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Migration Patterns in Company Profitability

ROE's Tend to be Pretty Stable

ROE’s Tend to be Pretty Stable

Firm profitability is a characteristic highly sought out by investors in private market transactions.  In public markets firm profitability tends to be frequently lumped together among “quality” factors.

Over the years I have always thought that “quality” is very much in the eye of the beholder while profitability as a concept can be measured in an unambiguous manner and stand on its own feet.

That is why in our stock selection and top-down sector and country allocation models we treat profitability as a separate conceptual category.

After all what more powerful combination can one have for long-term value creation than a company that is growing and doing so in a profitable way.  Some of the best known stocks in the world such as Apple and Google are living proof that a combination of growth and profitability is highly rewarding for long-term investors.

While market-wide ROE’s tend to be pretty stable across time we would expect some variability caused by the business cycle, the degree of leverage in the system, changes in the cost of money and tax rates among others.  The above chart shows the year-to-year median ROE along with points along the 3rd and 1st quartiles.  The average calendar year ROE in our global sample is 11.2 with a standard deviation of 2.1.

The conventional wisdom holds that in a competitive economy it is virtually impossible to remain a highly profitable company over the long-term.

In the case of a frictionless free market system, companies should all gravitate long-term to an economy-wide level of profitability.  The idea is that companies that are currently below a normal level of profitability will restructure and/or change their business strategy thus hopefully improving profitability.  Conversely, companies with above average levels of profitability will face increased competitive forces and revert back over time to a normal level of profitability.

In a free market open economy company profitability will exhibit a mean reverting pattern.  That is in theory. In the real world of partially competitive markets we would still expect to see mean reverting levels of profitability but with a lot more noise. We would also expect to see stronger mean reverting patterns over longer holding periods while in the short-term we would expect to see minimal competitive re-alignment.

In this note we present some high level findings on how Return on Equity (ROE), a common measure of firm profitability, evolves over time. ROE is calculated as Net Income / Shareholder Equity. For some background on what motivated our interest in profitability factors please take a look at a recent video Eric J. Weigel – The Manual of Ideas Interview available on YouTube.

What does the data show in terms of how companies migrate between profitability stages?

ROE MIGRATION MATRIX

Note: Decile 1 contains the highest ROE stocks in our balanced panel global equity sample

Some high level conclusions:

  • ROEs do not fluctuate that much over time and there is a high persistence in relative universe profitability rankings. We call this the “status quo” effect
    • Mean reversion in ROE (estimated over a five year window) is best found in the middle portion (Deciles 4-6) of the profitability spectrum
  • The highest ROE stocks tend to, over the subsequent five years, remain in the higher portions of our sample profitability at a greater rate than expected.
    • Buying a high ROE stock and five years down the road ending up with a company in the bottom end of profitability occurs with a frequency less than expected by pure chance
    • Deciles 2 and 3 appear to be the place for finding companies with high sustainable levels of relative profitability
  • The greatest rate of improvement in relative profitability rankings occurs in Decile 10 comprising those companies with the lowest ROEs, but the rate of improvement fails to beat expectations. Going long Decile 10 stocks is fraught with significant risk of disappointment
  • A contrarian investor investing in low relative ROE stocks such as those in Deciles 7-9 is taking a bet with unfavorable odds of success. The improvement rate of these ROE laggards tends to fall below expectations

As a final note, our view is that stock picking is a multi-dimensional endeavor balancing among others valuation, profitability, and growth concepts.  The behavior of any one factor should always be viewed in the context of the current capital market environment.  Our current view on the attractiveness of stock factors augurs well for favorable returns to stocks with high sustainable levels of company profitability.

To read the full report please click here Migration Patterns In Company Profitability

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Is it Really All About Oil?

oil&stocks levels

A large number of stories in the financial press this year have revolved around the relationship between equity prices and oil.  In fact some commentators have focused on a recovering oil price as the key lynchpin for rising equity prices.

As an example, the Wall Street Journal published an article this year “Oil, Stocks at Tightest Correlation in 26 Years”. Many other publications and strategists have written pieces this year noting the close relationship between oil prices and equity index performance.

The human mind is conditioned to look for patterns and in the tumult of early 2016 the oil market meltdown started playing a leading role in explanations of why global equity markets were under stress.  But as any econometrics professor will say “correlation is not causation“.

In this note we look at the sensitivity of asset class returns to changes in the price of oil.  We take a risk management perspective and find that while oil price sensitivity is significant when analyzing one-on-one relationships, the effect is close to zero and statistically insignificant in a multivariate context.

Eq Beta to OilWhat you see is not always what you get.  We conclude that rising oil prices have little long-term significance for broad equity market prospects and that a rising oil price is more of a reflection of supply curtailment efforts.

 

The key lesson to us from our analysis is that commonly heard explanations for asset return drivers are often incomplete and in some cases highly misleading.

Every market environment has its own context and no single factor in isolation will ever be able to fully explain the complexities of market behavior.  Even in hindsight it is often hard to pin down a story that holds up to serious scrutiny.

Best to stay humble and realize that over shorter time periods capital markets will always be subject to a lot of noise of no material significance to long-term investors.

Click here to download the report: Is It All About Oil

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

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Looking for a Second Income? Take a Look at Dividend Stocks.

newspaper-job-section-1427231-639x372How about adding dividend stocks to your portfolio to complete the job that bonds can’t at the moment?

For some ideas regarding the difference between high yield stocks and dividend growth equities take a look at our latest white paper – Click here to download the report: “Equity Income For the Yield Starved Investor

Some of our report conclusions:

►High Dividend Yield stocks tend to be inexpensive but lacking in growth and historically have been members of distressed categories

►High Dividend Growth stocks are only slightly more expensive than their lower growth peers but exhibit much higher rates of prospective earnings growth as well as superior profitability

►Our overall conclusion is that High Dividend Growth stocks are not materially over-valued versus lower growth companies and that there is an adequate margin of safety to fund dividends out of earnings growth

►We strongly suggest employing dividend growth strategies as the preferred way to implement income generation programs

►We also believe that significant dividend growth opportunities exist outside of the major equity markets so a global perspective is recommended

►Finally, priority should be given to the analysis of company fundamentals in terms of their ability to increase dividends in a financially responsible manner while also allowing the investor a margin of principal (price) protection

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

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A Marriage of Necessity but with Benefits

1000785262One of the key underpinnings of modern-day investing is the concept of diversification.  Adding assets to a portfolio will almost universally lower the overall volatility of a portfolio assuming that the correlation between the investment in question and the portfolio is lower than one.  As the correlation falls the greater the drop in the volatility of the portfolio, i.e. the greater the diversification benefit.

Investors often fret about the lack of diversification opportunities in capital markets.  The sentiment is especially pronounced during equity market selloffs such as what we have experienced this year.

Investors have been often discouraged by the high correlations observed among investments in the same asset class.  For example, the early day (70’s and 80’s) arguments for increasing exposure to international equities hinged on the portfolio diversification benefits accruing from the low correlation between US and international stocks.

Sometimes expectations need to be re-adjusted. Unfortunately, as US investors increased their exposure to international investments and both US and foreign domiciled companies became more globally integrated the net result was a significant upward drift in correlations and a loss of diversification benefit.

The same story can be told about emerging market and even domestic small-cap investing.  Investors looking for significant divergent behavior among equity sub-asset classes have been generally disappointed.  Our latest estimates of the correlations of the S&P 500 to US Small Caps, International Stocks and Emerging Market Equity are all north of 0.7.

CORR TO US STOCKSThe long-term performance of these equity sub-asset classes will naturally gravitate towards their fundamental value, but over shorter holding periods the pull of the broad equity market factor will be unmistakable.  Style, market cap and sector membership are secondary to what happens to the broad equity market.  The market effect dominates.

The same applies within other asset classes.  For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds.  Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

So where does that leave investors looking for a little zig when their portfolio zags? The answer is so simply and obvious but the message is often ignored.  Bonds, bonds and more bonds.  In recent times investors have shown a strong dislike for fixed income especially in light of the low prevailing interest rates.The same applies within other asset classes.  For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds.  Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

From a prospective return perspective we agree, but, in our opinion, investors are forgetting about the diversification benefits of bonds.  Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets.

Our current estimates of the correlation of US stocks to high quality domestic and developed international debt markets are south of -0.3. Ok, correlations have been lower in the past, but they have also been higher. In fact the average correlation of US stocks and bonds over annual holding periods is indistinguishable from zero.

ROLL CORR STOCKS BONDS

Is it a free lunch?  No, not given the low interest rates on bonds today, but compared to the costs of using other forms of portfolio protection plain old bonds seem to offer the lowest opportunity cost with the lowest execution risk. The way we look at it is that the below normal yields are the premium you must pay to protect your portfolio.

Let’s look at a simple case using a portfolio composed 60% of the S&P 500 and 40% of the Barclays Aggregate. We are assuming that stocks have a volatility of 16% and bonds of 6% (these are currently our long-term normalized estimates).

The benefits depend on the volatility of stocks and bonds as well as their degree of co-movement. Historically, the correlation between stocks and bonds in the US has been about zero.  Under such a scenario, the 60/40 portfolio would have a volatility of 9.9%.

60 40 VOL

There have been long periods of time, however, when the correlation has actually been positive. Stocks and bonds moving in the same direction either up or down.  Let’s assume a modest correlation of 0.2. Under such a scenario the diversification benefits still accrue but at a lower rate.  The 60/40 mix now exhibits a volatility of 10.4%.

What happens when the correlation between US stocks and bonds is actually negative?  The simple answer is that the diversification benefits are significantly enhanced.  Let’s assume a correlation of -0.2.  This estimate is in line with our current estimate from our proprietary multi-asset class model.  Now the 60/40 portfolio has a volatility of 9.4%, a full point lower than the earlier case.

Why stop there? Let’s push the envelope and assume a stock/bond correlation of -0.6.  Quite dramatic for sure but not out-of-bounds from previous capital market experience.  Now the benefits are further enhanced with the portfolio exhibiting a volatility of 8.4%

The role of bonds should be seen from the perspective of the total package of benefits. Historically, the role of fixed income has been income generation, but in today’s environment investors should focus as well on the diversification benefits created by mixing bonds with equity-like assets.

Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets. Incorporating bonds into the mix will be especially important in risk on/off markets such as those we expect to prevail over the next few years.

Let us hope that the marriage between stocks and bonds which at times has been a bit awkward remains beneficial as we transition into a low capital market return environment.

Sincerely,

Eric J. Weigel

eweigel@gf-cap.com

Managing Partner and Founder of Global Focus Capital LLC

 

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

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