Humans: Hertz Machines In A Megahertz World

Most debates in investing focus on strategy: active or passive; hedge funds or private equity; gold or inflation protected bonds.  But while these debates are important (and fun), the most important element of investing success is your behavior. Trouble is, culture (e.g. markets) evolve quickly, but human beings evolve very slowly. We are left with bodies and brains that are optimized for a world that doesn’t exist anymore. The famous psychologist Phil Zimbardo wrote a very interesting book called The Time Paradox, from which I’ve pulled two of my favorite quotes:

YOU ARE A LIVING ANACHRONISM Because of the rapid change in the world around us since our birth, we humans are living anachronisms. Our world has changed dramatically in the past 150 years. Human physiology, in contrast, took millions of years to create and has not changed much in 150,000 years. Your body—even if it is in mint condition—is designed for success in the past. It is an antique biological machine that evolved in response to a world that no longer exists. Although we live in a world in which computer processing speed doubles roughly every twenty-four months, human information processing has not expanded substantially over the past 150,000 years. Our physiology is clearly behind the times.

As markets and technology get more sophisticated, we are being left in the dust.

We are hertz machines in a megahertz world. For an average human, simple reaction time is about 250 milliseconds. Simple reaction time is the time that it takes to react to a stimulus, such as a light going on when a button is pushed. Therefore, each “cycle” of light input and button depression response takes a quarter second. Four complete cycles can take place each second. Thus, a typical human has a processing speed of about four hertz. In comparison, modern desktop computers have central processing unit (the brain of a computer) clock speeds of over three gigahertz; they are roughly 750,000,000 times faster than we are. This relatively slow processing speed has two important implications. First, it means that all of us live more than 250 milliseconds in the past.

What this means for you, the investor, is that your body/brain will push you to make foolish decisions because your brain reacts to market threats and opportunities just like it did hundreds of thousands of years ago in the savannah.

My suggestion is to remove yourself from the equation as much as possible by making your investment plan automatic. Instead of trying to time the market, you should instead contribute automatically to your 401(k) and other investment accounts with every paycheck—even if the amounts are small. Instead of trying to rotate between asset classes, pick an allocation and stick to it with scheduled rebalances. These simply tactics cut out the main investing obstacle: you!

Boring Is Good

I’ve always liked investing rules, because they impose discipline. Here is one rule I find useful: boring investments are good investments. The more boring the investment, index, or asset class, the better it will probably be for your portfolio. This has been true throughout market history, and the rule manifests everywhere:

·         Trading less often isn’t as fun, but it leads to lower costs (trading and taxes) and therefore higher long term returns.  

·         Index funds are plain and dull, but they outperform a significant majority of active managers over the long run.

·         The best performing U.S. sector for the past 50 years is consumer staples, which includes companies that sell simple, boring products which rarely change.

No matter where you look, dull trumps exciting.  Consider, for example, two very different industries at opposite ends of the dull/exciting spectrum: food, beverage & tobacco (Coca-Cola, Altria, Kraft Foods--BORING) and technology hardware & equipment (Apple, Qualcomm, Cisco—EXCITING).

The technology sector is almost always the most exciting part of the stock market, because technology companies offer new and exciting products and services. The market is rabidly speculating about every detail of the upcoming iPhone 6, but no one gives a crap about (or expects) some revolutionary new flavor of Coca-Cola.

So here is the remarkable fact: since 1963, the boring stocks (food, beverage & tobacco) have had a return of 13.6% per year (or 69,402% total), while the exciting stocks (technology hardware & equipment) have had a return of just 9.2% per year (or just 8,464% total).  

You often hear that earning higher returns requires taking higher risk, but the opposite has been true for these two industries. Food, beverage & tobacco stocks have been HALF as volatile as technology hardware stocks (14.2% annual volatility versus 29.5%).  You can see the difference, here is the rolling five-year return for each industry for the past 50 years.

Technology is an incredibly competitive industry with a very high rate of change. It is impossible to predict what technologies will emerge in the future, and equally impossible to predict what companies will profit from those new technologies. 3-D printing may be revolutionary, but we have no clue what company will emerge from what will be an extremely competitive playing field.

And yet, even with such an unpredictable future, investors have almost always paid a premium for technology stocks, because they excite and inspire.  Here is the historical valuation percentile (higher = more expensive) for the two industries in question.

This means that, historically, investors have paid more for stocks in one of the most competitive industries, where it has been the hardest to succeed and stay on top.  

Change generates excitement, but as Warren Buffett has said, “We see change as the enemy of investments...so we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.”  

Your smartphone has more power than the first super computers; hardware has evolved at an unbelievable rate.  Over that same time frame, here is what has happened at Coca-Cola.

Stick with boring, and you’ll win. 

 

 

Calculation notes: The industry returns are based on an "equal weighted" custom index, which includes all stocks in the industry with a market cap > 200MM, inflation adjusted. The index is rebalanced/reconstituted annually in December 

Reading List July 2014

A few books for the Summer, to receive these lists every month, sign up here 

 

Creativity, Inc.: Overcoming the Unseen Forces That Stand in the Way of True Inspiration by Ed Catmull, Amy Wallace

This book was launched with tons of buzz, and deservedly so. It’s one of the most entertaining and useful business books I’ve ever read. The story behind Pixar is fascinating, but so are the management tactics used to keep the company edgy and creative. I found many ideas applicable to my job and my business. For those that follow asset management companies, there are many similarities between Pixar and Bridgewater. The emphasis on constant candor, honesty, and feedback are essential cultural elements at both firms. I particularly enjoyed the discussion of randomness.

Here are a few teaser quotes:

What is the nature of honesty? If everyone agrees about its importance, why do we find it hard to be frank? How do we think about our own failures and fears?

This principle eludes most people, but it is critical: You are not your idea, and if you identify too closely with your ideas, you will take offense when they are challenged. To set up a healthy feedback system, you must remove power dynamics from the equation—you must enable yourself, in other words, to focus on the problem, not the person.

When I mention authenticity, I am referring to the way that managers level with their people. In many organizations, managers tend to err on the side of secrecy, of keeping things hidden from employees. I believe this is the wrong instinct. A manager’s default mode should not be secrecy. What is needed is a thoughtful consideration of the cost of secrecy weighed against the risks. When you instantly resort to secrecy, you are telling people they can’t be trusted. When you are candid, you are telling people that you trust them and that there is nothing to fear.

Rational Expectations: Asset Allocation for Investing Adults (Investing for Adults Book 4) by William Bernstein

I’ve really enjoyed William Bernstein’s e-book series, especially this latest one. In typical Bernstein fashion, it’s very straightforward and informative. A few choice passages:

Oh, yes, and one more thing. Make sure, absolutely sure, that you have enough riskless assets to tide you over during the bad times, when you are the most likely to see your income fall or even lose your job. Preferably, you should have yet more than this, so as to take advantage of that high exchange rate when it shows up, as it inevitably does. Even more simply: you must have patience, cash, and courage—and in that order. All else, as Hillel said, is commentary.

This is no small point: how much liquidity you have when blood runs in the streets is likely the most important determinant of how successful you’ll be in the long run, since this is the time you’re most likely to lose your job, need cash to purchase stocks on the cheap, or buy the corner lot you covet from your impecunious neighbor.

Beware! Financial systems are not airfoils or electrical circuits that respond identically, each and every time, to given inputs. Stock, bonds, and portfolios are different animals, and can behave unpredictably.

Shadow Divers: The True Adventure of Two Americans Who Risked Everything to Solve One of the Last Mysteries of World War II by Robert Kurson

This book has nothing to do with investing; I include more as a riveting summer read. Two divers discover a U-Boat sunk off of the New Jersey coast which cannot be identified, and then go to amazing lengths to explore and ultimately identify the boat. I could not put this book down.  Kurson is a gifted storyteller.  One good lesson for investors is to never trust official documents or data.  We tend to believe that data is fact, but it is created/reported by fallible people. If a particular datum matters to you, you should always double check for accuracy. Data gets fudged all the time.

As One Is: To Free the Mind from All Condition by Jiddu Krishnamurti

This book is only for those interested in philosophy. Krishnamurti always challenges his listeners to think for themselves, to never be “second hand people.” In keeping with this month’s theme, he also has a lot to say about creativity: “creativity is something that comes into being only when the mind is in a state of no effort.” Here are a few passages:

Self-knowledge is the beginning of wisdom. Self-knowledge is not according to some psychologist, book, or philosopher but it is to know oneself as one is from moment to moment. Do you understand? To know oneself is to observe what one thinks, how one feels, not just superficially, but to be deeply aware of what is without condemnation, without judgment, without evaluation or comparison. Try it and you will see how extraordinarily difficult it is for a mind that has been trained for centuries to compare, to condemn, to judge, to evaluate, to stop that whole process and simply to observe what is; but unless this takes place, not only at the superficial level, but right through the whole content of consciousness, there can be no delving into the profundity of the mind.

[You] must have immense patience to find out what is true. Most of us are impatient to get on, to find a result, to achieve a success, a goal, a certain state of happiness, or to experience something to which the mind can cling. But what is needed, I think, is a patience and a perseverance to seek without an end. Most of us are seeking; that is why we are here, but in our search we want to find something, a result, a goal, a state of being in which we can be happy, peaceful; so our search is already determined, is it not? When we seek, we are seeking something which we want, so our search is already established, predetermined, and therefore it is no longer a search. I think it is very important to understand this. When the mind seeks a particular state, a solution to a problem, when it seeks God, truth, or desires a certain experience, whether mystical or any other kind, it has already conceived what it wants; and because it has already conceived, formulated, what it is seeking, its search is infinitely futile. And it is one of the most difficult things to free the mind from this desire to find a result.

So, can I, who have vast education, knowledge, who have had innumerable experiences, struggles, loves, hates—can that ‘I’ come to an end? The ‘I’ is the recorded memory of all that, and can that ‘I’ come to an end? Without being brought to an end by an accident, by a disease, can you and I while sitting here know that end? Then you will find that you will no longer ask foolish questions about death and continuity—whether there is a world hereafter. Then you will know the answer for yourself because that which is unknowable will have come into being. Then you will put aside the whole rigmarole of reincarnation, and the many fears—the fear of living and the fear of dying, the fear of growing old and inflicting on others the trouble of looking after you, the fear of loneliness and dependency—will all have come to an end. These are not vain words. It is only when the mind ceases to think in terms of its own continuity that the unknowable comes into being.

 

Consumer Staples, Part II

 “We see change as the enemy of investments...so we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.” Warren Buffett

In Consumer Staples, Part I, I explored the unique nature of consumer staples stocks and their impressive historical returns. In this part, I’ll explore how to find the best individual consumer staples stocks.

Some aspects of security analysis require a heavy touch. For example, evaluating the value of a brand, or the sustainability of a “business moat” requires hands on work and deep knowledge of each company. My approach is, instead, quantitative.  In this sector series, I’ll highlight “factors” that can be quickly calculated and compared across a wide universe of stocks. I’ll cluster these stock selection factors into several key categories: valuation, profitability, momentum, and quality.  I’ll also include some factors that do not add value historically, despite their appeal.

As we will see, the secret to success in the consumer staples sector is similar to the secret to success in the broad market: focus on high quality, cheap stocks. Value has been the most successful factor for choosing consumer staples stocks, but the value strategy can be enhanced by insisting on strong profitability and a shareholder orientation.

What Matters for Stock Selection

There aren’t that many consumer staples stocks. Today, there are just 108 U.S. stocks in the sector with a market cap greater than $200MM. If you include international stocks listed on a U.S. exchange (usually as an American depository receipt (ADR)), there are 161 stocks.

Because there are so few, my analysis of factors separates the universe into quintiles (buckets that represent 20% of the market sorted by a factor, or roughly 32 stocks each today) rather than deciles (which I normally use in a bigger universe). I’ve tried to include as many factors as possible that are available at free screening services like www.finviz.com, but I’ve also included some factors that are not available from the free screening services.

Value

Given that consumer staples stocks have had such high returns on their equity for so long, it is curious that they are have been, on average, the second cheapest sector after utilities over the past 50 years[i]. And their valuations have been steady. Look at the thick black line in the chart below. Measured against all stocks, consumer staples are almost always cheaper (i.e. their average valuation percentile is less than 50).  In this chart, 1 means cheapest and 100 means most expensive.

The sector is often cheap, but investing only in the cheapest stocks within the sector has yielded even more impressive results. The panel below breaks the universe of consumer staples stocks into quintiles based on different valuation factors. The analysis is run since 1963, and the quintiles are rebalanced on a rolling annual basis (so if you were to run a similar strategy, you’d want to hold positions for 12 months—this holds true for all other factors referenced below).

Clearly, buying cheaper stocks works. All four value factors can point you to sector-beating stocks, but EBITDA/EV and Earnings/Price work best.  Where do these factors point you within the staples sector? Here is the historical valuation percentile (similar to the one above) for the three industry groups within the staples sector.

Food & Beverage companies have tended to be cheaper while Household & Personal Product companies have tended to be more expensive. Take Altria Group (formerly known as Philip Morris) for example. It is the single best performing stock since 1963, but has spent a lot of time as one of the cheapest stocks in the entire market! Pretty amazing. Bottom line: buying the cheaper staples stocks leads to superior results.

Quality

The term ‘quality,’ like the term ‘smart beta,’ can mean a lot of different things. I’ve included a number of different factors here that I think are applicable to the staples sector.

Several lessons stand out.

·         High ROE is the defining feature of the Staples sector: the sector as a whole has earned market-beating returns on equity for 50 years. But buying the stocks with the highest individual ROEs has not been a winning strategy. Return on invested capital has been a better measure of profitability and a better way to select stocks.

·         I remember thinking the cash conversion cycle was very compelling during my CFA days, but it is not a helpful selection factor in this study.

·          A focus on strong free cash flow can help you find the best staples stocks. By avoiding stocks with low free cash flow/ sales and avoiding stocks with low free cash flow / short term debt, you can sidestep stocks that have tended to underperform the broad sector.

·         A focus on earnings quality (change in net operating assets[ii], and total accruals to total assets) can also give you an edge.

Yield

Two measurements of yield are very effective in the consumer staples sector: dividend yield and shareholder yield[iii]. I’ve only included the top 25 stock portfolio for dividend yield[iv].

Buying stocks with higher yields has been a very effective strategy. Companies paying regular dividend (whose yield is high because the stock is out of favor) have been reliable investments, and companies buying back shares have done well.

Momentum

Buying stocks with strong momentum has worked well in the broad market, but hasn't added much value in the staples sector. This could be a coincidence of history, and I cannot think of a reason why it hasn't worked that well in this sector, but it is interesting nonetheless. 

Combining Factors for Superior Results

So what happens when you rank stocks on a combination of the best factors? Below are the results of a strategy that combines EBITDA/EV, shareholder yield, change in operating assets (earnings quality), and free cash flow/short term debt (financial strength).  Each stock is given a rank 1 to x and the 25 stocks with the highest average ranking are selected by the model.  The annualized return is similar to some of the factor portfolios above, but the Sharpe ratios are significantly improved. The annualized return is 17.5%--slightly better than the 17.3% for the cheapest stocks by EBITDA/EV listed above. But the volatility is just 14.6% for the four-factor strategy, versus 16% for EBITDA/EV.  That means the four-factor strategy has a Sharpe ratio of 0.85, a big improvement over the 0.76 Sharpe ratio for EBITDA/EV.

BONUS FACTOR

In my research, I found one final factor very interesting: Research & Development expenses divided by market value. I didn’t include it above because not all companies have R&D, so you cannot compare all companies to each other. But among those that do spend on R&D, it is a very effective factor. It is part value factor, part earnings quality factor. It measures value because the denominator is price, but also measures earnings quality because of an accounting quirk.

R&D is an investment meant to provide a long term benefit, but it must be “expensed,” meaning subtracted from earnings during the period that the spending takes place. This stands in contrast to other investments like property, plant and equipment which can be “capitalized.” Capitalizing just means that you only count a fraction of the cost—of say a machine—against current earnings. If a machine is going to last 10 years, you only subtract 1/10 of the cost of the machine in the first year. Capitalizing makes sense and smoothens earnings. You can argue that like a machine, R&D spending will have an impact over the course of many years, so the fact that companies have to expense R&D costs can make earnings look weaker than they are and lead to nice future earnings surprises and therefore nice future returns. Here is the factor, split out by quintile.

As always, let me know your thoughts by commenting below or emailing me at patrick.w.oshaughnessy@gmail.com

IMPORTANT DISCLOSURE! These backtests do not include any costs whatsoever and so should be taken with a grain of salt.  While a once-per-year trading strategy is fairly easy to trade these days, the costs can still be significant when trading in small cap names. These test also have a fairly small sample size. With just about 150 stocks at any given time, the staples sector is small. The good news is that the factors that work in the staples sector work in the other nine sectors too, as we will see over the course of this series, and also work in international and emerging markets (which are nice out of sample tests).

Calculation Notes: everything, as always, is rebalanced on a rolling annual basis to avoid seasonality in the results. Only stocks with an inflation adjusted market cap above $200MM are included in the sample. Going smaller can improve results, but leads to trading and liquidity concerns.  Due to several comments about excluding international stocks in part I, I’ve included non-U.S. stocks that have a U.S. listing in this study. Results are similar if the universe is U.S. stocks only, but are improved for the most part with a larger (global) universe. The inclusion of ADRs is the reason the consumer staples overall sector return is slightly different from my first post.


[i] Cheapness measured using a composite of value factors: p/sales, p/earnings, ebitda/ev, etc.

[ii] Net Operating Assets = non cash assets minus non debt liabilities. A large positive percentage change is bad: it means things like accounts receivable, inventories, and property plant and equipment are growing at a rapid pace, which has historically boded poorly for future returns.

[iii] Shareholder yield = dividends yield plus buyback yield (% change in shares outstanding in prior year, negative better)

[iv] Dividend yield doesn’t “quintile” cleanly because of a group of stocks with zero yield.

What Drives the Market's Return on Equity?

Earning a high return on equity is one of the primary reasons to do business. Managers of (and investors in) companies want to earn the highest return on their equity as possible, and sustain this high rate of return over as long a period as possible. Some sectors of the market, like consumer staples, have had remarkably high returns over the very long-term, while others, like automobiles, have had extremely cyclically returns on equity.

The market as a whole is cyclical too, sitting somewhere between these two extremes over the past fifty years. In this piece I’ll break the market-level return on equity into its components (profit margin, asset turnover, and financial leverage) and try to identify where we are in the current cycle.

Three Components

High return on equity is almost always a good thing, but the source of return can come from three different areas.

1.       Profit Margin—calculated as net income (earnings) divided by sales (revenue), this simple measure shows how much of a company’s (or the market’s) sales are converted to bottom line earnings after all ordinary or extraordinary expenses. Higher margin = higher return on equity.

2.       Asset Turnover—calculated as sales divided by average assets, this measure shows how “productive” assets are. Imagine two companies that both use similar machines (which each cost $10,000) to make widgets. Company A uses its machine to produce $10,000 in widget sales per year while company B uses its machine to produce $20,000 in sales. Company A has an asset turnover of 1.0 while company B has an asset turnover of 2.0. Company B is using its assets more effectively. Higher asset turnover = higher return on equity.

3.       Financial Leverage—calculated as average total assets divided by total common (owner’s) equity, this measures how much the company has borrowed to earn its way. Leverage is always a tricky beast. Some leverage often makes sense and is an easy way to boost returns and profits; but too much leverage can spell doom. Higher financial leverage = higher return on equity.

With these three components, we can calculate return on equity as:

Profit margin * asset turnover * financial leverage = ROE

So where do we stand on these three measures? The figure below shows the rolling history of each—alongside the market’s total return on equity[i]

Several interesting trends emerge. While the market’s ROE itself has been very cyclical and mean reverting, the components have had more secular trends. Asset turnover has been in steady decline for several decades, falling from 1.23x in 1981 to 0.81x today. Financial leverage has also had a fairly steady decline from its all-time high of 3.4x in 1994 to 2.7x today. In fact, if you just multiply asset turnover times financial leverage, the resulting trend line looks very different from ROE.

Margins

That means that profit margins are the driving force (mathematically anyway) behind the market ROE’s cyclicality. Net profit margins can, in turn, be broken down into components just like ROE, and again there are three key variables:

1.       Operating Margin—operating profits (earnings before interest and taxes) divided by sales

2.       Interest Factor[ii]—Earnings after interest divided by operating earnings

3.       Tax Factor[iii]— Net income divided by Pretax income (earnings after interest) 

Just like with ROE, net margin is calculated as:

Operating margin * interest burden * tax burden = net margin

Here is the history of each component:

The two most recent spikes down in margin (and therefore in market-wide ROE) are due in large part to spikes down in the tax and interest factors. Think about interest, for example. During these two rough markets in 2000-2002 and 2007-2009, earnings fell off a cliff but fixed payments on interest remain fairly steady, so a much higher percentage of earnings are going towards interest payments.

Here is the combined effect of taxes and interest over time.

What’s Next?

I am no good at predicting anything, but it’s clear that each of these components can have a large influence on the return the overall market’s ROE. While the combination of asset turnover and financial leverage appear to be in the midst of a secular decline, margins are near all-time highs. Can margins stay here much longer? Operating margins have moved off of their recent all-time high, while the combination of taxes and interest is reducing operating profits by less than is typical throughout history (meaning that the combination of low effective tax rates and cheap debt are allowing companies to “keep” more of their operating profits).  

Interest rates will rise at some point (right?) and operating margins have been fairly cyclical in the past. My guess is that, like most things in the market, things will be cyclical and ROEs will decline. Hopefully this causes everyone to freak out so that we can buy stocks at cheaper multiples than we can today.

NOTE: I’d love to hear your thoughts on this piece. I am swimming in new macro/top-down waters here, because my investment philosophy/process is purely bottom up and ROE is not an important component in stock selection.  I mainly write to learn, so these posts are me reporting data and learning on the fly, so I may be getting aspects wrong. Email me Patrick.w.oshaughnessy@gmail.com with any thoughts.

Calculation Note: Prior to 1976 I have to use annual data (as opposed to quarterly) due to availability issues.


[i] This entire analysis excludes financial stocks, where return on assets are often a better measure of returns. If people are interested I may do another post specifically on financials because they are such a large part of the market.

[ii] Normally these are called interest “burden” and tax “burden,” but I hate that name because a higher “burden” sounds bad but you want these numbers to be higher (because a higher number keeps the total margin higher).

[iii] Other items sit between Pretax income and net income and would be bundled in this calculation: noncontrolling interest income, extraordinary items, and discontinued operations

Investor Behavior: The Final Frontier

Jack Bogle and Vanguard have been incredibly good for the investing business. They’ve made equity markets more accessible to investors and have minimized the cost of investing to the point that it is almost free. As a result, the market share of index funds has risen from the low single digits in 1990 to nearly 30% today.  While I believe (vehemently) that some investors can earn returns superior to market-cap weighted index, I still often recommend index funds to friends and family. I do so because picking active managers is very hard, and, as Bogle says, in investing “you get what you don’t pay for;” the lower your costs (fees, transactions costs, taxes), the better your long term returns will be. Index funds quite brilliantly sidestep what Bogle refers to as the “tyranny of compounding costs”…man is Bogle quotable! These costs can be up to 2% per year, which compound to a huge disadvantage over time. This interview with Bogle is a great read.

But even index funds cannot solve the number one problem for investors: their consistently putrid, almost-always-perfectly-mistimed, buy-high-sell-low, self-defeating behavior. The Vanguard 500 index fund (VFINX) should be THE beacon to long-term investing. It is designed to be purchased and held forever. But in the past 15-years (as will likely be the case in the next 15) the “investor return” (dollar weighted, what the actual investors earn) in VFINX has significantly lagged the “total return” (time weighted, what the fund itself earns). The 15 year return for the fund itself is 4.25% per year, which for 15 years compounds to 86.7%. But the “investor return,” as calculated by Morningstar, was just 2.29% per year, for a total return of 40.4%. That means that because investors have entered and exited the fund at the wrong times collectively, they’ve missed out on more than half of the total return earned by the fund.

Now that investing is almost free, this is the final frontier: how to effectively protect investors from themselves.  The best financial advisors earn their keep by doing just this: keeping clients oriented towards the long-term during times of greed/euphoria and during times of fear/panic. Still, as a group, we are terrible decision makers. Look at this chart below of all fund flows into/out of equity mutual funds during the same rough 15 year period referenced above. Inflows peak at the exact market top, outflows peak at the exact market bottom. The return gap between 4.25% and 2.29% is huge. At 1.96% per year this gap, or “human tax” as I like to call it, is roughly the same as the 2% cost gap that Bogle uses to criticize non-index investment strategies.

Fund Flow Data from ICI

Investing arguments are always about strategy, but most investors would be better off spending their energy on improving their own behavior. It is a tall order, because human nature isn’t changing anytime soon. But by reading a lot (market history, investor psychology, and even some philosophy) and working with financial advisors/friends/family who can help you weather the storms of greed and fear, you can overcome some of your own investing self-flagellation. As Nick Murray says, “You can’t, as we’ve seen, build and hold wealth without equities. But the converse is even more importantly true: equities can’t do it without you.”

Good Businesses at Good Prices

There isn’t a more commonly recited investment strategy than “buy good businesses at good prices.” This simple strategy sums up much of Warren Buffett’s success, and countless investors have attempted to mimic his style. Indeed, when I asked those on twitter what their favorite investing ‘factor’ was, the most common response was price-to-book (P/B) divided by return on equity (ROE).  The idea behind the simple ratio is to find good businesses (high ROE) at good prices (low P/B). This factor is similar to another similar two-factor comparison, Joel Greenblatt’s “magic formula,” which also combines a measure of good businesses (high return on invested capital) and good prices (cheap earnings-before-interest-and-taxes to enterprise value).

I rebuilt the factor since 1963, ranking all stocks by P/B-to-ROE and sorting them into deciles[i].  Since each decile represents several hundred stocks (and is therefore unrealistic for individual investors to manage) I’ve also included a concentrated, 25 stock strategy which selects the best stocks in the market by this measure. So does this simple measure help you find stocks that will outperform the market? The answer is a qualified yes. The top 20% of the market by the P/B-to-ROE measure does tend to outperform by a decent margin…but the concentrated portfolio isn’t as impressive.

Results

Here are the results for the 10 deciles—and the 25-stock strategy—versus the market. Both of the top two deciles outperform the market, but the second decile provides the highest Sharpe ratio.

More curious is that the concentrated version doesn’t do all that well. While it does beat the market over the very long term, it is not at all consistent. In rolling 10-year periods, it only beats the all stock universe 26% of the time—before costs. If transaction costs and taxes were factored in, it wouldn't be worth it.  As for the top decile, you'd have to be very patient to win with this strategy. There has been a 1-in-5 chance, historically, that the best decile underperforms the market in a 5-year period--and again, that is before costs. 

I should note that price-to-book is the least impressive value factor I’ve tested, and ROE is the least impressive measure of quality/profitability. EBITDA/EV, for example, yields much better results than P/B, and ROIC yields much better results than ROE. Is this just historical coincidence, a small bit of data mining? It is impossible to say, but there are compelling reasons for using factors other than P/B and ROE—but that’s a topic for another post.

Let me know if you have other ideas for testing, email me at Patrick.w.oshaughnessy@gmail.com

 

[i] Deciles are rebalanced on a rolling annual basis, and companies with negative earning and/or negative equity are excluded.

We Are All Factor Investors

Smart beta, indexing, Fama/French, margin of safety, Graham (deep) value, growth, momentum, GARP. Each of these terms represent very different styles of investing, but they all have one thing in common: they are all predicated on the fact that certain factors have, and will continue to, drive stock returns.

·         Smart Beta: fundamental-weighting, low volatility

·         Indexing: market cap (larger better), costs (lower better)

·         Fama/French: book/price (higher better), market cap (smaller better)

·         Margin of safety: business moats, cheap valuations

·         Graham Value: very cheap valuations

·         Growth: earnings growth

·         Momentum: strong price trends

·         GARP: strong earnings growth and reasonable valuations

If you think about the stock selection process, you’ll see that everyone makes decisions based on some factor(s).

How we make investing decisions

If you are an “active” manager, trying to select stocks that will outperform the market, the process is always the same, and it looks like this:

Both traditional and quantitative managers follow this same process: they collect data they believe to be relevant, process/evaluate that data, and reach conclusions. They buy certain stocks based on certain factor inputs.

Each approach has one major weakness (and many other small ones).

Quantitative Weakness: The quantitative approach is reliant on data that tends to be fairly raw. This means that its weakness lies in its lack of nuance. Raw reported data will sometimes be wrong or hide important realities (think off balance sheet items on bank balance sheets in 2008).  I don’t mean to plant the axiom that traditional managers all do pick up on these inaccuracies/nuances, but some do and have been successful as a result.

Traditional Weakness: Any good strategy only works if it is consistently applied over long periods in the market, but human beings are extremely inconsistent thinkers. This means that relative to quantitative managers, it is very hard for traditional managers to measure and apply their preferred factors across a large universe of stocks, and to do so consistently through time.

One of the reasons that indexing works is that it is so consistent. Its strategy (buy big stocks, the bigger the better) is mediocre, but it never veers off course. Most humans are extremely inconsistent in their decision making and processing of information. Losing $100, for example, has twice the emotional impact on the average human than does gaining the same $100 dollars: we are wired to be especially sensitive to losses.

You can see this tendency in the following chart of all U.S. stock market bull/bear markets. The bulls tend to be slow & plodding, often lasting many years. The bears, by contrast, tend to be sharp, quick and painful.  They are fueled by panic: our oversensitivity to losses.

Humans are a lollapalooza of behavioral biases, and these biases precipitate bad decisions.  Because we aren’t well wired to make smart and consistent investing decisions, I believe that the quantitative approach is superior despite its weaknesses; it removes emotional influences from the investing process. If you believe in factor investing over index investing, then the quantitative approach is more reliable.

Factor Investing in the Future

The funny thing about factors is that just like individual stocks themselves, a factor’s short term success will likely be inversely related to its popularity among investors (which will, of course, wax and wane). Measuring a stocks popularity is pretty easy: lofty valuations, large returns over the past few years, and very high share turnover can all help you identify the most popular stocks (and as I’ve written here and here, they tend to perform terribly). But identifying popular factors is more difficult.  We can look at factor spreads (e.g. how much cheaper are the cheapest stocks than the most expensive stocks) and conclude that the narrower the spread—and therefore the more similar stocks look—the more popular the factor. We can also look, more subjectively, at how often certain factors are mentioned and what sort of fund flows they are garnering (think of the large inflows into dividend yield in 2012, which went on to underperform in 2013). These are imperfect, though, so timing factors will be difficult.

Investing is an incredibly complex endeavor, so it is impossible to sum it up…but J.M. Keynes came close when he said, "It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them." So long as people (compelled by human nature) are responsible for pricing stocks, one edge will likely persist: that which is out of favor—be it a stock, industry, country, or a factor—will likely outperform.  It is psychologically difficult to do, but if you want to beat the global market index funds, you’ll have to position yourself in parts of the market that others disdain. Picking factors in the short term will be as difficult as picking stocks in the short term. I think the key is to instead focus on the longer term: do your own investigating, find what factors make sense to you, and stick with them through thick and thin. 

The Power of Share Repurchases

One of the most effective stock selection strategies in the U.S. over the past several decades has been to buy stocks that are in the midst of repurchasing significant quantities of their shares—but just blindly following buybacks isn’t always the best strategy. While many companies that are repurchasing large quantities of their shares make for great investments, others are dangerous and should be avoided. There are several important factors that should be considered when evaluating a stock with impressive buybacks. These qualifications lead to a strategy with an impressive historical record of outperforming the U.S. market.

This post outlines a very brief history of buybacks, explores the reasons (good and bad) that companies buy back stock, and explains the huge advantage available to investors who incorporate buybacks into a total “shareholder yield” calculation to be used in their investment strategy, while at the same time avoiding companies that are buying back shares for the wrong reasons.  For more on share repurchases and shareholder yield, read Jim O'ShaughnessyMichael Mauboussin, Meb Faber, and Wes Gray.

A Very Quick History

Share repurchases are an incredibly important tool for U.S. corporations. Buybacks have several large advantages over dividends, and have grown very popular as a result. Since the late 1990’s, the total amount of cash used to buy back shares has exceeded cash paid out as dividends, with one brief exception during the financial crisis. U.S. companies are sitting on cash that is the equivalent of 24% of their combined market capitalizations as of April, 2014, so buybacks figure to continue in force in years to come. 

Fig 1

Fig 1

Any study of buybacks should focus on the period after 1982.  Normally, an investigation into a stock selection factor like buybacks would be best if it covered a much longer time span, but with buybacks, a specific piece of legislation forces our attention on the period after the SEC passed the “Safe Harbor” Rule 10b-18 in 1982. This ruling protected corporations from being sued for repurchasing shares, and began an open season for share repurchases that has lasted ever since.

The best data for investigating the history of dividends and buybacks comes from the statement of cash flows, which breaks down cash used for (or coming from) dividends, share buybacks, share issuance, debt paydown, and debt issuance. Figure 2 shows the total value, in millions, of cash used by U.S. companies to make dividend payments or repurchase shares since 1987 (when the statement of cash flows was first reported).

Sometimes, companies buyback and issue shares at the same time, so we must differentiate between “gross” buybacks (blue line) and “net” buybacks (orange line). “Gross” buybacks do not take into account shares issued during the same period as when shares are being repurchased, but the “net” number does. So if a company bought back $100 of shares and issued $20 during the same year, its gross buyback would be $100, and its net buyback would be $80.

Fig 2

Many have complained that the market’s dividend yield—which over the very long term averages 3.8%[i]—is very low today at just 2%[ii]. But as seen in Figure 3, when you add in the effect of net buybacks, companies in the U.S. market are still sending the cash equivalent of 4% of their market cap back to shareholders annually. This total return of cash—dividends + net buybacks—is called “shareholder yield.” Dividend income has its virtues, but it’s taxed twice—at the corporate level and then at the individual level. One great advantage of buybacks is that continuing shareholders don’t pay the second round of taxes.

Fig 3

Of note in this history of shareholder yield is the huge decline during the financial crisis, which resulted from the biggest U.S. financial companies—like Bank of America and Citigroup—raising so much capital; but buybacks quickly rebounded. With the rise of buybacks in the U.S., shareholder yield is a more appropriate measure of yield than dividend yield alone.

Why Do Firms Repurchase Shares

There is a short list of key motivations for share repurchases[iii].

1.       First, companies like to repurchase shares when their stock is cheap, and a big buyback program often sends a message to investors that a company’s management believes its stock is trading below intrinsic value. As we shall see, this first motivation is the only one we are interested in following as investors. Companies that repurchase shares when they are expensive destroy value for shareholders.

2.       Second, shares are sometimes bought back to offset the dilution that happens when shares are granted to employees. This isn’t a signal that the stock is cheap, rather it is just a means to maintain total shares outstanding after paying executives. One way to control for this is to focus on “net” buybacks, which we will do below.

3.       Third, share repurchases can be used to “manage” or “boost” earnings per share (EPS)—a metric that remains extremely important to investors and to corporate executives, some of whom are paid for hitting EPS targets. By controlling the number of shares (the denominator in EPS), managers can control EPS to some degree[iv].

When using buybacks as a factor to select stocks, it is critical to ensure that companies are buying back stock for the first reason, and not for the second two.

Finding the Best Buyback Programs

Repurchasing shares when they are undervalued is one of the best ways to create value for shareholders. If a company is trading for $80, but the value of the business is really $100, then share buybacks would be the equivalent of buying dollars for 80 cents each. And nobody understands a company’s intrinsic value better than the managers of that company (well, at least one would hope!). Company’s engaged in this proper sort of share repurchases make for great investments—provided their motivations are not tainted. Luckily, there are three empirical factors that can be used to weed out unattractive share repurchasers.

1.       Investors should focus on “net” buyback yield, that takes share issuance into account alongside buybacks, rather than “gross” yield which does not.

2.       Investors should avoid companies that have significant buyback programs but trade at expensive valuation multiples.

3.       Investors should avoid the “EPS management” problem by insisting on strong quality of earnings alongside big buyback programs.

Let’s look at how each of these qualifiers improves the signal from buybacks. Table 1 below details the calculation used for each factor in this analysis.

Table 1

Table 1

First up is a comparison of two different calculations for “buyback yield.” The period tested is 1987-2014 because the statement of cash flows is required to calculate gross and net buyback yield. Table 2 breaks the universe of all U.S. stocks into deciles (10% buckets) based on the two measures of buybacks and shows the excess return earned by each decile vs. the market since 1987[v]. Deciles are rebalanced on a rolling annual basis.

Table 2

In each case, companies that have made the largest share repurchases over the past year have gone on to significantly outperform the market in the following year, and do so with fairly low volatility. But by focusing on the “worst” decile of these factors, you can see that the “net” version is far more useful. Often, a stock selection factor like buybacks is as useful for the stocks that it helps you avoid as for the stocks that it leads you to buy. One way of measuring the “strength” of a factor is to look at the return spread between the best decile and the worst decile—the wider the spread, the more useful the factor. Clearly, the “net” versions of the buyback factor that take share issuance into account provide a much stronger signal. Companies issuing large amounts of equity have historically underperformed the market by a wide margin. By focusing on net buybacks instead of gross, you can protect against firms that are buying back shares just to offset shares issued to employees or issued for other reasons.

Value is Key

The buyback deciles above were calculated in the “All Stock[vi]” universe to show the broad applicability of the factor, but the majority of large buyback programs are conducted by large, established firms. The large cap space is also supposedly the most “efficient” and difficult to outperform, so now I narrow the analysis to just large stocks to show that two additional refinements significantly improve the raw buyback signal even among large cap stocks.

We’ve controlled for the first pitfall of buybacks (repurchases to offset share issuance). The second pitfall is buying companies with large repurchase programs that are buying back shares at exactly the wrong time: when their stock price is very expensive. Table 3 below breaks all large stocks into 25 groups according to two factors: their net buybacks, and their valuations (value calculated using definition in Table 1). It shows each groups historical annualized return.

Stocks in the upper right—which do very poorly—are both expensive and issuing shares; this is a brutal combination. Stocks in the lower left, with a return of 15.3%, are buying back lots of shares, but are doing so when the stock is also cheap; this has been a powerful combination historically. Finally, stocks in the lower right are also buying back lots of shares, but are trading at expensive valuation multiples. This final group has a return of just 5.1%, which means that there is a 10% difference in historical annual return between the top share repurchasers that are cheap and the top share repurchasers that are expensive (15.3% vs. 5.1%).  This evidence confirms that value is a crucial component to any strategy that favors large buybacks. You should never buy stocks trading at very expensive multiples no matter how significant their buyback programs.

Table 3

Insist on Quality Earnings

After controlling for dilution, and avoiding companies that are buying back shares at expensive prices, the final key qualification is to avoid companies that seem to be manipulating or smoothing their earnings. The panel below shows the same 25 groups—again among large cap stocks—but instead of combining buybacks with value, it combines buybacks with earnings quality. A similar story emerges. Focusing on the bottom row, you can see that strong buybacks and strong earnings quality produce a much better annual result (14.5%) than strong buybacks and poor earnings quality (9.0%).

Table 4

Stock Example: Seagate Technology

One good historical example is Seagate Technology. The charts below show a time series of Seagate’s valuation percentile versus the rest of the market (blue line) and its net buyback yield (green line), which is calculated as the net dollar amount of share’s repurchased over the last year divided by market capitalization.

Seagate went from one of the more expensive stocks in the market to one of the cheapest very quickly, and as you can see, they’ve been aggressively repurchasing shares ever since; at one point, the dollar amount repurchased over the prior year was the equivalent of nearly 30% of its total market cap!

Fig 4

Fig 4

During the same period, Seagate has significantly outperformed the S&P 500 with a total return of 326% versus 96% for the market over the same period. Of course, I've picked an example that worked out, but as the numbers above indicate, these examples work out more often than they don't.

Fig 5

Fig 5

A Complete Approach to Yield

As Warren Buffett has said, “By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders.” As Buffett hints at here, share repurchase programs are also a proxy for management discipline. Often, managers flush with cash elect to use that cash to acquire other firms or invest in new ventures that are speculative or unlikely to earn an acceptable rate of return (that is, a return above some hurdle rate—be it a fixed 20%, or the opportunity cost of capital). These sorts of reckless investments often destroy shareholder value. For example, a variety of studies have shown that between 70-90% of mergers fail to create value for shareholders[vii]. If, on the other hand, managers recognize value in their own share price, then foregoing misguided investments and opting instead for large share repurchases can create huge value for shareholders.

To bring all of these concepts together, consider the growth of $1 invested in 1982[viii] in four different large cap strategies:

1.       S&P 500

2.       Top 10% of large stocks by dividend yield (this strategy—and the following two—are run with a rolling annual rebalance)

3.       Top 10% of large stocks by shareholder yield (dividends + buybacks)

4.       Top large stocks by shareholder yield after eliminating the half of the stock universe with the worst valuation and poorest quality

Fig 6

Fig 6

Each incremental refinement to investing in the U.S. large cap stocks has led to significant improvement in returns. After controlling for nefarious or misguided motivations, a strategy based on both dividends and buybacks has delivered outsized returns since 1982. Further qualifying the strategy by insisting on attractive valuations and high quality earnings creates a strategy that has been formidable in what arguably should be the most efficient area of the global stock market.

 

 

[i] Average yield for S&P 500 1926-2014, data from Global Financial Data

[ii] 2% is the approximate total yield on the U.S. market, determined by summing all dividend payments made by U.S. companies with a market cap >$200MM divided by the total market cap of those same companies. The dividend yield on the S&P 500 is a similar 2.05%

[iii] A fourth reason would be to affect the company’s operating leverage.

[iv] EPS will increase only if the company’s price-to-earnings ratio is below a level determined by the following formula: 1/(interest rate * (1-corporate tax rate)) where the interest rate is either the return being earned on the cash used to buyback shares, or the rate paid on the debt capital raised to fund the buyback program. This is less impactful in today’s environment when cash earns next to nothing and debt is so cheap (think of Apple’s large debt issuance used to buyback stock). See Michael Mauboussin's recent piece on buybacks for an in depth explanation. 

[v] Deciles are rebalanced on a rolling annual basis to avoid any seasonality issues

[vi] All companies with an inflation adjusted market cap > $200MM

[vii] Study by KPMG International (1999) found 83% fail to create shareholder value, study by Bain & Company (2004) found 70% fail, and a study by the Hay Group at the Sorbonne (2007) found 90% of mergers in Europe failed to add value.

[viii] To bring the test back to 1982, prior to the statement of cash flows, I calculate buyback yield as the year over year percentage change in shares outstanding, which is a “net” buyback yield.

The Best Performing Sector (Consumer Staples, Part 1)

When Jeremy Siegel and Jeremy Schwartz were doing research for the book The Future for Investors, they wanted to find the best performing stock from the original 1957 version of the S&P 500[i]. What they found wasn’t an exciting technology stock, or a behemoth oil company, but rather a simple consumer stock: cigarette maker Philip Morris (now called Altria Group). What’s more, Siegel and Schwartz found that 11 of the top 20 long-term performers came from the same boring economic sector: consumer staples.  The sector is defined by great brands, wide economic “moats,” and above market returns on equity. So how can you use consumer staples stocks in your portfolio? My plan is to answer that question in a multi-part sector series.

For each of the ten economic sectors, I’ll write two parts. Part one will be an overview. I’ll tell a quick history, highlight important companies, and discuss any interesting trends or characteristics. In Part two, I’ll explain how you can find the best investments in each sector, and discuss when the sector does well across market cycles. (Click here for Part II)

At first, I’ll focus on American stocks for a few reasons. First, they are more recognizable and therefore more interesting to U.S. investors. Second, U.S. stock data is clean, broad, easy to work with, and has a deep history. Depending on the popularity of this sector series, I may expand globally as well, perhaps collecting a similar analysis into an e-book (so let me know what parts you enjoy and what you find boring).  We’ll start with the consumer staples sector which, as we’ll see, has been the best performing sector in the U.S. market since the early 1960’s.

A Peculiar Sector

The reason consumer staples stocks caught my eye was a bit of research I was doing on returns on equity (ROE). Over the past 50 years, consumer staples stocks have had persistently excellent returns on their equity. They haven’t obeyed the same ROE mean reversion that other economic sectors do.  Because outsized profits and rates of return on equity should attract stiff and serious competition into an industry, it’s fascinating that an entire sector could enjoy above market returns on equity for so long. 

Such sustained excellence must mean that these companies have had impressive “moats” around their businesses—barriers to entry in the form of brand, economic scale, or other advantages that make it very hard for newcomers to knock off the market leaders. Warren Buffet, Charlie Munger, and other great investors have often said that a good moat is one of the most important attributes for any company. For more information on moats, read this great piece by Michael Mauboussin.

The consumer staples sector is divided into 3-primary groups (known as industry groups) by S&P’s Global Industry Classification Standard (GICS). These are food & staples retailing (think Wal-Mart), food beverage & tobacco (think Coca-Cola), and household & personal products (think Proctor & Gamble). Here are the number of stocks in the sector (and in each industry group) over time.

There have never been more than 200 consumer staples stocks in the all stock universe[ii]—it has always been a fairly concentrated and top-heavy sector. One convenient measure of concentration is to measure how much of any market is controlled by the top companies. One well known measure is the “four firm concentration ratio,” which simply adds up the market share (% of total sales) of the top four firms in each industry group. Here is the historical concentration of each group:

Today, roughly 75% of the sales in both the food & staples retailing and the household & personal products industries come from just the top four companies.

Historical Returns

Though it is populated by companies that seem plain vanilla and don’t excite with new technologies, the consumer staples sector has been the best performing of the 10 economic sectors since 1963. Below are the annualized returns for each of the ten economic sectors[iii].

In addition to delivering the highest returns, consumer staples stocks have had the second lowest annualized volatility, trailing only utilities for lowest annual standard deviation of returns.

Within the sector, returns for the food, beverage & tobacco industry group are especially impressive, while household & personal products have had returns similar to the rest of the market.

So why do these two industry groups do so well? Part of the answer is extremely effective economic moats, mainly resulting from powerful and iconic brands. Warren Buffett has ridden this trend to success—to this day three of his largest holdings are Coca-Cola, Anheuser-Busch (Beer), and Proctor & Gamble.

Food, Beverage & Tobacco

The largest (and best performing) industry group is food, beverage and tobacco. Some of their success comes from the fact that as a group they’ve earned exceptional returns on their equity across history, well above the rest of the market as seen below.  Unlike an industry like automobiles—which are the ultimate cyclical stocks—these companies do not show strong mean reversion in their collective return on equity.

It is amazing, but market trends like these often come down to just a few companies. Coca-Cola and Pepsico, for example, represent about 25% of the food, beverage & tobacco industry group’s common equity. Since both have had high ROEs, they are a major reason for the sustained dominance of the industry.

Outstanding Long-Term Returns

Thinking back to The Future for Investors, I wanted to update the research on long-term returns by looking for the best performing stocks in the U.S. since 1963 (using all stocks as a universe rather than just the S&P 500).  My criteria was that the stock was around in 1963 and survived through the present.  Sure enough, Philip Morris (now Altria) was the number one performing stock with an annualized return of 20.23% per year since 1963—that is a total return of more than one million percent! Other consumer staples stocks peppered the top thirty stocks: Hormel Foods, Anheuser-Busch, Pepsico, and Coca-Cola (among several others) were all near the top of the list.

Clearly, consumer staples stocks have been great investments over the long-term. Lucky for us modern investors, we can buy staples using a low cost ETFs.  Of course, sector ETFs are market-cap weighted so there may be a better way. Improving on a market-cap weighted strategy will be the subject of part two: how to find the most attractive consumer staples stocks in any given market. Stay tuned!

SIDE NOTE: With each of these posts, I am learning. I would love to hear from you with ideas, questions, or disagreements about what matters most in each sector. Email me at patrick.w.oshaughnessy@gmail.com with any thoughts.

 

[i] Pg 36 of The Future for Investors by Jeremy Siegel

[ii] All stocks = any stock in the U.S. with an inflation adjusted market cap>$200MM

[iii] Each custom sector index (and industry group index) is constructed as follows: first, every stock with an inflation adjusted market cap floor of $200M or higher is included. Stocks must be domiciled in the U.S., so no ADRs. Stocks are then equally weighted in the index and the index is rebalanced using the same criteria once per year in December. 

Overdiversification

Who doesn’t like to be diversified? It’s one of the easiest words to throw around when pitching an investment product or process because the word has an almost perfectly positive connotation. I am guilty of overusing the term because it’s just so easy to throw around.

But diversification isn’t all peaches and cream. There is such a thing as being overdiversified. Take an index fund. It owns tons of stocks that will stink over the next year. Apple last year is a great example. It was the biggest stock in the S&P 500 (and therefore most impactful on returns), and had a relatively weak year.

Owning everything means you will always own certain types of stocks that tend to perform poorly. Let’s look at four such types, and then see how an index would perform if it first stripped out the worst stocks by these measures. Because market indexes are weighted by capitalization, I’ll focus on large stocks here.

Value

Expensive stocks—those trading at high multiples of their sales, earnings, and cash flows—have been very poor performers historically. These are usually exciting companies, but the market expects too much of them, and when reality sets in, the stocks underperform. The most expensive stocks in the large stock universe (the worst 10%, rebalanced annually) have underperformed by 6.8% annually since 1963.

Momentum

Same story for the falling knives out there. Stocks whose recent returns have been among the worst in the market tend to continue to lose over the next year. Stocks with the worst momentum have underperformed by 4.5% annually since 1963.

Quality

Stocks with suspicious earnings quality—which tend to have very high accruals and weak cash flows—have also gotten beaten up over the years. Stocks with the worst earnings quality have underperformed by 3.4% annually since 1963.

Shareholder Yield (Dividends + Buybacks)

Stocks with the worst shareholder yield (meaning they are issuing shares and typically not paying a dividend) have also underperformed, by 5.3% annually.

An Index without the Crap

So what would happen if we just refused to invest in expensive stocks, low quality stocks, stocks with poor price momentum, or stocks issuing shares? The results below illuminate what I mean by overdiversification. An equal weighted basket of all large stocks (junk included) has grown at an annual rate of 10.3% with an annual standard deviation of 15.9%, since 1963.  If, instead, you stripped out stocks (annually) in the worst 20% of the market by value, momentum and quality, and also stripped out any stocks that were net issuers of shares (issuance – buybacks > 0), then you’d have achieved a much better result. This modified index would have grown at a 13.1% annual rate and done so with less volatility, with a standard deviation of 14.6%. You’d still own several hundred stocks, and be very diversified, but you’d have a smarter portfolio. Here is the historical growth of the two strategies. Diversification is good…to a point. But owning everything—even the junk—can be a drag on returns over the long term.

My Five Favorite Investing Books

I recently asked a number of my favorite writers to list their five favorite investing books. You can read the fantastic list that resulted here. For this month’s reading list, here are my five all-time favorites.

1.       What Works on Wall Street by James O’Shaughnessy—I am, of course, massively biased in this first selection but hear me out. I never like anything just because it was produced by someone well known or well regarded, my father included. But this book is a classic for two reasons. First, its early chapters give an excellent overview of the modern investor’s options and obstacles. These chapters (1-4) explain investor fallibility and how a model-based approach to investing can help investors overcome their inherent faults.  Second, the remainder of the book—the “data” chapters (5-29)—provide extensive evidence in favor of systematic investment strategies that favor value, quality, momentum and yield. My entire personal portfolio is dedicated to these ideas.

2.       Inside the Investor’s Brain by Richard Peterson—this is the best book on investor behavior that I’ve ever read. It is like Daniel Kahneman’s Thinking, Fast and Slow¸ but specific to investing. It is comprehensive, entertaining, and chock full of stories and examples that I use on a weekly basis.

3.       The (mis)Behavior of Markets by Benoit Mandelbrot—A unique take on (and dismantling of) the efficient market hypothesis. I adopted and extended my favorite chart ever from his book, shown below.

4.       Contrarian Investment Strategies by David Dreman—this was one of the first books I read on investing when I was 22 and remains one of the best. It reveals “forecasters” as charlatans, highlights the contrary nature of the most successful investing strategies, and proposes concrete strategies for outmaneuvering the market.

5.       Devil Take the Hindmost by Edward Chancellor—No investing education is complete without a healthy dose of history. Chancellor’s book is—BY FAR—the best collection of investing history lessons ever compiled. Learning from your own mistakes is great, but learning from the mistakes of others is even better. This is the most entertaining book on the list. 

A (Very) Short History of Shareholder YIeld

I'm working on a longer piece on share repurchases (and shareholder yield) and found the two charts below very interesting.  Buybacks are an important part of the corporate toolkit here in the U.S.--since the late 1990's, cash spent on gross buybacks has exceeded cash spent on dividend payments. This first chart shows the total dollar value of all gross buybacks, net buybacks (subtracting any stock that was issued), and dividends in $MM over the trailing 12-month period.  These values come directly from the statement of cash flows for all U.S. firms. 

I've seen people argue that the peak of buybacks in 2007 shows how foolish buyback programs are--this is nonsense.  The raw dollar is less important that the "yield" that results from dividing buybacks and dividends by total market cap of the market, seen in the second figure below. 

Buyback yield is a great factor for stock selection that I will expand on in a future piece, but what stands out here is the total yield for the market is around 4% today--much higher than the 2% of so dividend yield for the market.  The net yield took a huge bath in 2009 mainly because big banks were raising so much capital. 

Of course some investors want the actual cash dividend, but for shareholders that intend to keep holding their stocks, buybacks should be considered in the total calculation of yield. 

The Best Investing Books Ever

I've only been posting here for a few months, but already I've learned that the most valuable part of writing online is meeting smart, interesting people and learning from them. I learn mostly through books, so I've asked a bunch of my favorite writers what their all-time favorite investing books are. I love the list that has resulted from the first group of respondents. Here is a meta-curated list of the best investing books ever, from Meb Faber, Morgan Housel, Josh Brown, Michael Kitces, Michael Batnick, and Ben Carlson (full list below). My own top five will be the feature in June's book list, so sign up over here.

I've read most of these books (but did find some great suggestions that I didn't know of) and can attest that if you read each one, you would have an incredibly thorough and well rounded take on markets.  This is like a bachelor's and master's degree combined. Thanks to all the great writers who submitted books--hopefully this will be the first of several similar lists. 

THE BOOKS

The Worldly Philosophers by Robert Heilbroner 

Investing: The Last Liberal Art by Robert G. Hagstrom 

Backstage Wall Street by Joshua M. Brown

Irrational Exuberance (2nd Edition 2009) by Prof Robert J. Shiller

Simple Wealth, Inevitable Wealth (Fifth Edition 2013) by Nick Murray

Fooled by Randomness by Nassim Taleb

Unexpected Returns by Ed Easterling

Myth of the Rational Market by Justin Fox

Misbehavior of Markets by Benoit Mandelbrot

Against the Gods by Peter Bernstein

The Most Important Thing by Howard Marks

Your Money & Your Brain by Jason Zweig

The Warren Buffett Portfolio by Robert G. Hagstrom

The Little Book of Common Sense Investing by Jack Bogle

Poor Charlie's Almanac by Charlie Munger

The Intelligent Investor by Ben Graham

Market Wizards by Jack Schwager

Trend Following by Michael Covel

Bull! by Maggie Mahar

Reminiscences of a Stock Operator by Edwin Lefevre

Triumph of the Optimists by Dimson, Marsh and Staunton 

 

Margins Don't Matter When Picking Stocks

With all the talk of high profit margins, it is worth remembering that they are nearly useless as a tool for individual stock selection. If you are an index investor, then margins (and maybe more accurately, ROEs) matter a great deal because when margins/ROEs revert to longer term norms, the market will likely suffer. But if you are instead building your own portfolio (whether it be through a quantitative screen or individual stock selection), then net profit margins haven't mattered nearly as much as other measures like valuations across history.

In the below chart, you can see the historical excess return, by decile, for two factors: net margin (relative to companies in the same industry group) and valuation (relative to the entire market).  On the left hand side (decile 1) are companies with the cheapest valuations or highest margins, and on the right side (decile 10) are those with expensive valuations or very low margins.

1963-2014

1963-2014

You can see right away that where valuations have been highly predictive of strong future excess return, net margins haven't been over the past 50 years. A high margin does not a great investment make--but a cheap price often does. 

Calculation Notes: deciles are run using a rolling annual rebalance. The universe is all stocks with an inflation adjusted market cap > $200MM between 1963-2014.  To control for differences in margins across industries, I've calculated margin relative to companies in the same industry group. I've also excluded companies with negative earnings.  Value is calculated using a variety of measures like price-to-sales, price-to-earnings, EBITDA/EV. The benchmark (against which I calculate the excess returns) is an equal weighted basket of all stocks with an inflation adjusted market cap > $200MM.

The Market's Return on Equity

“Jesse Livermore” has a thorough and convincing new article in which he argues that return on equity (ROE) matters more than profit margins, because it is high ROEs—not high profit margins—that lure new entrants into a market and drive competition.  As Livermore says,

Corporations seek to maximize their total profits…The mistake we’re making here is to assume that corporations “compete” for profit margins. They don’t. Profit margins have no value at all. What has value is a return. The decision to expand into the market of a competitor and seek additional return is not a decision driven by the expected profit margin, the expected return relative to the anticipated quantity of sales. Rather, it’s a decision driven instead by the expected ROE, the expected return relative to the amount of capital that will have to be invested, put at risk, in order to earn it.
— "Jesse Livermore"

Indeed, market ROE has exhibited strong mean reversion over the past 50 years. What follows is a breakdown of contribution by sector to the overall market’s ROE. We are above the long term average, but current levels look completely normal relative to past ROE “peaks.”

I wrote an article about the changing composition of market profit margins, and the story for ROE is very similar. 50 years ago, technology and health care stocks represented a small percentage of the market’s ROE.  In 1964, the two sectors represented just 5% of the markets total common equity (book value). But today, these two sectors combine to represent nearly 32% of the non-financial market’s common equity value.

ROE mean reversion is much more pronounced in some sectors than in others. Here are a few examples.

Current ROE levels are high but well within reason based on historical averages and market cycle peaks. This paints a much different valuation picture than the popular profit margin chart (corporate profits/GDP) that bears are fond of citing (seen at left below). ROE reversion will no doubt continue in future market cycles as it has in the past—nothing appears to be that different this time.

Some calculation notes: ROE by market and sector is a simple comparison of total annual net income to total common equity. The universe is all U.S. domiciled stocks with an inflation adjusted market cap larger than $200MM since 1964. I exclude financials and any securities for which I am missing either net income or common equity data. I also exclude companies with negative common equity. 

Gold vs. The Stock Market

I've never been able to figure out gold as an investment. It has a rich history as both a precious metal and means of monetary exchange, and more than forty years after the end of the gold standard, gold still gets an inordinate amount of attention.  I’ve read lots about gold, but even after countless pages written by very smart people, I am no closer to deciding if it’s worthwhile to own any. The main problem I have with it is that it is unproductive.  There are no earnings against which to measure gold's price. But I thought in lieu of earnings it would be fun to compare the value of all the world’s gold to the value of stocks at various points in history.

I remember reading an anecdote in one of Berkshire’s annual shareholder letters about how all the world’s gold could fit into a baseball infield, and that the value of all the world’s gold ($9.6 trillion at the time) could buy all the cropland in America plus sixteen Exxon Mobiles. I thought it would be fun to see how a similar comparison would look over the past 50 years.

This first chart shows, since 1963, how many times over all the world’s gold could buy the largest American company (whether it be Exxon, GE, AT&T, IBM, Microsoft, or Apple). So, for example, in February 1980—near a huge peak in the price of gold—the world’s supply of gold ($2.3T) was worth 56 times more than the value of IBM ($41B), the largest company in the U.S. stock market at that time.

So with a pile of metal—beloved for its beauty and mutually agreed upon value (but not so much for its utility)—you could buy IBM 56 times over.  Fast forward 20 years and the low point on the graph comes at two simultaneous market extremes: the tech bubble peak, and a multi-decade low for gold.  In March 2000, you could only have purchased 2 Microsofts ($535B) with all the gold in the world ($1.2T).  You get a much better deal today: the world’s gold ($7.1T) would net you about 14 Apples ($529B).

It’s more fun to calculate based on just one company, but the story is almost identical if you apply the same principle to the entire U.S. stock market (seen below).  Some of these numbers are amazing. In the early 1980’s—the major equity valuation low of our lifetimes and a peak in gold prices—the world’s gold could have bought you the U.S. stock market two times over, but in 2000, at a equity valuation peak, it could only have bought a 7% stake!         

Gold tends to do well when the stock market is skittish, so it is no surprise that many of the “peaks” in these charts come near major market bottoms in 1974, 1980, 1990, and 2009.  I think these charts are an interesting way to look at the market’s perception of the U.S. stock market. If they indicate anything today, its that we somewhat complacent and heading towards more overvalued territory, but we are not near the 1972 and 2000 lows of gold vs. the market. They also put in perspective how crazy the 1980 peak in gold was. Regardless of these fluctuations over the years, I am sticking with the productive asset (stocks) and only buying gold on my wife’s birthday.

 

NOTE ON CALCULATION. There were 165,000 metric tons of gold in the world in 2011.  I have assumed 2,500 more tons have been mined in each year since.  Prior to 2011, I adjusted the total world tonnage based on the data available here (http://www.numbersleuth.org/worlds-gold/), which reveals how many tons were mined each year since 1963 (and prior). The price of gold, in U.S. dollars, is from Global Financial Data, and I used 32,150.7466 as the number of troy ounces in a metric ton.  For U.S. total market cap, I simply summed the market cap of every publicly traded company domiciled here in the U.S that had a market cap>$200MM (a standard floor I use in most tests).  Here is the historical price and total value of gold in U.S. dollars:

Following Trends Across and Within Industries

Last week, I posted about two ways to improve a momentum strategy by using value and quality to screen out dangerous momentum stocks. It so happens that lots of the momentum high-fliers from 2013 were concentrated in several key industries, like social media and biotechnology. This concentration begs the question, how much of the momentum effect comes from riding the hottest industries?

One of the more interesting elements of factor/quantitative investing is the industry effect.  For any style/factor—like value or momentum—how much alpha is the result of just making industry bets? For example, any unconstrained value strategy over the past 50 years has been chronically underweight tech stocks (until very recently), and this underweight has been beneficial because tech has been one of the worst performing sectors. The ability to make industry bets—like the one against tech— can be a significant advantage even though it increases some traditional measures of risk like tracking error.

So what about momentum? Does the excess return from momentum investing come mostly from rotating between industries, or can you also benefit from buying stocks within each industry that have the best momentum relative to other companies in the same line of business.  

For this analysis, I use two different definitions: industry group, and industry. There are 24 industry groups and 68 different industries (you can even get more specific to sub-industry, but in many cases there aren’t enough companies in each sub-industry for this type of analysis).

Here are the results (return and volatility), by decile since 1964, for 3-calculations of momentum: raw 6-Month return (which would allow you to rotate between industries freely), and 6-Month return relative to both industry group and industry. These second two calculations would result in a portfolio that was more spread out across industries and looked more similar to the overall market[i].  

A few interesting points stand out. First, momentum works both within and across industries.  This means that you can do well by using momentum to determine your industry allocations, but you can also do well by using momentum to select stocks in the industries that you like. Second, the unconstrained, raw version of momentum provides the best overall returns, but requires a bumpier ride. The annualized volatility is much higher than the industry relative calculation.

The chart below shows the rolling 3-year excess return for high momentum strategies. As you can see, momentum investing is quite cyclical, and returns can be painful for years at a time. The period following 2009, for example, was one of the worst factor inversions we’ve ever seen.

Bottom line, the flexibility to rotate more between industry groups and industries has added a significant amount of alpha over the long term. Of course, you pay for this alpha by having to endure higher volatility. Either way, the trend is your friend more often than not.


[i] Specifically, these are percentiles calculated within different groups.  The percentiles which are relative to industry or industry group would result in portfolio with lower overall momentum, because you’d own some stocks that may not have great momentum compared to the market, but do have good momentum compared to other stocks in the same industry (think Telco stocks in 2013, or some other laggard).

Skin in the Game

They say you should put your money where your mouth is. With that in mind, I really liked the spirit of Meb Faber’s recent post about having “skin in the game,” and so here I copy his idea (and hope others follow suit).

To reiterate something Meb said, my situation is unique and my investment allocation isn’t relevant for other investors with different preferences, risk tolerances, and time horizons. None of this is investing advice.

I have 100% of my invested assets in quantitative, long only strategies. The vast majority (90%+) is invested in strategies run by O’Shaughnessy Asset Management (“OSAM”). The only reason that it is not 100% is that I cannot access OSAM’s emerging markets strategy in my retirement account, so I have to get my EM exposure through another option (DFA, in this case—although whenever the OSAM EM strategy becomes available I will switch 100% of my EM exposure to that strategy. I also have a small amount in Meb Faber’s Global Value strategy).

Some key points about my allocations.

  • I’m 29, have a high tolerance for equity volatility (in fact I’d welcome it for the chance to buy more at better prices), and have a very long time horizon.
  • I believe that automatic allocations are one of the keys to investing success because, like quant strategies, automatic allocations take most of the emotion out of investing. I contribute to my 401(k) automatically, and I also contribute automatically to other investment accounts.  

Some key points about the strategies I use to invest.

  • I believe investing should be completely rules-based/systematic/quantitative
  • Every strategy I use to invest is predicated on four key factors: valuation, yield (dividends, buybacks, debt paydown), quality, and momentum. I have a roughly equal exposure to these key factors.
  •  I use a number of different strategies and allocate across them using a contrarian approach. I add to strategies that have 1) better current valuations (i.e. lower expectations) and 2) negative recent results (absolute and relative).  For example, for the past year or so I’ve been adding mostly to our global, yield driven strategy because 1) international and emerging markets are cheaper than the U.S. market and 2) the strategy has underperformed. Like the strategies that I use themselves, my allocations across strategies are rules based.
  •  I have a very global portfolio, and am underweight the U.S. market. This is because 1) the U.S. is more expensive than almost all global markets and 2) my career and earnings are concentrated in U.S. dollars and U.S. markets, so I like the diversification.  
  • To give you a flavor for where these strategies are pointing right now, I own a lot of international energy and telecom companies, and “old world” tech stocks in the U.S.

Because of the nature of value investing, it’s usually easier to tell a scary story about many of the stocks that I own than a rosy, growth story. If I wasn’t comfortable with that, I’d just buy index funds.  

More Expensive Than Ever?! (No)

Profit margins are high, so I’ve seen many bears resort to using price-to-sales as their go-to barometer of market valuation. My data-torturing heckles are up a bit (as is, if you torture the data long enough it will tell you anything you want to hear).  Price-to-earnings doesn't tell a catastrophic story, nor does market level price-to-sales, so lately some have resorted to median price-to-sales. On this measure, the S&P 500 is more expensive than ever! Lookout below!!! Price-to-earnings and even market level price-to-sales refuse to cooperate with the bear argument, so this new valuation method has become popular because it suits the bear story. So let’s look at some price-to-sales stories over the past 50 years.

First up is a long-term look at market level price-to-sales (sum of all market caps in U.S. stocks divided by sum of all sales for U.S. stocks) compared to median price-to-sales for all investable U.S. stocks[i].

You can see that there have been large divergences between median and market level price-to-sales since 2002 or so, and the median p/sales is currently 27% higher than the market level p/sales. Across the full sample, the median p/sales and market p/sales track more closely, with the median being 7% higher than market level p/sales, on average.

A second interesting way of looking at price-to-sales is to look at the distribution of price-to-sales ratios in today’s market versus the very long term.

Like the first chart, this paints today’s market as richly priced, but not outrageously so. For the past 50 years (dotted line), the most common p/sales ratio is roughly 0.6 (the peak of the chart). Today, the most common ratio is roughly 0.9.  The right (expensive) tail is also interesting. Over the long term, 11% of stocks trade at a p/sales ratio great than 3; today, 21.5% of the market trades at a p/sales above 3.

Bottom line: the U.S. market is on the expensive side. But it’s not “more expensive than ever,” not by a long-shot. The current market level price-to-sales (1.53) is 30% lower than its all-time peak (2.21). Even the median—which is high at 1.96—is 13% below its all-time peak of 2.25.  I continue to believe that investors should build a global portfolio, because many of the best valuations are outside of the U.S. market.

 

[i] Investable = market caps > $200MM, adjusted for inflation back in time