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Thursday, February 4, 1999

An Investment Opinion
by Dale Wettlaufer

The Weakness of Relative Strength

Beware "relative strength" as a measure of a stock's attractiveness. While there are useful aspects of this statistic, there are overwhelming weaknesses, too.

Relative strength measures a stock's performance versus all other stocks in a universe being measured. It's usually expressed by percentile with 1 percentage point increments. Thus, if a company's stock has outperformed 900 stocks out of a universe of 1,000, its relative strength (RS) will be 90. Its usefulness stems from its telling a short story about how much shareholder value has been recognized by the market over a period of time. For investors, the thinking on buying high RS stocks is this: You want to acquire shares of companies where sales, earnings, or cash flow are growing and you want to be involved with businesses that have proven they can build shareholder value.

There are problems with relative strength, though, just as there are problems with other one-shot indicators such as beta. For beta, one has to know how many data points are being gathered if the covariance coefficient means anything. For relative strength, you want to know its composition if the data are to mean anything. For instance, if you're measuring relative strength on a five-year or ten-year basis, then you're looking at a relative indicator of how the company has built shareholder value over a longer period of time.

But not all relative strength indices are the same. The best-known relative strength data comes from Investors' Business Daily. There's a huge flaw with that data, in my opinion. It's not simply how a company's stock has done over the last year. The most recent three months is given a double weighting in a year comprised of four quarters. In the trailing twelve months, then, each of the first three quarters are weighted at 20% apiece and the most recent quarter is weighted at 40%. You can see the problems that would arise from that data.

A company's stock can have a great first quarter, stay in line for the two subsequent quarters, and then have a poor fourth quarter. Even if the company and its stock have had a good year in absolute and relative terms, the most recent quarter is going to color the relative strength performance under this weighting scheme. If you're using RS as a forward-looking indicator, then perhaps the weighting helps, since the market is supposed to be telling you something with the fall of a stock. You should ask why a stock is down. But just because a company's stock starts to slip below an arbitrary relative strength threshold does not mean it should go off your research list.

One should realize that the stocks of excellent companies are not going to outperform every quarter of every year. But if you filter your world through the RS indicator, you're going to miss the most attractive points to add money to an investment. It's a bizarre situation when relative strength all of a sudden tells you that a company that was attractive last quarter is less attractive because it has been marked down this quarter.

Personally, I think it's a non factor in selecting companies for investment. I'm sure you can backtest these things and say that high relative strength companies do this or do that. That's okay if that's your bag -- I'm not going to try to dissuade you from believing that investing is all science and no art, even if I don't agree with you. Good investment returns can be had on companies whose stock has been crushed or whose stock has crushed the market over the last year. I would just like to call attention to the failings of the standard relative strength data people use. They are:

1. It only measures one year, when management's ability to create value relative to the rest of the competing investments is better judged over longer timeframes; and

2. It overweights the most recent quarter, distorting full-year performance and dissuading those who take high RS as gospel from considering investments where quality AND good value compound to provide portfolio outperformance.

In all, push relative strength way down or off your list of things to consider in researching a company. There are much better uses of your time and much more relevant data to consider.

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