Migration Patterns in Company Profitability

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 3^rd and 1^st 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?

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 https://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

Low Volatility – One Factor or Several?

Once a month in our Equity Observer publication we share our analysis of what stock selection factors are working. This year the best performing factor in our global sample is “low volatility”.

The issue of what constitutes a factor will be endlessly debated, but while “low vol” does not quite rank up there among academics with the original Fama-French-Carhart variables (market, size, value, momentum) there is nevertheless a growing investor demand for lower volatility strategies.

The growing demand for “low vol” strategies does not seem entirely driven by the performance of these strategies relative to core benchmarks. For example over the 2015-2013 period the S&P Low Volatility Index under-performed the S&P 500 core index by 3.4% annualized. Yet demand for these strategies appears to have grown as manifested by the large number of new ETF’s launches in this space.

Investors seem particularly interested in the capital preservation characteristics of “low vol” strategies and appear willing to sacrifice returns during the good times in return for less pronounced equity market downdrafts.

Low volatility strategies seem here to stay. Given their market beating returns thus far in 2016 it is reasonable to expect growing interest. We therefore analyze our global sample of 13,000 stocks to ascertain the basic characteristics of low volatility stocks.

Stocks in the lowest volatility decile have an average return volatility of 20%

Higher volatility stocks exhibit low levels of market sensitivity (beta)

During periods of equity market stress ‘low vol” strategies should out-perform broad market indices

The lowest volatility decile enjoys the highest current yields while the “high vol” names in Decile 10 barely register for income

Lower volatility stocks have lost their historical valuation advantages. The growing demand for ‘low vol” and its close cousin dividend income have eroded the typically lower valuations seen in lower volatility sectors and stocks.

Even after adjusting for sector and region/country effects we observe a strong monotonic relationship in YTD returns across volatility deciles.

The lowest volatility stocks (Decile 1) have had the highest 2016 returns while the highest volatility stocks have shown the greatest losses.

Our general conclusion is that “low volatility” strategies play a useful role for investors looking to provide short-term downward protection in their equity portfolios. However, we think of “low vol” as part of a package of stock attributes designed to lessen market exposure during periods of equity market stress. These strategies along with lower betas, higher yields and exposure to more stable sectors should exhibit lower levels of downside capture.

Investors worried about equity market downturns should not view these strategies as a substitute for properly assessing and managing the risk of their overall portfolios.

Click here to download the report: Low Volatility – One Factor or Several?

Sincerely,

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

eweigel@gf-cap.com

Less Bunny, More of a Rocky Balboa Market!

Rocky Balboa View

The start of the year felt like a Rocky Balboa fight. Risky assets were absolutely pummeled during the first 6 weeks of the year and were down for the count.

Most investors were taken by surprise by the strength of the first punch and the retail section started emptying out early. White towels were being thrown about but out of nowhere equity markets started gathering strength.

Just like a fighter on the ropes biding time equity markets started little by little chipping away. By the end of February stocks had stabilized and the first real signs of a competitive fight emerged during the first week of March. The point count had evened out and by the end of the month the count had swung around in many categories. At the end of Q1 world equity markets were essentially flat but there were surprises galore.

The biggest surprise by far this year has been the re-emergence of Emerging Market Equities. The asset class had been left for dead after many years of disappointing returns, but this year the asset class is punching above its weight – already up 4.4% (MSCI EM).

Q1 2016

EM equities have vastly out-performed developed markets especially those in Asia and Europe. A 9% gap has developed between developed and emerging international stocks (MSCI EAFE).

Despite the poor showing of the average Chinese stock how is it possible that EM equities as a whole are up for the year? No doubt investors are somewhat stunned by the YTD eye-popping returns to resource-oriented markets such as Brazil and Russia.

In our sample of global equities the average Brazilian stock is up over 24% while the average Russian equity is up about 16%. South Africa, another major EM market, punches in at an average stock return of close to 14%. Other emerging markets with average YTD returns exceeding 10% include Indonesia, Turkey, Chile and Malaysia.

Commodity markets have no doubt recovered, but is the strong performance of EM simply due to a recovering commodity market?

Precious metals have done very well this year with gold up 15% and silver up 9%. While $20 oil is still mentioned from time to time, energy markets have had a tenuous recovery but still show losses close to 10% for the year. Smaller components of commodity indices such as grains, livestock and industrial metals are all only slightly above water this year. Our conclusion is that there is more to the re-emergence of EM equity markets than simply a direct benefit from recovering commodity markets.

While broad based equity indices have gyrated at times like a punch drunk Rocky Balboa behind the scenes we have been witnessing a strong rotation toward out of favor sectors such as Energy, Materials, Utilities and Telecom. Momentum sectors of the past few years such as Health Care and Technology have receded.

The country and sector performance numbers indicate to us that global investors have been quietly changing their stripes. Glamour sectors and equity markets with the best post-Financial Crisis performance are being re-priced.

Part of this shift toward more value-sensitive sectors and regions may be driven by a desire to better protect the downside and capture yield in what most strategists would agree is a low capital market return environment.

We perceive that investors are changing their stripes. Valuation levels are being more carefully examined. Investors are also showing a desire for lower risk both from a return as well as financial statement perspective. Momentum strategies have lost their punch as have sell-side analyst recommendations.

Many of the characteristics typically associated with larger capitalization companies such as lower volatility, higher yields, stock buybacks and higher levels of profitability seem to be gaining favor among global equity investors.

We see global markets being more similar to Rocky Balboa – at times exhausted and bloodied but despite great hardships triumphant in the end. For the foreseeable future we see ourselves living in a risk on/off world with investor preferences increasingly tilted toward capital preservation strategies.

Click here to download the report: Less Bunny, More of a Rocky Balboa Market

Sincerely,

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

eweigel@gf-cap.com

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