François Trahan — Quantitative Analysis
Below is our Quantitative Analysis library of research listed in reverse chronological order. Please use the search box to look for research on a specific company or topic, or use the Calendar, Archives, or Sector links at left to browse for research from a specific time period or sector. If you are a Wolfe Trahan client and can not access any of the links in our library, please contact ITSupport@WolfeTrahan.com to request our PDF decryption plug-in.Analyst Estimates: What Investors Need To Know
An inflection point in leading economic indicators changes the dynamics of investing for all. In our Portfolio Strategy work, we have written (to the point of exhaustion) that the defining moment of 2010 would occur when LEIs peak – whether you are an asset allocator or a bottoms-up stock picker. We have already seen how things have changed with regards to asset class performance (e.g., stocks vs. bonds), style preference (e.g., value vs. growth), sector rotation (e.g., hyper-cyclicals vs. counter-cyclicals) and, even in the quant world with factor performance (e.g., beta vs. profitability). This morning we will get the August ISM Manufacturing report, one of the most important data points of the month. We expect growth prospects will continue to recede (as they have in most countries). Until there is a case for a sustained improvement in leading indicators, a preference for stability over cyclicality is likely to offer a good risk/reward tradeoff for investors.
In today’s report, we focus our efforts on earnings surprise, and its efficacy in producing excess returns across the business cycle. What we have found is that positive earnings surprise as a factor on its own is a decent alpha generator. However, when modeled around the business cycle, we see that its usefulness dries up after leading indicators peak. Investors that have made money in the past year by incorporating an earnings surprise factor into their screening process may want to reconsider its weighting when 3rd quarter earnings season rolls around. This is because the next earnings season will be the first one that investors see in a “post-LEI peak” environment. This typically leads to fewer companies beating analyst estimates and a more muted excess performance when doing so. One explanation for this is that guidance often diverges from earnings trends following a peak in LEIs as guidance is forward-looking and earnings are backward-looking. While LEIs are rising, we generally see both EPS and guidance rise in concert – thus an “earnings surprise” often coincides with a “guidance beat” as well. However, following a peak in LEIs, investors are less likely to see this, as the rise of “earnings surprise” tied with “guidance misses” increases. We expect third quarter earnings season to be less rosy than the past two. This suggests that investors ditch the earnings surprise models and focus more on the forward-looking data.
Operating Leverage: Is It A Risk Or A Reward?
The current expansion has been slower to recover than in past recessions, largely due to a contraction in private-sector credit. Deleveraging has made, and will likely continue to make, the path of recovery unlike any that we have seen over the past 50+ years. There has also been a clear behavioral change in the attitudes towards leverage with regards to consumers – less is better today. While most definitions of leverage now have a negative connotation attached to them today, operating leverage is not one of those. Corporate America’s earnings have been quite resilient during this recovery, largely due to aggressive cost-savings initiatives. While top-line has grown moderately for most companies, earnings-growth has recovered with a bang – thanks to a 20-year high in operating leverage (the ability of a company to translate revenue growth into growth in operating income).
The good news is that corporate earnings have surprised to the upside. The risk, however, is that the current rate of operating leverage is likely unsustainable. With that in mind, we are not convinced that the sell-side agrees with that statement as earnings for 2011 and 2012 are expected to be $95.16 and $108.63. These levels imply growth rates in earnings of 17% and 14% respectively. If our base case scenario of slower growth in 2011 (~1% GDP growth) comes to pass, companies would likely have to return to peak operating leverage levels to get anywhere near those earnings estimates.
Most companies with strong operating leverage outperformed in 2009 and early 2010 as earnings growth surprised on the upside. However, looking ahead, we see high operating leverage as a factor that is likely to underperform alongside other higher-risk factors. According to Aswath Damodaran’s working paper entitled, “Estimating Risk Factors”, operating leverage is a major determinant of a company’s beta. In a world where LEIs are decelerating, we know we want to steer clear of higher risk factors such as beta as they often lag the market. Avoiding high operating leverage is just another chapter in our 2010 story of stability over cyclicality.
Corporate Cash … Clouding The Profitability Picture!
In our strategy work, we have made several comparisons of the current environment to the 1950s and 1960s. While many aspects of the world are very different today, some things are the same. A lot has been made of the excess build-up of corporate cash over the past few years and the potential fuel it may provide to keep the economy humming along as the government stimuli fade. Interestingly, this isn’t the first time that corporations have been this flush with cash. During the 40s and 50s, when interest rates were last at today’s levels (10-year at 2.9% today), corporations held just as much cash. The chart below illustrates corporations’ behavior over the past 65 years and reinforces the notion that inflation rewards spenders and deflation rewards savers. If deflation lies ahead, expect more cash buildup.
There are both positives and negatives to holding cash on the balance sheet. On the plus side, having excess liquidity during times of uncertainty is something that investors typically reward (see our 4/14 report entitled “Profiting From The Abundance Of Corporate Cash”). But as we have all witnessed at some point in time, too much of a good thing can be problematic. Holding too much cash on the balance sheet can mask the true operating profitability of a firm (using metrics such as ROA), which in the end may leave investors bidding at a lower multiple for the stock.
In this report, we offer a better way to screen for corporate profitability by removing non-operating assets such as cash and financial assets from the equation. We have found this to be a better metric of true profitability and a more profitable strategy. Historically speaking, in a world where economic prospects are moderating, factors such as profitability and operating efficiency become the centerpiece of defensive portfolio construction.
A Better Measure Of Credit Worthiness… Filling The Ratings Void
The use and misuse of credit has fostered scandal and mistrust throughout financial market history and are unfortunately a recurring reality. Going all the way back to the days of John Law (1700s), when he set up the Mississippi Company and Banque Royale to alleviate France’s national debt woes in what ultimately turned out to be a massive debt-for-equity swap of the national debt, credit has been integral in igniting boom and bust cycles. Following each bust, regulation, in some form or another, arose to avoid another crisis, but as government leaders and investors came and went, so did the rules. There is nothing new about the credit boom and subsequent crisis that began in early 2002. For hundreds of years, easy money cycles have fostered economic expansion that lead to even easier money, economic euphoria (“a new normal”) and obscene asset price levels. For the most part, each cycle ended the same: financial market and economic collapse. The signing of yesterday’s bill is just the normal course of events that typically takes place after a major financial crisis.
In 2002, following numerous accounting scandals by big business, congress passed Sarbanes-Oxley to make sure that company management was held accountable for their communication to the investing public. In that same vein, the signing of yesterday’s bill makes credit-rating agencies such as S&P and Moody’s legally accountable for the quality of their ratings, effective immediately. Thus, if the bonds don’t perform in accordance with their ratings, these agencies could be sued for potential wrongdoing.
With this news, rating agencies have temporarily pulled back from rating securities on new issues in many markets causing a large disruption (see “Bond Sale? Don’t Quote Us” in yesterday’s WSJ). With now an even greater void to fill in the credit-rating world, how can investors objectively gauge the creditworthiness of a company? In this report, we put forth a straightforward and objective framework for deriving credit ratings for public companies. As is usually the case, our conclusions are the result of combining our own research alongside inspiring work from the academic world. If the big three credit-rating agencies do not want investors to use their ratings, then take a look at ours for a pretty good, and in many cases better, starting point for credit analysis.
Coming Up Next … M&A Boom Or M&A Bust?
While today’s markets may not be ideal in the eyes of investors, what we have seen in recent months is fairly typical of market performance around inflection points in leading indicators. To date, it hasn’t been about cash on the sidelines – it has still been about the Marco backdrop. Some have argued that the unusually high levels of cash on corporate balance sheets would lead to some sort of M&A super cycle. Obviously, this has yet to unfold. Still, while we haven’t seen a full recovery in terms of dollar value, raw deal activity is significantly up year over year. We would agree that it may be too early to call a rebirth of the M&A cycle, but with the amount of recent deal activity along with the fact that this is typically the time of the cycle when deals pick up, we thought it an appropriate time to look at the ins and outs of M&A activity in the stock market.
While M&A activity may not be on the tip of everyone’s tongue right now, we have seen some rather large deals over the past few quarters. In 2009, we saw the acquisition of Burlington Northern and this year Qwest Communications was purchased by CenturyTel. Thus far in 2010, almost 90% of the deletions from the S&P 500 were due to M&A activity. While the M&A field is constantly changing, one dynamic that we have been following is the increase in cross-border deals. With the rise in globalization, more foreign buyers are stepping into domestic markets (e.g. the Sybase and Millipore deals). It may not be the boom days for M&A activity, but given that acquisition deals are now on the rise again and the big investment banks haven’t closed their doors, today’s report takes a top-down look at M&A activity and what it means for investors. While we may only be scratching the surface of a very broad topic, we try to address what an acquisition means for a shareholder, how academia has tried to predict potential M&A targets, our take on classic acquisition model and how to improve upon them.
A Light Hearted Read For The Long Weekend
As we head into the 4th of July weekend and many minds are elsewhere (the beach), we thought it would be fun to put out a report which was a bit on the lighter side. As many of our regular readers know this is a semiannual tradition for us around the 4th of July and December 31st. Some of our past exploits have included an examination of the Hemline and Hersey Bar Index. We’ve even written about the effect that sunspots have are the market … P.S. there is actually a lot of academic research on the subject. This report is not intended to downplay any of the strategies, many of them are actually very serious, it is purely putting pen to paper on some Wall Street folklore. In today’s report we cover three market strategies that clients have requested over the last few months.
Out of the three strategies that we tested for this report, the one that performed the best was Joel Greenblatt’s Magic Formula, followed by our Dart Board Selection strategy. The weakest performing of the three was the Dogs of the Dow (both the worst performers of the last year and the highest dividend payers).
If you have any similar ideas that you’d like to see in our December report feel free to email us at quant@wolfetrahan.com. After the holiday we will be back to our regular publishing schedule. Have a great weekend, happy 4th, and a sincere thank you for supporting our endeavor this year.
A Quantitative Take On Forensic Accounting: Introducing The MM Score
A decade worth of serial bubbles (e.g., Tech, Housing, Credit, etc.) and questionable accounting (e.g., Enron, AOL, and even Greece, etc.) has reintroduced investors to the “fat tails” of the financial market’s risk profile. Interestingly, investors’ renewed awareness and concern for these “low probability, high impact” events has not been an area that Wall Street’s sell-side research has chosen to focus on. In fact, it’s quite the opposite. Within the research coverage of the S&P 500, 70% of stocks are now rated a “buy”. Unfortunately, much less time is spent looking for short-candidates and potential problems, at least as compared to the interest on the buy-side. Over the past year, both earnings and expectations have recovered strongly. With leading indicators now beginning to decelerate, we believe that earnings growth could likely do the same later this year and into next. Thus far, analysts’ estimates in aggregate have not addressed the slowdown signs that we (and the equity market) are seeing. Elevated expectations of the sell-side are lifting a very high bar for companies to reach, opening up the door for a few bad apples to manipulate their earnings in an effort to meet short-term expectations.
While material earnings misstatements has been a popular topic for some time now in the academic world (e.g., the accrual anomaly), the debacles of recent years have spurred renewed interest in the field of forensic accounting. From this pool of work has come some significant advancements in the field of “misstatement detection”, such as the model we focus on today (we call it the MM-Score). This model builds upon some of the key models that have come before it to create a robust detection model based on company fundamentals. Similar to models such as the Altman Z for bankruptcy detection, the MM-Score attempts to flag companies at risk by assigning a score and determining a risk cutoff. We view this as a little brother to our QOR-score earnings-quality model. The QOR score is a broad screening tool for earnings quality, while the MM-Score is a targeted approach to detecting the highest risk, lowest quality names.
Improving The Odds Of Outperformance In A Flat Market
We are almost half-way through 2010 and the S&P 500 is back to where it began the year. A flat market is one where active managers have a better opportunity to outperform their benchmark. While we all prefer a bull market, the truth is that passive investment strategies tend to outperform in such years (e.g., 2003, 2009). We have stressed that this year is one where investors should look to hit singles and even take the occasional walk (i.e., dividends), and not look to hit home-runs. As of yesterday’s close, roughly 50% of stocks are up for the year and 50% are down. The difference between outperformance and underperformance boils down to the likelihood that one’s stock picks are in the “upper 50%”. Integrating quantitative analysis into the investment process helps investors stack the odds in their favor, increasing the likelihood that even the most mediocre stock picker outperforms.
This year, much of our quantitative research has been focused on taking everyday stock selection strategies and making them better. In today’s report, we focus on the most commonly-used valuation strategy – P/E screening. At the root of investing, is how much we are willing to pay for the lemonade stand down the street. Since we never have perfect information with regards to future earnings potential, we either have to use what knowledge we have (trailing P/Es) or make a prediction of what we believe future earnings may be (estimated forward P/Es). In terms of stock selection, both of these valuation methods have generated alpha over time, however they both have shortcomings. Analysts’ mean earnings estimates are the weakest of the two, probably because of the upward bias of the sell-side and the subjective over-extrapolation of earnings trends that can alter perceived valuation levels. The only issue that we have with trailing EPS is that they are backward looking. In this report, we introduce an alternative and objective measure to forecast EPS that addresses both the biases of analysts and the lagging nature of trailing EPS and, more importantly, outperforms both strategies as a stock picking tool.
Read This If You Are A Stock Picker … The Game Has Changed
A former colleague of ours would often say that “listening to what the market is saying” is an integral part of the investment process. Indeed, we know that the equity market has been speaking rather loudly over the past month or so, and in a much different tone than it had previously communicated. Understanding what the market is discounting is always informative, and can even become profitable when a disconnect between market prices and economic fundamentals forms. This was the case in late April, after the market had risen at a 100% annualized pace from the February 8th bottom in equities. Notably, at the time there were several series and intra-market trends that pointed to an upcoming slowdown in leading economic indicators. Indeed, the proverbial yield sign was ignored until it was too late.
As we wrote in our 5/5 report entitled “Everything Is About To Change”, the business cycle has an enormous influence on the investment process, from asset allocation down to stock selection. The way that investors will make money from stock selection in this new market-regime will likely be different from what had previously worked. A market bounce is likely and should be used as an opportunity to realign portfolios for this new backdrop … one that is likely to persist throughout 2010
Time To Put On Your Summer Shorts?
Reconciling The Dearth Of Sell Ratings With A Peak In Leading Economic Indicators
As of last night, almost 70% of the stocks in the S&P 500 carried a mean-analyst buy rating according to First Call. This is as high of a number that we have seen in the post-Spitzer settlement era (2002). In fact, for Technology stocks, over 80% are rated as a buy, the highest since early-2001. Over the past month, analysts have used the market’s decline as an opportunity to add buy ratings to their coverage universe as falling prices have increased expected returns with respect to their sticky price targets. In many cases, analysts are upgrading their ratings based on attractive valuations following a strong Q1 earnings report and sharp price correction. Very few analysts have sell ratings today.
From the top-down crowd, we are seeing a similar level of bullishness from strategists. According to Bloomberg, the 13 strategists they follow have a mean target of 1270, or 18% higher from here. Indeed, from top to bottom, price targets have barely, if at all, addressed any of the macroeconomic changes that have taken place over the past month such as: 1) a peak in leading economic indicators around the world; 2) an EMU debt crisis; 3) tighter policy in China; and 4) higher unemployment to name a few.
In today’s report, we attempt to fill the void in sell-ratings that Wall Street has created with the introduction of a quantitative model designed specifically to select potential underperformers. While the market may be due for a bounce, investors should take this opportunity to reposition their “longs” with more stability in mind and begin to search for “short-candidates” using strategies specifically designed for finding underperformers. Ironically, the market almost always delivers more underperformers than outperformers in a given year, something Wall Street has forgotten. Whenever a market dislocation such as this exists, there are opportunities to profit. We hope that our short-focused model, which has selected baskets that underperform 84% of the time historically, will help investors to do just that.
