In last week’s column I explained how to use data analysis to identify common attributes or factors in investment portfolios. This week I want to talk about the results of studies looking at what makes portfolios successful.
It seems that there are six major factors investors should look for when considering stock investments. All six of these are based on numerousstudies by dozens of financial economists includingmyself. Some of these factors were even part of the basis for the 2013 Nobel Prize in Economics. To be clear, buying stocks that exhibit these factors does not mean that the company will go up in value today or tomorrow – it just means that on average, over time, firms displaying these characteristics have vastly outperformed other firms.
- Small Size – Past research studies have shown that investors should be looking for small companies to invest in rather than large companies if their goal is to maximize returns. This makes sense intuitively since smaller companies have a lot more room to grow than large companies do. Smaller companies are riskier on average than larger companies, but if the investor buys a reasonable portfolio of small firms, they can benefit from the extra return associated with small firms while mitigating the risk.
- Low Valuation – A lot of investors like to think of themselves as value investors. Unfortunately, most of these investors are assessing value ineffectively. Popular metrics like the P/E ratio or even the PEG ratio are not very effective ways to measure the relative value of a firm. Those investors who do use the right measures of value hold stocks that, on average, perform much better than other stocks.
- Low Volatility – It seems intuitive that companies with the highest level of risk, should also have the highest level of return. Unfortunately, that’s not the case, at least based on the common measure of risk used in the financial industry. Risk is usually measured based on the volatility of a stock. Stock pickers often cite their Sharpe Ratios – the ratio of return divided by standard deviation of a stock pick. In fact, research has shown that the most volatile companies are often the worst investments. Higher risk (as measured by higher volatility) equals lower returns. A portfolio invested in the least volatile stocks starting in 1980 would today be worth 19 times as much as a portfolio of the most volatile stocks. Investors need to understand and try to capture returns built on this “vol anomaly”. Capturing extra return based on that anomaly is harder than it sounds
- Earnings Momentum – Earnings momentum refers to the economic performance of a firm over the last 12 months. Studies have shown consistently that firms with strong positive earnings growth over the last 12 months outperform other comparable firms. This is the basis for strategies by some of the most successful hedge funds in the world today. Stocks with good earnings growth might seem expensive because their price has usually risen considerably – yet investors should ignore the firms that seem “cheap” and tilt their portfolios to the “expensive” firms with good earnings momentum. Those firms are the ones that will continue beating earnings expectations in the future. In fact, the real power in earnings momentum is with those stocks that have outperformed 6 to 12 months previously. Firms that hit that hurdle will continue to outperform for the next 12 months on average.
Two good metrics for assessing earnings are operating cash flows and the recycle ratio. Operating cash flows are a cash flow statement term which includes only the cash that a firm generates from its regular operations rather than through financing or investing activities. Operating cash flow consist of non-cash earnings such as depreciation and amortization plus net income.
Recycle ratios are a little more complicated to calculate, so it might be worth consulting a source like Bloomberg or a financial expert for help on that front.
- Quality – Value investors should never look at a simple stock price or even a price-to-earnings ratio to decide which stocks to buy. Instead, investors should be screening for high “quality” firms where quality is defined as low debt, and high stable gross profits measured as revenues less COGS.
- Short Interest Ratio – Finally, investors need to consider the short interest ratio of a firm. Short interest ratios measure the amount of shares in a company which are shorted divided by the number of shares traded per day on average. Firms with a high SIR have abysmal future returns on average. Investors should look for stocks that have low SIR compared to their peers. On average a SIR less than 3.0 is reasonably acceptable, while SIR less than 1.0 is good. Firms with a low SIR have outperformed otherwise similar firms with a high SIR by an average of about 2% per month over the last 10 years!
There are no guarantees in investing of course, but following these metrics should substantially improve the performance of a portfolio over time...if you believe the researchers.
Mike McDonald is a PhD in finance and a university professor in the subject at Fairfield University in Connecticut. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com