Stock market and investing thought bubbles, quantitative research and factor portfolio modelling.

At present in Australia, compared with offshore markets there is a dearth of investment solutions available for individuals or SMSFs that desire to invest in particular factors or themes. With many hundreds of managed funds and ETFs available to Australians this may appear a ludicrous assertion. And yes…, there are plenty of high-dividend funds or ETFs plus socially responsible themed products. However I am alluding to ETFs that screen ASX listed stocks for single criteria including value, price momentum, earnings momentum, or cash flow ratios. Equity fund managers already apply most of these investing principles, however as single factor screens they are not readily offered. Hence, my posting some ‘thought bubbles’ on the search for a solution.

Factor Investing

Successful investment is simple enough in theory: maximising return while minimising risk … However, from my roots as a private trader/investor I know that in practice it’s much more complicated. This is why I’ve assembled systems and processes over many years to build and manage portfolios that are individually my own.

The investment approaches I adhere to are driven by an overarching goal to enhance total portfolio performance while controlling risk across all market cycles. To accomplish this, my approach adheres to a strong set of ideals consistent with a conservative, disciplined, factor based investment philosophy:

•             A focus on after-tax, total portfolio returns

•             Global diversification and balance across multiple sectors

•             Disciplined strategies emphasising the long-term

Upside Down Investing: Active Investing on Stocks You Shouldn’t Own 

Portfolio management is in a conundrum these days with the debate between active and passive management supporters. The hindsight expert's observations about performance and fees is fairly cut and dried, but for me the real conversation is about the behavioural aspects of sitting through drawdowns. However active management has one potential advantage versus passive index investing…. active stock elimination or identifying stocks not to own in the portfolio. Don’t get me wrong, I am fan of buy and hold (passive) investing in certain circumstances but the competitive spirit in me naturally seeks a better option.

While owning strong performers is the most obvious source of excess returns versus a benchmark, the stocks that are in an index but not in an active portfolio often explain much of an active portfolio’s relative returns.

In 2015 for example, not owning the big four Aussie banks, BHP, RIO or Telstra was a large advantage relative to the S&P ASX200 index. Large cap stocks like CBA have a big impact on the return of index-based funds. This is true regardless of the current quality or valuation of these stocks. This is a weakness that disciplined active approaches can exploit.

Creative destruction

A point to note about the distribution of stock performance is that about 2/3 of stocks under-perform the index over time, so you can be at huge disadvantage if you are picking individual stocks. Also around 40% of all stocks essentially have a negative rate of return over their lifetime and something like 20% go to zero, plus less than 20% generate all the gains for their respective index (via longboardfunds.com). This is why market-cap weighted investing can give you a good starting point, but then tilting to the better factors improves returns again.

One interesting side effect of the rise of index funds is that every stock in any major index fund receives a constant bid in the market as more and more net cash flows into the major index funds and ETF's. When an investor buys STW, the ASX200 ETF, they do not do so thinking that WBC or ANZ is a good buy. They are instead simply betting on the ASX’s overall appreciation and dividends. But their buying decision creates demand for bank shares indirectly and, if and when there are negative net flows out of index funds, selling pressure is created in the individual stocks.

So the popularity of index investing creates upward pressure regardless of current share quality. However our premise is that the relative quality of a stock should not be ignored. A simple test removing the lowest quality stocks from a respective index shows by that screening for a quality factor like a debt-to-equity ratio can improve annual returns by a couple of percent annually.

Notionally cap-weighted indexes should be beatable. It would be silly to advocate a simple approach like the one mentioned above but we believe that certain stocks should be removed from consideration using certain quality metrics. Results can demonstrate the potential power of not owning certain stocks, even in the existing cap-weighted index framework.

As a starting point we believe that in the age of indexing, active strategies should first work hard to remove the poorest quality stocks from consideration entirely, regardless of their weight in the index. Size alone is the driver of a stock’s weight in All Ordinaries and corresponding ETF’s and shouldn’t be the primary reason for owning a stock.

Screening For Quality

The 'quality' factor means different things to different investors. The theory is to use quality as a negative screen which tries to avoid stocks rather than to select them. Specifically, that means factors that measure financial strength, earnings growth, and earnings quality are the most effective ways to objectively remove stocks from consideration for investment.

Financial strength as a factor would filter for a company’s levels of financing and leverage. Companies that are more reliant on external financing, particularly those with significant recent growth in total debt, and have low cash flows relative to their total debt, tend to under-perform the market.

A good plan is to evaluate a company’s recent earnings with an earnings growth factor. Using available data one can calculate the return on equity based on past and expected future earnings that company will generate. Companies with low levels of profitability, falling earnings, and negative recent earnings surprises have historically under-performed the market.

Earnings quality identifies companies that are aggressively reporting or misrepresenting their earnings. Accounting treatment of certain items can inflate earnings by delaying expenses or recognising revenue early, but these actions create an imbalance in the financial statements. It’s best to avoid companies with high and rising non-cash items, one off growth effect on assets, and low depreciation costs relative to capital investment. Analysts find that companies that are aggressively manipulating their earnings cannot sustain it forever and tend to under-perform in future years.

These primary measures of quality can help eliminate poor performers from your investor universe, regardless of their weight in a given market index. The historical data suggests that, no matter a company’s size, if it is among the lowest stocks in the market by financial strength, earnings quality, or earnings growth, it should be avoided.

The Impact of Quality

Historically the Aussie market has seen several bankruptcies or bailed out companies, examples being Pasminco or Arrium. These and several more companies all exhibited the warning signs of poor quality. Major indexes pay no consideration to financial strength, earnings quality, or earnings growth. At their peak, Pasminco and Arrium each would have been within the largest 200 companies on the ASX, based solely on the size of their market cap. If index’s screened for quality to remove stocks like these, their historical results would have been very different - and much better for equity holders.

There are two ways to build a successful strategy directly or indirectly. You can win directly by identifying and buying stocks that are poised to outperform using factors like valuation and shareholder yield. This is a central part of any fund managers investment process. However you can also win indirectly, by identifying stocks that have suspect financial strength, earnings quality, and earnings growth and remove them from consideration. A broad index will own everything but by not owning the lowest quality stocks, the game can tilted for an active investor to improve their odds of success.

source research: osamresearch

source research: Defence Wins Championships