u.s. equities weekly note 13th 17th...
TRANSCRIPT
U.S. Equities: 13TH – 17TH April, 2020
The stock market continued its impressive run last
week with the S&P 500 gaining 3.04%. Since March
23rd, the index has risen more than 28% in 18
sessions. The equity market tends to be a leading
indicator and is forward looking, explaining why we
are seeing a continuation of the rally that began in
March despite news reporting historically bad
consumer confidence and manufacturing productivity. As an indication of how bad the broader economic data has
been, 22 million Americans have filed first-time jobless claims- more than the amount of jobs lost in the whole of
2008. As we mentioned last week, there is not a lot of faith in the sustainability of this rally and a lot of investors are
expecting earnings seasons to surprise to the downside. That’s despite estimates suggesting earnings could fall >90%
YoY. Despite the last couple of weeks of positive returns, extreme volatility remains in the system. In 2020 so far
there has been 24 daily moves greater than 3%. That’s in comparison to one in 2019 and zero in 2012, 2013 and
2014.
Growth & Quality Outperform
Recently in this note we have focused a lot on which
stocks typically outperform during a crisis. Historically,
the stocks that outperform after 20% drops in the S&P
500 have been small value stocks1. Admittedly the
sample size is insignificant, but so far in the recovery
since March 23rd, whether it is merely a bear market
rally or not, that has definitely not been the case.
Growth stocks, just as they have done since 2009,
continue to beat the market. In an article posted last
Friday the WSJ explained, “This time is different so far.
Rather than breaking the habits investors fell into
during the bull market, the coronavirus crisis and
economic shutdown have reinforced two of the biggest
trends in stocks: U.S. technology and “quality” stocks,
those with a steady earnings record, continue to beat
the market.”2 The criteria that define what counts as
‘quality’ is ever-evolving, and we will discuss this in
1 https://verdadcap.com/archive/making-good-decisions-in-uncertain-times 2 https://www.wsj.com/articles/how-to-play-coronavirus-bear-market-exactly-like-the-bull-market-11587123831
Aravis Research
U.S. Equities Weekly Note 13th – 17th April
Sam Wood, CFA
In this note we cover:
A summary of U.S. market movements in the prior week.
The extent of the return premium in growth and quality stocks in 2020.
How we define ‘quality investing’ and the criteria that have generated excess returns.
Rich pickings for active investors in the most disperse market since 2009.
Index Week % Change
S&P 500 3.04%
Russell 2500 Growth 1.41%
Russell Mid Cap Growth 3.02%
Market Prices Week April 13th - 17th
more depth later, but in the mainstream
quality has a big overlap with the high-growth
stocks, as technology makes up almost half of
the MSCI USA Quality index. There are plenty
of examples of the extent of the valuation
spread between technology stocks and the
rest. The chart to the right compares the
Nasdaq 100 index with the Russell 2000,
which is representative of the small cap
universe in the U.S. The difference between
the two indices is the greatest it has been
since the 2000-2002 tech bubble. To some
observers, this relationship shows why tech is overvalued and that this spread will revert to the mean. To others it is
a fair representation of the premium that tech stocks demand due to their role in the new economy, their typically
asset-light, low-debt balance sheets and high margin business models.
Not only has the NDX dominated smaller cap stocks, but it dominates any comparison with a value index as well.
Using the Russell 1000 Value as our value
benchmark, the Nasdaq 100 has beaten value
by 30% over the past year, and is already
ahead close to 25% in 2020. Despite history
being on their side in the aftermath of market
crashes, small cap value stocks are still
lagging large cap growth stocks at levels last seen twenty years ago and we have seen no evidence yet that points to
a reversal.
Quality Investing
The rotation in outperformance between growth and
value is a familiar pattern and is closely followed by
market participants. ‘Quality’ investing, though, tends to
be overlooked as there is yet to be a widely accepted
definition of what constitutes quality stocks. The MSCI
USA Quality index that I have used to demonstrate the
stellar performance of quality stocks in the last decade
uses the following criteria: high return on equity (ROE),
stable year-over-year earnings growth and low financial
leverage. This formula feels like a straight forward short-
cut to finding great businesses. In a paper that examined
how predictive quality criteria were to returns, Robert
Novy-Marx found that gross-profitability (revenues –
cost of goods sold scaled by assets) was the most
powerful indicator of excess return, “all of the quality
measures appear to have some power predicting
returns, especially among small cap stocks, and when used in conjunction with value measures. Only gross
profitability, however, generates significant excess returns as a stand-alone strategy, and has the largest Fama and
French (1993) three-factor alpha, especially among large cap stocks.”3 I thought this was an interesting conclusion, as
gross profitability has a large growth bias in comparison to other quality criteria such as those based on current
ratios and earnings stability, which tend to be more biased towards value stocks. Despite this Novy-Marx’s paper
3 Robert Novy-Marx, Quality Investing, http://rnm.simon.rochester.edu/research/QDoVI.pdf p.3
Period Russell 1000V Nasdaq 100 NDX - R1000V
1 month 12.64% 24.83% 12.19%
Year-to-date -22.60% 0.58% 23.18%
1 year -14.63% 15.63% 30.26%
Relative Performance: Russell 1000 Value vs Nasdaq 100 as of 16th April
2020
Year MSCI USA Qual. MSCI USA
2019 39.11% 31.64%
2018 -2.65% -4.50%
2017 26.00% 21.90%
2016 7.97% 11.61%
2015 7.04% 1.32%
2014 11.81% 13.36%
2013 33.51% 32.61%
2012 13.97% 16.13%
2011 8.40% 1.99%
2010 12.65% 15.45%
2009 32.04% 27.14%
Annualised 16.00% 13.44%
Annual Performance: MSCI USA Quality vs. MSCI USA
advises combining value investing with quality investing, perhaps as growth investing apparently captures a lot of
the quality premium already- especially in large cap stocks with low net debt. His reasoning mirrors the factors that
have accounted for Warren Buffett’s alpha over several decades- which was examined in a paper by AQR and was
concluded to be buying quality companies cheaply4. It all sounds so simple, as Novy-Marx explains, “Buying high
quality assets without paying premium prices is just as much value investing as buying average quality assets at
discount prices.”5 Although this conclusion is hardly novel, implementing this type of strategy is very difficult-quality
stocks aren’t often found in the bargain basement, and are expensive for good reason. Similarly cheap stocks are
normally cheap for very good reason. However, certain periods do offer investors the ability to buy undervalued
quality companies, and we might be in one now.
Rich Pickings for Active Managers?
Due to the historic market volatility this year, active investment managers have been quick to claim that active
strategies will outperform passive index funds in the forthcoming period. Clearly, active managers have a vested
interest in making this claim and there is ample evidence for us to be sceptical. Information ratios, which measure
active return per unit of active risk, are a widely used measure of true skill for active investors. In the three years
ended March 31, 2020 the mean IR for U.S. mutual funds was -0.26, suggesting that the average U.S. mutual fund
manager generated negative alpha per unit of active risk in the time period. That isn’t good. However, is this a
function of a lack of skill on behalf of active managers or of highly efficient markets negating the impact of any
investment skill? In a recent paper on the link between dispersion of returns and alpha, Michael Mauboussin and
Dan Callahan explained the ‘paradox’ of skill among investment managers, “skill is obscured if the opportunity does
not offer differentiated payoffs. In this case, skill is high but uniform among competitors. Imagine two tennis players
of excellent but identical skill. The outcomes of their matches will appear to be random even though they are highly-
skilled players. This is what happens in an efficient market: the ability of investors to gather, process, and reflect
information means that security prices accurately reflect expected values.”7
A key conclusion the paper draws is that there is a great deal of variance in how ‘efficient’ equity markets are year-
to-year and which styles and sectors have the
greatest dispersion. Dispersion of returns are
highly correlated to the ability of active
managers to generate alpha, and in sectors and
styles where dispersion is high the relative
opportunity to prove investment skill will be
greater, “…there is a bountiful opportunity to
pick the winners, avoid the losers, and create a
portfolio that meaningfully beats the benchmark
if the dispersion of the constituent stocks is high.
Research shows that dispersion is a reasonable
proxy for breadth and that the results for skilful
mutual fund managers are better when dispersion is high.”8 For example, in the exhibit on the left it is clear to see
that there have been more opportunities to generate alpha in tech stocks and health care stocks than there has in
utilities or financials in the past twenty five years.
4 https://www.aqr.com/Insights/Research/Journal-Article/Buffetts-Alpha 5 Robert Novy-Marx, Quality Investing, http://rnm.simon.rochester.edu/research/QDoVI.pdf p.1 6 Michael J. Mauboussin & Dan Callahan, CFA, Dispersion and Alpha Conversion: How Dispersion Creates the Opportunity to Express Skill, https://www.morganstanley.com/im/publication/insights/articles/dispersion-and-alpha-conversion.pdf?1586895497145 p.2 7 Ibid., p.3 8 Ibid., p.6
Similarly, you can see in the second chart where the best opportunities are for active managers in different asset
classes and styles. Both of these charts help
allocators and investment managers’ fish in ponds
where there are plenty of fish.
However, as we outlined above, information ratios
for the average U.S. mutual fund manager in the
last three years have been negative, so why have
active managers struggled? Part of the reason
could be that the years 2017, 2018 and 2019 had
historically low dispersion of returns. In contrast,
2020, on an annualized basis, has exhibited the
greatest amount of dispersion in stock returns
since 2009. Intuitively, this is why active investors
are excited about the opportunity set to display
their skill in the current market environment.
Returning to our discussion of the building blocks of information ratios (active return/active risk) it is worth focusing
on the numerator in the ratio and the different methods that active managers can take to achieve that active return.
The two methods worth focusing on (rather than market timing) are security selection and position sizing. The idea
of a ‘batting average’ to judge security selection is a familiar one, but a more novel measure for position sizing is
introduced in the Mauboussin piece as the ‘slugging ratio’ or win/loss ratio. This measures the average gains for the
successful investments divided by the average losses for the unsuccessful ones- you want bigger positions in winners
and smaller positions in losers. Combining the slugging ratio and batting average sheds light on how different
investment managers implement skill in the investment process, “One of the crucial observations is that an investor
can be correct much less than half of
the time and still deliver a high IR if the
slugging ratio is sufficiently high. It’s
not how often you are right that
matters, it’s how much money you
make when you’re right versus how
much money you lose when you’re
wrong.”9 Momentum investors, for
example, cut losses and let winners
run. By scaling their winners and trimming their losers their skill level is reflected in a high slugging ratio rather than
in great security selection. Value investors, by contrast, do the opposite as they seek to find investments with gaps
between price and intrinsic value and they will add to those bets if the spread widens. Bill Miller, the CIO of Miller
Value Partners, explains, “For most investors if a stock starts behaving in a way that is different from what they think
it ought to be doing—say, it falls 15%—they will probably sell. In our case, when a stock drops and we believe in the
fundamentals, the case for future returns goes up.”10 The table above shows the skill required for different
investment strategies. Concentrated equity managers, for example, have typically displayed excellent security
selection and their winners have outweighed their losers by more than 1.5x. In contrast, high frequency strategies,
such as quant hedge funds, require lots of breadth/dispersion to demonstrate skill.
9 Michael J. Mauboussin & Dan Callahan, CFA, Dispersion and Alpha Conversion: How Dispersion Creates the Opportunity to Express Skill, https://www.morganstanley.com/im/publication/insights/articles/dispersion-and-alpha-conversion.pdf?1586895497145 p.3 10 David Rynecki, “How To Profit From Falling Prices: Interview with Bill Miller,” Fortune, September 15, 2003.
Strategy Batting Average Slugging Ratio Breadth
Venture capital Low (< 50%) High (>2.5) Low
Buyouts High (>70%) Medium (>1.5) Low
Concentrated equity High (>70%) Medium (>1.5) Low
Russell 1000 Medium (50%) Medium (>1.5) Medium
Diversified momentum Low (< 50%) High (>2.5) Medium
High frequency Medium (50%) Low (>1.0) High
The data used by Mauboussin and Callahan supports the consensus that 2020 should be a year in which active
managers can exploit high dispersion of returns to display skill and generate positive information ratios. The
opportunity for active equity investors to do so in prior years has been greatly reduced due to record low dispersion.
What is also apparent is that there are different ways for active managers to express skill, primarily via a high batting
average or a high slugging ratio, and each approach is valid depending on the manager’s style and philosophy. What
is most clear is that when markets are a lot less efficient than normal, like they are now, investment managers with
true skill have much greater opportunity to differentiate themselves and generate significant alpha.
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