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What’s Working, What’s Not
• Key Debate: It has been a strange year. Arguably, we are in the midst of a bull market. Yet, high beta has
underperformed low beta and the market seems to be focused on high quality (measured by ROE). What else has been
working? Is this different from the past and how should portfolios respond?
• Our Approach: We address these questions and more with our new product focused on assessing what factors or
styles are working and which ones are not. We have reviewed the performance of 16 most actively used styles and
back-tested their ability to pick stocks (both winners and losers) in a portfolio context. We calculate factor (investment
style) returns as follows: At the end of each month, we sort the stocks in our universe on their current exposure to the
given style (for P/E, we sort stocks on P/E as at the end of the month). We then form a portfolio of stocks using the top
and bottom quintile and calculate the median returns for each basket going 12 months forward. We accumulate these
returns for each month by re-sorting at the end of each month, going back to 1993.
• This methodology allows us to test the efficacy of a given style in picking both good and bad stocks. Our 16 factors
include factors from three categories: Fundamentals (quality and growth), valuations and market dynamics (like price
momentum, ownership and beta).
• Conclusions: Over the long run, not surprisingly, the market focuses on a combination of quality, growth and cheap
valuations. Stocks with these characteristics do well over market cycles. The factors that do not work well in picking
stocks include consensus ratings, institutional ownership levels and beta. The market message is mixed on certain
growth and quality metrics such as free cash flows and ROE delta but it surely likes companies with disciplined capex.
There is surprising bias for past winners in future winners – implying stocks that have been doing well appear to be
continuing to do well.
• Whilst these conclusions hold true over the long run, the short run styles have been a bit different. Valuations and quality
continue to be important. Over the past 12 months, the market has been seeking stocks with a bullish consensus but
rejecting high-growth stocks and the winners of 2009.
Over the long run, long-only portfolio managers should be
picking stocks for their portfolios on the basis on strong
growth, high quality and low valuations. Price momentum is
also a key winning style – i.e., past winners seem to
continue to deliver returns. What doesn’t work includes the
consensus view, institutional ownership, and beta. The
market is also not a fan of too much change in ROE and
one-month trailing price momentum. Then again, low capex
is a favored “quality” metric over free cash flow. The market
does not like companies paying too much dividend – maybe
signaling that it prefers companies to plough back cash for
growth. The key valuation metric that works over time is P/B
and top-line growth is more important than EPS growth
Some of these factors have not worked over the past 12
months, notably revenue growth, while the consensus view
has assumed more importance.
Over the long run, hedge fund portfolio managers need not
look at factors different from what long only managers need
to look at. The difference is what works better when
“shorting” stocks. There it seems a bullish consensus, too
much short term change in ROE, low dividend yield and low
free cash flow are clearly winning styles.
Indeed, the results over the past 12 months have been a bit
different. For sure, price momentum has been a big loser
along with low free cash flow, low dividend yield and high
beta. However, low valuations and low capex continue to be
star performers for hedged portfolios.
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