What is the best way to position a portfolio in order to generate long term excess returns?
This question has been on the minds of thousands of managers and it is at the forefront of my analysis at Logos LP. Many investors subscribe to the "value investing" school of thought forged by the late great Benjamin Graham: buying cheap stocks (i.e. usually consistent dividend paying stocks with low valuation metrics like below 15 P/E ratios) and selling when those valuations reach premium level. This can be seen with buying a company that is on a down cycle with a low P/E ratio (i.e. look at some insurance and energy stocks in today's market) and just sit back and wait until Mr. Market turns from a voting machine into a weighing machine. There is no doubt that this method has been popular and profitable for many investors, including the ever-famous Warren Buffett, who utilized this approach very early in his career. However, the real question for investors, fund managers and other institutions looking to construct a portfolio that delivers excess returns (alpha) for a long period of time is this: is there an alternative "philosophy" or measure that provides excess returns? Is there a method of investing that is perhaps better than the concept introduced by Benjamin Graham almost a century ago?
A very recent academic study shows that, simply put, quality has by and large provided the most excess returns versus traditional value investing putting truth to the old adage "it is far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price." In fact, the study shows that a quality strategy (and more specifically where the focus is on gross profitability) has more power predicting stock returns than traditional value investing. Moreover, the study shows that all quality measures have some power predicting returns, especially for small cap stocks when used in conjunction with traditional value investing strategies. Interestingly, only gross profitability has the largest Fama and French three-factor alpha of all the strategies, especially among large cap stocks.
Below is a chart (Table 1) indicating performance using 8 different investing strategies, 6 of which are focused on "quality" (with gross profitability being one of them). Book-to-price buys stocks with low book-to-price ratios. Graham's G-Score is based on Benjamin Graham's 7 quality and quantity characteristics. Grantham quality is an investing strategy that emphasizes high profitability, low earnings volatility and low leverage (as seen in white paper "The Case for Quality-The Danger of Junk"). Piotroski's F-score measures financial strength and a defensive strategy involves purchasing companies with consistent earnings, low volatility and low betas (typically consumer non-cyclical stocks). Joel Greenblatt's ROIC method invests in stocks with very high returns on invested capital and the "earnings quality" strategy has been famously used by BlackRock as a method that looks for companies that use "an accrual measure between cash and accounting earnings, scaled to firm assets".
All of the strategies generate strong alpha outside of the book-to-price ratio strategy (which is traditionally seen as a deeper value strategy), with gross profitability providing the most significant excess returns in the group. Unsurprisingly, ROIC and Grantham's quality rank second and third highest, since these are the kinds of companies that provide the most economic value added above their WACC. Regardless of the particular strategy, it seems that quality "theme", which hones on the consistency and profitability of a company, provides the best way for potential investors to seek excess returns.
By finding stocks with high gross profitability premiums (gross profits-to-assets) an investor can find the true economic profitability of a company. Many investors look for earnings or EBIT as the best proxy (and they are important measures for different reasons) but these factors have many accounting "treatments" including R&D or SG&A as expenses which can distort valuations with lower net income. Many investors like to embark on an ROE measure for predicting future returns, but historically speaking this has been a poor indicator (and in fact, ROIC is a much better indicator of expected returns as seen below).
Value + Quality = Superior Results
Looking at differences in performance to account for size, it is clear that gross profitability is by and large the best indicator of future excess returns for large cap companies. Intuitively this makes sense, as large cap companies in more mature markets will generate more value when they increase their margins and thus free cash flow leading to potentially more shareholder friendly policies, innovations or acquisitions. However, it is interesting to note that the gross profitability measure ranks second to the Graham G-score as a stand-alone strategy for small caps, which is a much more traditional "value investing" measure.
Investors seeking much higher returns over the long run must combine a value based approach with quality. Table 3 provides results from a long-only equity portfolio combining both traditional (i.e. Graham G-score) with quality (the gross profitability measure). The result for this combined strategy is astounding: the average portfolio under this strategy provides expected returns of more than 12% per year for small cap stocks while generating the second highest level of alpha. This method also generated the highest level of expected returns and alpha for large cap stocks with 9.20% and 3.68, respectively.
It is important to note that the other combined value/quality strategies are also impressive and should not be ignored as a predictor of excess returns. Whether utilizing Grantham value strategy, cheap defensive, "Magic formula" (high ROIC with low valuation) or Sloan value (combining earnings quality with low valuation), these strategies all provided portfolios with returns above the market with lower than usual volatility. Investors should also combine this with specific market opportunities (such as downward momentum or oversold territory) as this has also historically been a significant measure when predicting future stock returns, especially in the shorter term.
Potential Names for Generating Excess Returns
Considering these results, I have provided a brief list of companies that I believe may outperform the broader market using the combined "value/gross profitability" strategy. These companies have very high gross profitability, medium to high ROIC, lower forward P/E ratios versus the market while being consistent revenue growers over the last 5 years. Long term investors should take a look at these names for their portfolio for potential excess returns. As you will see, 4 of the 8 names provided are related to energy and transportation which isn't surprising since it is one of the most undervalued sectors in the current bull market. Another 3 names are within the medical supplies sector, which certainly has pockets of value and quality.
Winamark Corporation (NASDAQ: WINA):
Gross margin = 90%
Revenue Growth (5 year average) = 10.40%
ROIC = 68.47%
Kansas City Southern (NYSE: KSU):
Gross margin = 61%
Revenue Growth (5 year average) = 11.73%
ROIC = 9.83%
(Stock considered oversold; down over 20% YTD).
Old Dominion Freight Line (NASDAQ: ODFL):
Gross margin = 76%
Revenue Growth (5 year average) = 17.50%
ROIC = 18.28%
(Stock down over 12% YTD).
Shire PLC (NASDAQ: SHPG):
Gross margin = 76%
Revenue Growth (5 year average) = 14.90%
ROIC = 38.49%
Sasol (ADR) (NYSE: SSL):
Gross margin = 56%
Revenue Growth (5 year average) = 8.02%
ROIC = 16.61%
(Stock is down over 39% the past year).
DENTSPLY International Inc. (NASDAQ: XRAY)
Gross margin = 55.4%
Revenue Growth (5 year average) = 6.23%
ROIC = 9.37%
Stantec (NYSE: STN)
Gross margin = 45%
Revenue Growth (5 year average) = 10.73%
ROIC = 13.66%
(Stock is down over 9% the past year).
Baxter International (NYSE: BAX)
Gross margin = 48.6%
Revenue Growth (5 year average) = 5.82%
ROIC = 14.41%
(Stock is down over 10% YTD).
I will be monitoring these names closely with a potential entry point during any market sell-offs or panic. Get in touch with us if you have any questions about a particular name or our fund.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in KSU over the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.