Reward, without the risk

In theory: The holy grail Contrary to conventional notions of risk and reward, buying shares in safe companies really does improve returns. That’s the message from a research note published last year by Morgan Stanley. It published an alluring chart, which depicts what goes on over a stockmarket cycle (click on it for a larger version): The story is familiar to practicing investors. At stockmarket extremes, psychology drives the market and overconfidence or lack of confidence pushes prices to highs and lows. In between the peaks and troughs the performance of companies, and their valuations matter more. The percentages are just opinion, but the investment styles that do best in different phases of the market are fact, at least judging by the last stockmarket cycle. Morgan Stanley demonstrated that cheap shares do best in the early and middle stages of bull markets. Growth and momentum are most important at bull market peaks and a fourth factor, the strength of company balance sheets, is critical for performance in bear markets: Click on the table for a larger version. To make a killing, all you’d have to do is consistently identify which phase of the market you are in. If that were possible you could adapt your strategy, and the investment ratios you use. In the early stages of a bull market you’d buy shares with low prices compared to their book values, annual sales, or profits. As the bull market peaked you’d gradually switch to momentum, buying shares that have recently gone up in price, and growth, companies which are expected to grow their profits impressively. In a bear market you’d switch to owning companies with low debt. You’d be the perfect herd-anticipator and by deftly switching from one style to another you’d avoid being trampled when the herd changed direction. While this is the kind of game investment banks might play, I don’t think such deftness is possible. Although we know whether the market is cheap or expensive, who can say with any precision when the inevitable correction will come? When investors will lose their confidence, or regain it. The Morgan Stanley team came to another conclusion, though, that is much more useful. Looking at returns since 1990, financially strong companies do better than the market average over whole cycles. Since weak companies are surely more risky, this flies in the face of the convention that to get more reward an investor must take more risk. One of Morgan Stanley’s measures will be familiar to readers of this blog. It’s Piotroski’s F_Score. The other is Altman’s Z-score. These calculations determine financial health. Generally speaking companies that score poorly for profitability, productivity, debt and working capital are more likely to fail. Companies in the opposite situation are more likely to succeed. Morgan Stanley found that companies with a Z-Score of one or less did 4% a year worse than the stock market average between 1990 and 2008, which is good reason to avoid them. Companies with F_Scores of seven or more out of nine did 2.5% per year better, which is good reason to consider them. The bank has subsequently reported even more impressive results for the Z-score because we’ve just experienced a major bear market, when balance sheet strength is the critical factor. At such times, companies with low Z-scores do up to 15% worse than the market average. Totting up the influence of Morgan Stanley’s factors at the bottom of the table (The Top ten factors...) is an interesting, though admittedly unscientific exercise. Five of the top ten factors in early-stage and four of the top ten in mid-stage bull markets are value factors but buying cheap shares leads to negative returns at the peak of bull markets and in bear markets. Over the cycle, value scores six, growth scores two, and balance sheet (safety) factors score seven. I can see why cheap shares might do badly in bear markets. At the peak of a bull market shares are generally expensive. Most shares left on low valuations will be the really smelly ones that not even exuberant investors touch. They’re not really good value, they’re cheap because of the palpable probability they’ll go bust. They're loaded up with debt and business is going nowhere. They’re cheap and nasty. They're the Woolworths of this world. They’d have deteriorating balance sheets. A strategy that combined value and safety, apparently the major factors that drive returns, ought to do very well in the long-term. Piotroski established that, the Morgan Stanley team demonstrated it in another report published in April, and I’m trying to achieve it with the Thrifty 30. In practice: Predicting the market Currently shares cost about fourteen times average earnings (profits) over the last ten years. They’re not particularly cheap, or expensive. If you put my arm behind my back and thrust it so far it was about to pop out of my shoulder socket I’d probably squeal that we’re in a kind of mid-stage bull market. However, I’m haunted by the same doubts haunting many an investor, that this year’s remarkable rises are a reprieve, and the long-term trend is down. Regardless of the state of the market, and probably because I don’t think you can say much about the future with certainty, my policy is to buy when there is the opportunity to do so. Currently there there are plenty of cheap companies with good finances, candidates for the Thrifty 30 model portfolio: As usual the data used to calculate this table comes from the Sharelockholmes.com database. The companies near the top of the list are generally cheapest, strongest and most liquid but all of the companies are, subject to checking the data and confirming the investment case, candidates for the Thrifty 30. Some (marked T30) are already in it. 10yPE
It’s easy to get carried away by a company’s prospects and pay too much for a share, reducing the return. The Price earnings ratio compares the price of shares to the profits (earnings) of the company. In theory, because profits belong to shareholders and will be returned to them as dividends or invested in their company to produce more profit in future, the more profit for every pound invested, the better the investment. Since a single year of profit may not be representative of a typical year, because companies have good years and bad years, I use the average of the past ten years of earnings to calculate the 10 year PE. Academic research indicates it’s a better measure of value and by restricting the Thrifty 30 to companies with 10 year PE ratios of less than 20, I’m protecting it from the most expensive shares in the stockmarket. 10yCF
Just as the PE ratio compares the share price to accounting profit, the Price to cash flow ratio compares the share price to cash profit. I’m including it as an experiment. Some investors and analysts think cash flow is more trustworthy measure because accounting profit is more easily manipulated. While that’s true in one particular year, because accountants can shift profit from one year to another to make bad years look better, in the long-run it shouldn’t make much difference. Nevertheless, I might be suspicious of a company that had a considerably higher price to ten-year cash flow ratio than its ten-year PE. FS
Piotroski’s F_Score is a measure of financial strength, like a credit score. It rates companies highly if they are profitable, profitability is improving, they are paying off debt, consuming less cash as they operate and relying on their own profits to fund their business. Needless to say, unprofitable companies raising funds from creditors or shareholders score less well. Statistically companies with low F_Scores are more likely to go bust, and earn investors lower returns. By restricting the Thrifty 30 to companies with F_Scores of five or more out of nine, I’m protecting the Thrifty 30 from the weakest companies in the stockmarket. GG
Graham Gearing is a blunter measure of financial strength. It compares what the company owns (its total assets) to what it owes (its liabilities – bank debt, pension liabilities and so on). I named it after Benjamin Graham, who invented the measure. Graham thought companies that owned more than twice what they owed (total liabilities are less than half of total assets) were financially strong. NMS(£)
Market makers only commit to supply a certain number of shares at the price quoted by the stock exchange. That number is the Normal Market Size. Traders wishing to buy or sell in greater quantities may have to pay more, or sell for less. They may not even be able to trade at all. NMS is a measure of liquidity, or how readily a share can be traded. The more liquid it a share is, the better.