A 5-year model for consistent outperformance
In the world of investing, alpha is the holy grail. It represents the excess return an investment earns above its benchmark—typically the S&P Composite Index.
Capturing alpha isn’t just about beating the market once; it’s about doing so consistently, with discipline and skill. This article outlines a model for identifying companies that have delivered positive alpha in at least four of the past five years, using the S&P 1500 Composite Index as the benchmark.
Positive alpha indicates outperformance. Negative alpha suggests underperformance. It’s a measure of skill, not luck—especially when sustained over multiple years.
What drives persistent alpha?
1. Sector Tailwinds
Many alpha-generating companies operate in high-growth sectors like AI, energy, or digital infrastructure. For example, MicroStrategy’s exposure to Bitcoin and data analytics fueled its meteoric rise.
2. Operational Excellence
Companies like Celestica and Innodata have consistently improved margins, expanded market share, and reinvested in innovation.
3. Behavioral Edge
Alpha often comes from exploiting inefficiencies—buying when others panic, selling when others chase. Firms with disciplined capital allocation and contrarian strategies tend to outperform.
Risks and Limitations
Survivorship Bias
Our model only includes companies still trading today. Those that failed or were delisted are excluded, potentially inflating results.
Data Mining
Looking backward can lead to overfitting. Just because a company produced alpha doesn’t mean it will continue to do so.
Volatility
High returns often come with high risk. That’s why we include Sharpe Ratio and Beta filters to ensure risk-adjusted performance.
Practical Applications
For DIY Investors
Use this model to build a watchlist of alpha-generators. Focus on companies with strong fundamentals, consistent earnings growth, and sector momentum.
For Portfolio Managers
Incorporate alpha filters into your screening process. Combine with qualitative analysis to identify sustainable competitive advantages.
For Educators and Coaches
This model is a great teaching tool. It shows how to move beyond raw returns and evaluate performance through a structured lens.
Tools and Resources
- Excel or Power BI: Use Power Query to automate alpha calculations across multiple tickers.
- Portfolio Visualizer: Run backtests and compare risk-adjusted returns.
- Yahoo Finance or Morningstar: Pull historical total return data.
- Thrive Quiz Builder: Segment users based on their understanding of alpha and offer tailored modules.
Behavioral Finance Angle
Investors often chase performance without understanding the source. This model encourages a disciplined mindset—rewarding consistency, not hype. It also helps counter cognitive biases like recency bias and overconfidence
Knowing where to look
I'm taking a leap of faith when I say that we are all seeking alpha in one way or another. If you're not seeking alpha, you are investing in stocks that have more units of risk for every unit of return you earn.
Since alpha is the excess return of a stock above its relevant benchmark, it makes sense to start with the benchmark. The stock price is part of recorded history, and you can get prices from any reputable vendor. I happen to use Finance.Yahoo.com for mine, and it gets the job done.
The benchmark, though, is slightly more ephemeral in the sense that a given stock can have more than one benchmark. I get around this problem by using the broad-based S&P Composite Index of 1,500 Large, Mid, and Small companies. Over the last few years, the Composite has lagged behind the large cap S&P 500 index, mostly due to the outperformance of the Mag 7 big tech stocks.
What I like about the S&P 1500 Composite index is that the companies that make it up must meet certain criteria of financial health, liquidity, and publicly traded float of at least 50% of outstanding shares, otherwise they potentially could get booted from the index.
Purists might argue that each stock should be judged against the performance of a specific index, but I don't follow that type of thinking. By using the same index for all stocks under consideration, I level the playing field and set a bogey that all stocks must exceed.
The Fishing Net
When you're hunting for high alpha stocks, you need a mechanism for vetting them using alpha as the main criteria. I have found that one of the best ways to find alpha candidates is by using a screener that has the 1-3-5 year performance metrics. Look for the highest numbers, and go as far as that will take you. I usually stop at 10% average annual alpha over the last 5 years. (I don't go lower than 10%.)
The Candidate List
After you have compared the performance of the stock and the index, check to see if the stock averages 10% or more alpha per year over 5 years. This will be your initial candidate list. The next hurdle will be a little higher, so you're bound to end up with a shorter list when you're done.
In this step, you look at the individual years, and only give a passing grade to stocks that produced excess returns for 4 out of the last 5 years.
The Sortino Ratio
Some of you may be familiar with the Sortino Ratio, and I use it in my analysis. The Sortino Ratio is a measure of risk-adjusted return for a stock. Essentially, it looks at the daily or monthly stock price movement, relative to the benchmark, and penalizes those days or months where the alpha was negative. It applies no such penalty to the periods with positive alpha.
The purpose for this part of the process is to gain more valuable information. It is often possible for a stock to have a stellar record of producing alpha, but it also suffers big down periods along the way. The Sortino and Sharpe Ratios allow you to measure this behavior and factor it into your thinking.
Automate the process
Set up an Excel workbook with the first tab as your summary of all the names in your list. Then on tab 2 place the ticker of your first stock. Tab 3 will have your second stock, etc.
Back on the summary tab, write the formulas that will link to the cells on the individual stock tabs for Sortino, Sharpe, Beta, Std Dev, and average alpha. If you get stuck on this part, reach out to me at erik@zeninvestor.org and I will help you.
Set price alerts
Use your preferred methodology to assign a buy price to each of the stocks on your final watchlist. Then sit back and wait for the market to come to you.