2 70 and EPS 2 80 provides statistically significant market-adjusted
abnormal returns of al = .42% and beta-adjusted abnormal returns of a,= .28%.
Holding these stocks for twelve months provides abnormal returns of a12= 2.54%
and a 1 2 = -.07%.
Investors may be able to further enhance returns by selecting among only the
highest ranked stocks. For example, buying only RS 2 90 and EPS 2 90 stocks
provides one-month ahead abnormal returns a, = 1.08% and a1= 39%.Over longer
holding periods, market-adjusted abnormal returns are a6 = 3.93% and aI2= 4.04%.
Further restricting stocks to have been in the upper RS and EPS deciles in the
previous month (RS12 90 and EPSl2 90) increases abnormal returns to al = 1.81%
and a1= 1.55%. This restriction reduces the impact of one-month price reversals
noted by Arnott (1979) as a problem for relative strength systems.
The abnormal returns from this last strategy appear to be exploitable even after
paying commissions, adjusting for slippage, and noting the difficulty of actually
buying at end of month closing prices. For example, Berkowitz, Logue, and Noser
(1988) estimate that total round-turn transaction costs (commissions and market
impact costs) were. .47% for trading NYSE stocks in 1985. Although transaction
costs are larger for individual investors, low commissions have become more widely
available since 1985.

The lowest ranked EPS stocks are not strictly negative earnings stocks over the previous year. The
EPS rankings are based on five-year earnings growth and stability. At the time of portfolio formation,
the lowest EPS quintile stocks had earnings per share that were roughly one-half the size of all other
S&P stocks. About one-third of EPS < 20 stocks and slightly over one-half of the EPS < 10 stocks had
negative earnings over the preceding year.
The average beta would be 1.00if the equal-weighted return for all stocks in the sample were used as
the market proxy.
D.O. Olson, J. Nelson, C. Witt, C. MossmanIThe Financial Review 33 (1998) 161-176 169

Table 2
Results of Combining Stock Selection Criteria
This table shows abnormal returns (in %) from purchasing SCP 500 stocks on the basis of end of month
RS and EPS rankings. Holding periods ( t ) range from one to twenty-four months. PI is the portfolio
beta over a i month holding period, and a, and at are market-adjusted and risk-adjusted cumulative
abnormal returns, and CRS and CEPS are monthly change in RS and EPS rankings. For brevity, not all
values of a,and PI are presented. The notation * denotes statistical significance at the 10% level and
** indicates statistical significance at the 5% level.
Panel A. Returns to high ranked stocks
Criteria al a1 PI a6 a12 a12 PI2 aZ4
Entire sample .08 -.01 1.11** .37 .61* -1.04** 1.09** 1.09
RS>70, EPSs50 .31** .21** 1.11** 1.13** 2.61** .57 1.13** 3.56**
RS>70, EPS>80 .42** .28** 1.18** 1.49** 2.54** -.07 1.17** 2.86*
RS>80, EPSAO .51** .35** 1.20** 1.57** 3.09** -.01 1.20** 3.58**
RSs90, EPS>BO .83** .63** 1.24** 3.35** 4.62** 33 1.25** 5.16**
RS>90, EPS>90 1.08** .89** 1.26** 3.93** 4.04** .37 1.24** 3.80**
RS>90,EPS>90,and 1.81** 1.55** 1.25** 4.14** 4.61** 1.97** 1.27** 4.91**
RSb90, EPSk-90

Panel B. Returns to low ranked stocks

Criteria a1 0 1 PI a6 alz a12 PI2 az4
EPSc30 -.68** -.86** 1.22** -2.30** -2.82** -5.14** 1.18** -3.67**
RS<30, EPSC30 -1.11** -1.46** 1.35** -3.81** -5.02** -9.99** 1.29** -4.75**
RS<30, EPSc20 -1.46** -1.72** 1.29** -4.80** -7.79** -12.92** 1.30** -9.69**
RS40, EPS<20 -1.39** -1.70** 1.35** -5.28** -7.89** -11.69** 1.32** -9.47**
RS<20,EPS<20,and -1.90** -2.16** 1.30** -4.86** -7.84** -11.98** 1.32** -11.07**
RSlc20, EPS1<20

Panel C. Returns based upon changes in RS and EPS rankings

Criteria al PI a6 alz a12 PI2 aZ4
CRS>25 .87** .86** 1.01** -.18 .56* -.90 1.14** -3.05**
CEPS>25 .90** .74** 1.18** 1.33** 1.11* -1.71* 1.15** -.09
CRS>IO, CEPS10 1.44** 1.36** 1.17** 2.03** 2.78** 1.03* 1.12** 3.17**
CRSC-25 -1.03** -1.11 1.12** .02 -.84* -2.81** 1.12** -2.68*
CEPS<-25 -.30** -,37** 1.08** -1.71** -1.27* -3.85** 1.14** -2.69*

Cumulative market-adjusted and beta-adjusted abnormal returns for stocks

ranked in the upper deciles in two consecutive months for holding periods from
one to 24 months are shown in Figure 1. Market-adjusted returns peak at 5.24%
after 16 months and fall slightly thereafter. Cumulative beta-adjusted abnormal
returns for high ranked stocks peak at 3.1 1% after five months and turn negative
after 17 months.
For stocks ranked EPS < 20 and RS < 20, al = -1.39% and a1= -1.70%.
Further requiring stocks to be in the lowest ranking quintiles for two consecutive
months yields market-adjusted abnormal returns of al = -1.90%, a6 = -4.86%, and
170 D.O. Olson, J. Nelson, C. Witt, C. Mossmn/The Financial Review 33 (1998) 161-176
D.O. Olson, .
INelson,
. C. Witt, C. MossmadThe Financial Review 33 (1998) 161-176 171

a12= -7.84%. These returns are measured relative to the S&P 500 index and are
not actual returns. After netting out the 1.38%monthly return on the S&P 500 and
paying round-turn commissions of a least .5%, the net return from short selling low
ranked stocks is near zero. Thus, short selling by itself is not profitable.
In recent years there has been a proliferation of hedge funds designed to profit
from the simultaneous purchase and short sale of stocks. Consider a portfolio that
buys equal dollar amounts of all stocks ranked in the top EPS and RS decile groups
for two consecutive months. Simultaneously, equal dollar amounts of stocks ranked
in the lowest EPS and RS quintile groups for two consecutive months are sold short.
An arbitrage, or zero-beta, portfolio requires the dollar value of the long and short
positions to be identical each month. The holding period returns to the arbitrage
portfolio are 3.71%for one month. Subtracting the mean monthly risk-free rate of
return of .53% produces an abnormal return of 3.18% for a one-month holding
period. As shown in Figure 1, abnormal returns (above the risk-free rate) for the
arbitrage portfolio climb steadily to a peak of 5.80% after five months and drop
dramatically after 14 months. Most of this decline occurs from subtracting the risk-
free return from portfolio returns at a time when neither high nor low ranked stocks
are significantly out performing the market.
The standard deviation of monthly returns for 1984-1992 are 4.72% for the
S&P 500, .39%for the arbitrage portfolio, and .14% for ninety day Treasury bills.
Relative to the S&P 500 monthly excess return of .85% above the risk free rate,
the arbitrage portfolio provides an abnormal or excess return of 3.18% for signifi-
cantly lower risk.* Even if transaction costs are 1%,or double the cost of buying
high ranked stocks, the arbitrage portfolio significantly out performs the S&P 500.
This perhaps indicates why hedge funds have become so popular in recent years.

8. Reasons for abnormal returns

The existence of abnormal returns from trading strategiesraises questions about

market efficiency. To see if outliers in the data (particularly among stocks in the
arbitrage portfolio) are responsible for the results, trimmed regressions were run
discarding 5% of the observations furthest above and furthest below the regression
line. Trimmed abnormal returns are a, = 1.40%and a1= 1.11% for high ranked
stocks and al = 2.07%and a,= -2.40% for low ranked stocks. Hence, outliers are
not a likely source of abnormal returns.

* Returns on the arbitrage portfolio implicitly assume that proceeds from short sales can be used to
purchase other stocks. If only 50% of the proceeds can be used, abnormal returns are reduced, but not
eliminated. Even if abnormal returns are calculated by subtracting the S&P 500 monthly return, the
resulting value of al = 2.34% still exceeds transaction costs for most investors.
172 D.O. Olson, J. Nelson, C. Wig, C. MossmudThe Financial Review 33 (1998) 161-176

8.1 Risk

Stocks in the arbitrage portfolio are more volatile than the average stock. High
ranked stocks have an average beta of PI = 1.25 and low ranked stocks have an
average beta of PI = 1.30. Another possible risk is that some stocks perform differ-
ently in up and down markets. For RS 2 90 and EPS 2 90 stocks, the up and down
market betas are plu= 1.15 and P l d = 1.34, which means these stocks have greater
risk in down markets. However, further restricting these stocks to have been ranked
in the top decile groups for two consecutive months changes the betas to pIu= 1.24
and Pld= 1.27. For low ranked stocks in the arbitrage portfolio, Plu = 1.37 and P l d =
1.21, indicating the risk of short selling stocks during up markets. Although risk
can not be ruled out as source of abnormal returns, such an explanation requires a
more complex risk-return tradeoff than specified in the linear form of the capital
asset pricing model. Also, risk does not appear to explain abnormal returns for the
arbitrage portfolio.

8.2 Delayed response explanations

To see how abnormal returns are related to current and future changes in
earnings per share (CEPS), Cornpusfat quarterly EPS data were obtained and con-
verted into a monthly series. Data were available for an average of 412 of the S&
P 500 stocks each month. At the inclusion date, highly ranked stocks in the arbitrage
portfolio had a quarterly EPS of $.32, versus $.41 for the average S&P stock. Their
EPS steadily rose to $.41 after five months, declined back to $.32 after ten months,
and thereafter slowly reverted to the mean. For low ranked stocks in the arbitrage
portfolio, the average EPS is $.14 at the time of inclusion, rising to $.28 after five
months, with slow EPS growth and large fluctuations thereafter.
High EPS and RS rankings appear to be anticipating temporary increases in
future earnings, suggesting continuation of short-term momentum in prices and
earnings. However, future permanent increases in earnings for low ranked stocks
are not rewarded with short-run price appreciation. Such results seem consistent
with a type of asymmetric delayed response to firm specific information. The market
may take up to a year to fully reflect good news as conveyed in high RS and EPS
rankings. For “loser” or low ranked ZBD stocks, the market may take several years
to reward favorable earnings information, perhaps because of the future earnings
volatility associated with low ranked stock portfolios. This delayedresponseexplana-
tion is consistent with results in Lakonishok, Shleifer, and Vishny (1994) and
Jegadeesh and Titman (1993). Hence, value stocks can be a good long-term invest-
ment even though trend following and momentum-based systems provide abnormal
returns in the short-run.
D.O. Olson, J. Nelson, C. Win, C. Mossman/The Financial Review 33 (1998) 16I-176

8.3Seasonality
Figure 2 shows how highly ranked stocks and the arbitrage portfolio perform
on a calendar month basis for one month holding periods. Highly ranked stocks out
perform the S&P 500 in all months except July and August. The best months are
February, May, September, and December. Unlike evidence cited in Brush (1986)
174 D.O. Olson, J. Nelson, C. Witt, C. Mossman/The Financial Review 33 (1998) 161-176

for high relative strength stocks, highly ranked EPS and RS stocks out perform the
S&P 500 around the tum of the year. The arbitrage portfolio provides positive
abnormal monthly returns except in January, March, and August. Negative returns
in January accrue to the short side of the portfolio due to the well-known “January
effect” where the previous year’s losers out perform the market. Similarly, although
the reasons have not been documented in the literature, low ranked EPS and RS
stocks out perform the market in March and August, thereby producing negative
returns for the arbitrage portfolio.

8.4 Temporary ineficiency

Although abnormal returns may temporarily exist in reasonably efficient mar-
ket, returns above minimal transaction costs should eventually be recognized and
eliminated. As circulation of Investor’s Business Daily grows, the rankings may
provide less information content. To test this hypothesis, the data set is split in half.
During the first subperiod (1984 to mid-1988), market-adjusted abnormal returns
are a, = 2.49% for stocks ranked in the upper EPS and RS deciles in two consecutive
months, a, = -2.87% for the stocks ranked in the lowest quintile for two consecutive
months, and a, = 5.38% for the arbitrage portfolio. For the second subperiod (mid
1988-1992), market-adjusted abnormal returns are 1.07% for high ranked stocks,
-.81% for low ranked stocks, and 1.88% for the arbitrage portfolio. After deducting
transaction costs of .5% for high ranked stocks and 1% for the arbitrage portfolio,
small (but exploitable) monthly abnormal f e r n s still exist during the 1988-1992
period. Nevertheless the magnitude of potential abnormal returns is much smaller
in the later period. A potential explanation for the differential subperiod results is
that investors have slowly begun to recognize the value of Investor’s Business Daily
stock rankings and have acted accordingly. Hence, the magnitude of any temporary
inefficiencies may be approaching a level consistent with transaction costs plus a
risk premium associated with selecting stocks with above average ~olatility.~

9. Summary and conclusions

Results suggest that the Investor’s Business Daily stock rankings have provided
investors with useful information during the period 1984-1992. Market-adjusted
abnormal returns, in excess of transaction costs, could have been realized by buying
highly ranked stocks. Larger profits were obtainable, at less risk, using an arbitrage
portfolio that buys high ranked stocks and sells low ranked stocks.

Savitz (1994) notes that William O’Neil started a mutual fund in April of 1992 that uses CANSLIM
to select stocks. The New USA Mutual Fund under performed the S&P 500 by six percentage points
(3% versus 9%) during the 26-month period ending in June of 1994. Taking a more extreme view,
Hanley (1993) has written an obituary for momentum investing as espoused by O’Neil and Value Line,
noting that it “is one of the most obvious bubbles I have witnessed in my 22 years on Wall Street.”
D.O. Olson, J. Nelson, C. Witt, C. Mossman/The Financial Review 33 (1998) 161-176 175

The existence of trading strategy profits may be indicative of market ineffi-

ciency, but the best strategies examined in this paper would not have been widely
known to work during the period from 1984 to 1992. Some of the abnormal return
may be a risk premium for selecting volatile stocks, but the remainder is likely a
reward to investors who use the rankings to better forecast sustainable trends in
price and earning momentum. Such an explanation is consistent with the notion of
a delayed response to firm specific information. However, since abnormal returns
decline significantly between the first and second halves of the data set, this study
may have uncovered a temporary market inefficiency that is already being recognized
and exploited.

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