The key to suc­cess­ful Invest­ing is max­i­miz­ing upside poten­tial and min­i­miz­ing down­side poten­tial for every invest­ment decision.

Since the future is inher­ently unpre­dictable, there are no “sure things” in the stock mar­ket (none that are legal…). Ergo, when bat­tling against an uncer­tain future, the best strat­egy is to max­i­mize one’s odds of suc­cess — which means “max­i­miz­ing upside poten­tial and min­i­miz­ing down­side poten­tial for every invest­ment deci­sion”. In other words, we want to be long “good risk/reward” (low risk/high reward poten­tial) and sell/short “bad risk/reward” (high risk/low reward poten­tial). Find­ing the best and worst risk/reward in the US stock mar­ket is what New Con­structs is built to do.

That’s the theory.

Here’s how we implement.

Because we cover over 3000+ of the largest and most actively-traded US stocks, our broad mar­ket per­spec­tives are well-informed. Fig­ure 1 high­lights the pock­ets of inef­fi­ciency we see in the val­u­a­tion of stocks across the entire U.S. equity mar­ket. The fig­ure also shows that the mar­ket is fairly effi­cient on a large num­ber of stocks as well.

Fig­ure 1: Mar­ket Effi­ciency: Not Per­fect By Any Means

Sources: New Con­structs, LLC and com­pany filings

Next, we deter­mine the true eco­nomic prof­itabil­ity to iden­tify (a) under­val­ued stocks with under­stated cash flows and (b) over­val­ued stocks with over­stated cash flows.

Fig­ure 2 pro­vides another illus­tra­tion of our broad-market insights into how com­pa­nies’ reported prof­its cor­re­late to their true eco­nomic prof­its. It is not a very pretty pic­ture. Most com­pa­nies, in an effort to keep up with their peers, manip­u­late account­ing rules to over­state their profitability.

Fig­ure 2: Earn­ings Are Not What They Appear To Be Most Of the Time

Sources: New Con­structs, LLC and com­pany filings

Next, we over­lay val­u­a­tion and eco­nomic prof­itabil­ity to find the best and worst stocks in the mar­ket. See Fig­ure 3.

Fig­ure 3: Long = Most Attrac­tive Stocks; Short = Most Dan­ger­ous Stocks

Sources: New Con­structs, LLC and com­pany filings

We focus on the stocks where the fat tails over­lap. We want to be long stocks with the best risk/reward as mea­sured by a very low val­u­a­tion (lim­ited down­side) and under­stated cash flows (earn­ings upside). We want to be short the stocks with the worst risk/reward as mea­sured by a very high val­u­a­tion (high down­side) and over­stated earn­ings (earn­ings downside).

All the other stocks where val­u­a­tion seems fairly effi­cient and earn­ings some­what accu­rate are of lim­ited inter­est to us. I think focus­ing on the extreme inef­fi­cien­cies in the mar­ket is best.

You will see a Risk/Reward Rat­ing on every­ one of the 3000+ com­pa­nies we cover. For an exam­ple, down­load a free report from our Free Archive.

For arti­cles fea­tur­ing some of our best long and short ideas, click here.