Recessionary Equity Strategies: The Price Is Right

by: Marc Gerstein

When it comes to recessionary equity strategies, what could be more sensible than pursuing "value." You're buying stocks for which the bad news is likely already reflected in the stock price. You're not paying premiums for expectations that seem more likely to be dashed. The cheap prices reflect margin for error that should cushion portfolio performance in case conditions turn out worse than expected. There's just one fly in the ointment. These stocks often fail to deliver. But there's nothing wrong with value that can't be fixed by a bit of tweaking.

Longing for the S&P Stock Guide

How many readers remember the days before internet, and even before personal computing, back when trading had to be accomplished by speaking to a human broker? Instead of automated trading platforms, Yahoo Finance, and so forth, the small monthly paper-bound Standard &Poor's Stock Guide was hot stuff when it came to getting investment information. For more detail, one had to call companies and ask for financials, and beg them to send it through a faster method than third-class mail, or trek down to the local library or SEC office toting a suitcase filled with coins for the copiers.

It was easy for shares of promising companies to be under-priced, simply because many weren't getting the stories. Even professional investors missed things because it often wasn't cost-effective to look under every stock-market nook and cranny.

It was great to be a value investor back then.

More information, more work

Value investing today can still succeed. Plenty of investors have accumulated performance records that prove this. But to accomplish that, one has to work a lot harder.

Today, it would be very difficult to say a stock is bargain priced simply because The Street hasn't caught onto the story. There may, indeed, be such situations out there, but in this day and age, it's more prudent to start with the assumption that everybody knows everything and that low price metrics result from pessimistic interpretations of the universally-known facts.

So today, value investors can't just look for needles in haystacks. They need to assess the quality of the needles and satisfy themselves that their assessments are superior to those of the majority who knew all about the needles but chose to toss them away.

Specifying and testing a value strategy

Here are the components of a multi-factor value ranking system I created.

  • Earnings Yield
  • Enterprise Value/EBITDA
  • Enterprise Value/Estimated EPS
  • PEG Ratio
  • Price/Sales
  • Price/Book

Most of these equally-weighted factors are pretty standard. One oddity is the use of a manually-created earnings yield (EPS divided by price) rather than P/E. I chose this because screening databases assign NM (Note Meaningful) values to negative P/Es. I'd rather not exclude these, especially not now, when cyclical losses are likely to be more prevalent.

I backtested the approach using the advanced back-tester to create hypothetical portfolios at the start of each week between 3/31/01 and 9/13/08. All were then "held" for only four weeks. In other words, portfolio 1 ran from day 1 through day 28; portfolio 2 ran from day 8 through day 35, portfolio 3 ran from day 15 through day 42, and so forth. The results reflect the average performance of the 390 four-week portfolios thusly created.

Table 1 shows the results.

Click to enlarge

Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous blog

During up markets, value was fine. It would be premature to describe it as better than other strategies one could use. But it did, at least, beat the benchmark. Notice, though, that value was disappointing during down months. It did not provide the cushion we would have hoped to get.

Tweaking the strategy

As it turns out, it's pretty easy to enhance this approach during recessions. All we need do is restrict its application to a pre-determined sub-universe consisting only of defensive businesses; companies that seem likely to suffer less than most others when times turn tough. As described in a prior blog, these are drawn from consumer staples, healthcare and utilities (with some additional filtering applied for various industries). Table 2 shows how we fare if we limit value to the defensive group.

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Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous article

This is not a slam dunk. Rather than pronouncing value an unequivocal success, we need to make some upside-versus-downside judgments.

In down markets, defensive value was reasonable (far preferable to value as applied to the full universe), but not as much so as the defensive group in general. The only contribution value makes in down markets is invest-ability; the value lists were confined to the 20 highest rated stocks, while the defensive group in general has hundreds of stocks.

On the other hand, and contrary to stereotype, value turned out better in up months. This characteristic could be a difference-maker to an investor who wonders if recovery is closer at hand than many believe and is reluctant to forfeit too much of the upside in order to protect the downside.

The 20 stocks included in this strategy as of now are listed in Table 3.

The middle ground

Last week's flight-to-quality article showed how some strategies don't require picking the best; how the main point can be to avoid the worst of the worst. The defensive-quality strategy presented there performed just as well whether we selected top-ranked stocks or middle-ranked issues.

That theme expands when we turn to value. Table 4 shows how the strategy would have fared had we selected stocks that were mid-ranked under the value ranking system articulated above.

Click to enlarge

Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous blog

Now, the upside-downside balance looks more like what we'd expect from a recession-oriented approach. We nearly keep pace with the S&P 500 when stocks rise, but significantly outperform during bad periods. And the degree of outperformance we see for bear-market value is better than what we saw for the defensive group alone or for quality-oriented defensive stocks.

Investors who build models like these very often experience test results showing the best performance to be among middle-ranked stocks, and poor performance among the best and worst groupings. Many look at such results, grunt, and go back to the drawing board.

Actually, though, we should not always be so quick to discard such situations. To those who believe in the viability of the value style, the undesirability of the worst-ranked stocks is self-evident. And on reflection, problems among the best-ranked stocks are also logical, albeit not necessarily as severe as at the other end of the scale.

As discussed above, we often find today that stocks which seem most cheap are so for good reason, because the investment community at large looked at the companies, digested the facts, and determined that prospects are poor. We saw enough of this lately in finance, when stocks with low metrics suffered the worst of the meltdown. In this day and age, very low valuation metrics aren't so much a cue to buy as a signal to dig deeper if you haven't yet found reasons to worry.

With challenges at both ends of the value scale, it may well be that moderation, the middle ground, has much to offer; price tags that are not so high as to be out of proportion to fundamentals, but not so low as to signal trouble ahead.

This doesn't mean looking for mid-ranked stocks in isolation. While the second line of Table 4 suggests such an approach wouldn't be a disaster, it also leaves considerable room for improvement. what we've done here is apply the mid-ranked value strategy to a pre-selected and additionally-filtered defensive-stock list.

Table 5 shows the 20 stocks that presently make the grade in the mid-ranked defensive value approach.

The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.