Dogs Of The Market: How To Earn Excess Returns Without Taking On Excess Risk

by: Mike the PhD

How You Can Use Correlations within Industry, and the Size Factor, to Generate Alpha.

Note: While this is a stand-alone article, some readers may benefit from reading my recently published article about the size factor, which serves as the basis for the strategy described in this article. To read that article, visit my profile.

These days there has been a lot of talk among investors about companies that are "too big to fail," and the moral hazard this creates. What is less well known, and less talked about, is how many large companies are too big to win against their smaller peers, and the resulting underperformance of these big firms. In fact, there is substantial financial research showing that the stock's of large companies significantly underperform the stock's of small companies (see my recent article on this).

One way for investors to capitalize on this out performance by small companies is to buy their stocks. Yet in doing that, the investor is exposed to company specific risks if they buy only a few small firms. The obvious solution is to buy a larger basket of multiple firms, but again, the investor is still exposed to risks in the market or the industry in which they have invested. To truly, capture the benefits of investing in small firms while limiting idiosyncratic (firm-specific) risk or market risk, the investor needs to take a long-short position.

Specifically, in this article, I outline the returns to a strategy that involves shorting the largest stock in each of 10 major market sectors, while going long the rest of the sector. This simple strategy, which does not require size quintile sorting, or any firm specific analysis leads to large average market returns with little investment by the investor. These returns are persistent over time, and are just as strong (statistically equal) over 10 years as they are over one year. Further, this strategy is easy to do because of the proliferation of ETFs, and the fact that investors shorting a stock generally are not usually required to hold the full amount of cash required to cover their short position. (Note: Brokerages have different requirements surrounding shorting, check with yours before implementing this strategy or any other using short positions.)

So how big are the returns to shorting a sector's largest firm, and going long the rest of the sector? Well that depends on how much cash you have to hold against a short position, but if you are required to hold 100% of the cash needed to cover a short, the average annual return to this strategy over the last 50+ years is about 4% annually. However, this 4% carries very little risk, and in some industries the returns are 7% plus, again with very little risk.

Based on data for U.S. stocks from 1960-2011 for 10 major industries, the returns, are shown in the chart below. This chart shows the returns to shorting the largest stock by market capitalization on January 2nd of each year, and then going long the rest of the sector and holding the position for the year. The top row shows the average return for the trade for all 10 sectors, and then a couple of rows showing that this performance is statistically significant and positive. The next 10 rows then show the performance for doing the trade for each of the ten sectors. The way to interpret this chart is this is how much the return would be if you were required to hold cash to cover the short position rather than being able to use equity in your long positions as the cover for the short. Assuming a broker allowed you to use the equity to cover the short position, the returns would be much higher.

Return From Shorting Largest Stock and Going Long Sector

Sector

1 Yr

3 Yrs

5 Yrs

10 Yrs

Avg. All Sectors

3.88%

4.11%

3.79%

3.66%

Std. Dev

2.90%

3.30%

2.70%

2.10%

T-statistic

5.03

4.68

5.14

6.02

Non-Durables

1.10%

1.70%

1.60%

2.70%

Durables

6.80%

7.70%

6.70%

6.10%

Manufacturing

4.70%

4.50%

3.80%

4.40%

Energy

0.20%

0.10%

0.20%

0.30%

Chemicals

3.20%

2.30%

2.30%

2.70%

Business Equipment

4.20%

3.80%

3.90%

3.70%

Telecom

7.40%

9.00%

6.90%

6.60%

Utilities

5.00%

4.50%

3.80%

3.90%

Health Care

3.60%

3.40%

3.10%

1.50%

Finance

3.00%

4.30%

6.00%

5.30%

Click to enlarge

This type of long-short position is attractive because it hedges out most of your market risk, and if it is done over all ten sectors, it hedges out most of the firm specific risk for the largest stocks in each sector. This is especially true when correlations among different sectors are low. The second chart below shows the odds of the trade making money when held for 1 year, 3, years, 5 years, and 10 years.

Chances of Trade Making Money

Sector

1 Yr

3 Yrs

5 Yrs

10 Yrs

Avg. All Sectors

67%

74%

76%

81%

Std. Dev

6.60%

8.90%

10.90%

14.20%

T-statistic

4.14

4.54

4.16

3.98

Non-Durables

68.0%

65.0%

60.0%

77.0%

Durables

68.0%

79.0%

87.0%

96.0%

Manufacturing

65.0%

74.0%

72.0%

83.0%

Energy

58.0%

57.0%

58.0%

61.0%

Chemicals

57.0%

69.0%

72.0%

77.0%

Business Equipment

63.0%

74.0%

74.0%

79.0%

Telecom

75.0%

84.0%

87.0%

98.0%

Utilities

78.0%

82.0%

90.0%

94.0%

Health Care

67.0%

79.0%

78.0%

61.0%

Finance

73.0%

77.0%

78.0%

88.0%

Click to enlarge

As the chart illustrates, the trade will generally make money especially if the trade is held for several years. However, even in years when the trade does not make money, the losses are small relative to the gains (mean return of -0.9% in years when the trade loses money).

In a future article, I will profile similar trading strategies based on another of the four factors that predict long-term stock returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.