3 simple indicators, the 2-2-2 rule helps you select stocks accurately!

Who is Mike Bailey?

When it comes to stock selection, we usually consider many factors. So, is there a relatively simple stock selection strategy? Today I would like to introduce you to an expert, Michael A. Berry (Michael A. Berry), who once proposed a stock selection strategy that included only 3 indicators.

Mike Bailey majored in investment finance at Arizona State University (Arizona State University) and obtained his doctorate degree. After that, he worked as an investment professor at the University of Virginia (the University of Virginia) and James Madison University (James Madison University). He has published many studies on investment behavior strategies in numerous academic and professional journals.

In addition to academics, Mike Bailey also worked as a fund manager on Wall Street and managed small to medium value portfolios at Heartland Advisors and Kemper Scudder.

During his teaching and money management career, he discovered that there are many companies that have never been seen by the public. So in 2000, he founded Discovery Investing (Discovery Investing), which focuses on research investment opportunities in natural resources, biotechnology, and high technology.

In addition to this, he has also delivered speeches to the Federal Reserve, testified to Congress on natural resources, etc., and was the chairman of the Global Critical Metals Symposium in 2021. He and his son also write “Morning Notes” (Morning Notes) every week to discuss resource discoveries, geopolitics, etc.

Mike Bailey's 2-2-2 Stock Selection Rule

What kind of stock selection rules does such an expert who has done a lot of research on investment have?

Mike Bailey and David N. Dreman (David N. Dreman) co-published a paper called “Overreaction, Underreaction, and the Low-P/E Effect” (Overreaction, and the Low-P/E Effect) in the “Financial Analysts Journal” (Financial Analyst Journal), which condensed their understanding of value stock investment and proposed the 2-2-2 stock selection rule based on empirical research.

What exactly does this law mean? It consists of 3 indicators, each with a numerical target associated with 2.

1. First, stocks must have a reasonable valuation, and the expected price-earnings ratio should be less than 1/2 of the market average expected price-earnings ratio.

The price-earnings ratio (equal to total market capitalization/net profit) is the most commonly used indicator to measure stock valuations. Simply understood, it is how many years of profit can be used to buy a company.

It is generally believed that a price-earnings ratio of less than 20 is reasonable, and within the same industry, a price-earnings ratio lower than the industry average is reasonable.

The expected price-earnings ratio is used here rather than the current price-earnings ratio. This excludes the risk of profit fluctuations and prevents the purchased stocks from becoming “expensive” due to subsequent declines in profit.

2. Second, the company should have a certain ability to grow profitably in the future, and the expected profit growth rate will be greater than 1/2 of the market average estimated profit growth rate.

The profit growth rate can be understood as the net profit growth rate, which measures the company's growth.

The estimated value is also used here. This avoids the unsustainability of historical profit growth rates, and to a certain extent can better guarantee the relatively continuous growth of purchased stocks.

3. Third, the stock price should be at a reasonable level compared to the value that can be achieved. This is reflected in the indicators, that is, the net market ratio is less than 2.

This is also a valuation requirement, and also reflects the reflection of the stock market value on the company's net assets.

The net market ratio is equal to total market value divided by net assets. Simply understood, it measures how much investors are willing to pay for each dollar of net assets.

Overall, although this strategy has only 3 indicators, it is actually progressive. The first two indicators screen for “cheap” and “growth” attributes respectively, and the final indicator measures the rationality of stock prices from the perspective of net assets.

How do we apply this strategy?

So how can we apply this 2-2-2 stock selection rule?

In fact, in preliminary screening, it is difficult for us to filter directly through expected values because the expected values themselves are somewhat subjective. Therefore, for the first two indicators, let's replace them with the current values for the time being. So we can get 3 quantitative metrics.

1. P/E ratio <industry average price-earnings ratio*1 2< p></industry>

2. Net profit growth rate>Industry average net profit growth rate*1/2

3. Net market ratio <2

Valuation indicators such as price-earnings ratio and price-net ratio are actually relatively suitable types of companies. The price-earnings ratio is more suitable for companies with stable profits, while the net price-earnings ratio is more suitable for cyclical stocks.

Therefore, this strategy itself is more suitable for stocks that have stable profits and are cyclical.

What else can be done in specific practical terms?

So how do we put it into practice? Take US stocks as an example. Let's try it out using the Futubull and Bull Stock Selector.

Homepage Regarding the first and second indicators, we need to look at the state of the industry, so the first step is to find the industry you are interested in. Here is an example of the comprehensive oil and gas industry. It does not represent any investment suggestions; it is only an operational exercise. Specific industry choices need to be determined by everyone according to their own standards.

Well, we can see in the heatmap that the price-earnings ratio of this industry is 6.33 (based on September 15, 2023 data), so the first indicator became the price-earnings ratio <3.17. Regarding the second indicator, data on the average net profit growth rate in the industry is not easy to find, so here we lower the requirements and filter according to the generally accepted standard of “net profit growth rate of at least 20% is better”.

Finally, we selected 4 individual stocks (based on data from September 15, 2023). Once again, this does not represent investment advice; it is for teaching purposes only.

Of course, if after using this strategy, after further analysis of the selected individual stocks, you find that they may not be worth investing in, that is normal. We just hope that today's content has inspired you.