Those outperforming junk stocks
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There are lots of tools that investors use to try to outperform the stock market. Some use fundamental analysis, looking for stocks which are cheap. Others just want to buy high-quality qualities. And traders often want to buy stocks which are rising, playing the momentum.
In March, it seems, none of that worked, at least if you were using BarCap’s quant model:
Market Sentiment did not work, returning -4.37%. Quality did not work, as low Quality companies beat high Quality companies, thus underperforming by -2.83%. And Valuation didn’t work either, with expensive companies outperforming cheap companies, causing the theme to return -1.99%. None of the traditional styles for stock picking worked. One needed to be absolutely counter-intuitive buying expensive stocks of low quality that had recently underperformed to be successful.
I guess in retrospect the trick was to see the significant increase in risk appetite which happened in March, and then go long anything considered high-risk. Like expensive stocks of low quality that had recently underperformed. But I wouldn’t try that at home. And neither would I consider one-month stock performance to be an indicator of corporate or managerial quality.
More generally, this kind of thing gives lie to most market reporting, and the conceit that market moves happen for a reason. Insofar as they do, often that reason is so abstract — something like what Paul Murphy calls “the risk trade being put back on” — that it can never really be identified at the time. And even in retrospect, it looks more than a little random.
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“One needed to be absolutely counter-intuitive buying expensive stocks of low quality that had recently underperformed to be successful.”
great quote
The most successful hedge funds rarely do what comes intuitively.
Actually, I think what has been happening in retrospect has been quite logical and not at all random.
Many of these “low-quality” stocks ranked very poorly back in March and still do today on many fundamental factors. But the key drivers of valuation — ROIC and cash flow growth — bottomed at this time last year, and have been improving. MGM Mirage is a case in point: bit.ly/aZFVpE
What I think many of these quant models may have missed is that relative fundamental factors are irrelevant following a huge market correction. What simply matters is that there is some incremental improvement in ROIC and cash flow prospects, which can justify at least a partial return to some kind of long-term mean.
It’s hard for even industry experts to get behind a “low-quality” company at inflection points like last March, and I am not pretending I did so myself. But I think a delayed reaction to this is starting to happen now, and that we will see more of it — take a look at the recent upgrade of HOG for example.
In any case, I do agree that it’s more prudent to try to partially participate in a market rally by focusing on “higher-quality” stocks.
I just posted an article on such a strategy and some others, available here: bit.ly/cdT4hw
If the stock market’s doing well, why bother to ‘outperform’ it?
Sometimes people can be too clever.
P.S. It’d be interesting to catalog just who’s been predicting a ‘major correction’ — for six months already.
So today in a follow up Alphaville has a post from the Barclays guys discussing the ‘trash bank rally’ On there list of possible explanations if I might quote Alphaville quoting Barclays.
“Drivers for the year-to-date regional bank outperformance in our view includes: a) below tangible book valuations at the start of the year . . . b) relatively low valuations (mid-cap bank trading at 9x normalized EPS on Jan 1, though 14x currently) amid an improving economic backdrop (increased GDP growth, improved job creation)”
so how is that a “junk rally” and not a “cheap rally”. I suspect there is a similar character to the non-banks that outperformed during the quarter (low P/B, low P/Normalized EPS)
Sometimes higher risk shares outperform. Sometimes they underperform. If this phenomenon is unpredictable, then proper portfolio management calls for building portfolios that are neutral to this issue.
Once returns in March are better adjusted for systematic risk factors, there were useful valuation signals to benefit from including revenue and free cash flow based valuation.
To read more about this see: http://quantchat.com/?p=482.
“Unsurprisingly,” MGM Mirage ($MGM) Leads “Low-Quality” Stocks Higher – April 8, 2010 http://bit.ly/90fr78