Cigar Butts With Little Puffs - Low EV/EBIT Large Cap Strategy, Q1 Update

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Includes: AAL, ALK, ANTM, BBBY, BBY, CX, DAL, ERIC, FCAU, GILD, GPS, GT, HLF, HPQ, HUM, JBLU, KORS, LEA, LUV, MGA, RIG, SHI, SPLS, SPR, TRN, TX, UAL, UTHR, VVV, WCG
by: Ryan Telford

Summary

The buy and hold strategy of finding stocks trading at low EV/EBIT multiples has been shown to outperform over time.

The calendar year of 2016 was an average year for the strategy, matching the benchmark’s performance, however Jan 20 2016 to Feb 20 2017 performed particularly well.

The large cap version of this strategy is off to a slow start in Q1 of 2017.

Of the strategies I cover on SA, Large cap strategies have outperformed their large/mid cap counterparts this quarter.

(Credit: Pinterest.com)

Buying stocks with low enterprise value to earnings before interest and taxes, or EV/EBIT, as part of a portfolio has proven to outperform the market over time. Low EV/EBIT investing is a value strategy, and while similar to concept to low P/E ratio, the EV/EBIT ratio is arguably more refined and tells an investor more about the firm and stock. For a complete analysis of the low EV/EBIT strategy please read here.

Low EV/EBIT stocks tend to be Buffett's "cigar butts", potentially ugly and unattractive as businesses. Perhaps their industry has been hit hard due for a variety of reasons such as new government regulations, a commodity businesses in a down cycle, the business has been a steady underperformer, or there is some type of scandal that the business cannot seem to shake. Whatever the reasons, low EV/EBIT stocks typically fit this mold. The low EV/EBIT strategy finds these firms, but also attempts to get them while they are low and positioned for an improvement. Many of the stocks mentioned above do not remain beaten down forever and often eventually increase in price, or they attract the attention of activist investors or are takeout targets for larger firms.

The strategy calls for holding these stocks for one year; the concept being that within the one year period some of these firms will recover and offer the investor an increase in value. After one year, the portfolio is rebalanced with new stocks passing the screen, and those that do not are sold.

In this article, we will look at the performance of the Large Cap version of the strategy in Q1 of 2017. I covered performance for the Large & Mid-Cap strategy during Q1 recently, please read here.

2016

From 1999 to 2015, the large cap and large/mid cap strategies have provided average returns of 20.3 and 20.9% per year, respectively (arithmetic average). The benchmarks, Russell1000TR and Russell3000TR respectively, have returned 6.6% and 6.8% annually, respectively. Other statistics such as maximum drawdown, Sharpe & Sortino ratios are listed in the strategy profile article.

For the large cap strategy, buying stocks on 01 Jan 2016 and holding for the calendar year resulted in a decent return of 14.86%, however it only managed to beat the benchmark's performance (14.71%) by a marginal amount. If an investor managed to buy in later January 2016 and held for a year, results were considerably different at 30.57% and 23.74% for the strategy and benchmark respectively. The large/mid cap version of the strategy did exceptionally well during the latter period.

The graph below shows the historical 5 year CAGR over rolling 5 year periods from 1999 to 2015 for this strategy.

(Source: Portfolio123.com data and Author graph)

As was discussed in the Large & Mid Cap quarterly review, most quantitative investing strategies go through periods of both outperformance and underperformance. As can be seen in the above graph, 5 year CAGRs tend to drop off after an exceptional period of outperformance. For the large cap strategy, after an excellent period ending in 2004, return above the benchmark eventually dropped to zero in about mid 2006, returning to a peak of outperformance at the end of 2009, again followed by a gradual decrease in performance to a low at the end of 2012. No surprise, this was again followed by a spike in outperformance the following year. Performance since the end of 2013 has steadily been dropping again, to trailing the benchmark by 5% at the end of 2015.

Let's take a look at how the strategy performed over Q1.

Q1 2017

The graph below plots the performance of the large cap version of the strategy against the Russell 1000TR benchmark over the quarter.

(Source: Portfolio123.com data & Author graph)

January started off as a great year for the strategy, but then began to trail off during the second half of the quarter.

During the first month of the year the strategy managed to match or show brief periods of outperforming the Russell 3000TR, however the later two months of the quarter showed a marked decline. The strategy achieved a positive return of 2.88% over the period, however still trailed the Russell 1000TR's 5.14%.

As can be seen from the graph above, drawdown was also higher with the LC EV/EBIT strategy at 4.89%, compared to the benchmark's 2.25%.

Holdings

The table below lists the 30 stocks passing the strategy's screen on 01 Jan, and their respective performance over the quarter.

Ticker

Name

Price per share 01 Jan 2017 ($)

Price per share 31 Mar 2017 ($)

% Change

Market Cap ($M)

Industry

FCAU

Fiat Chrysler Automobiles NV

9.55

10.93

14.45

11,756

Automobile Manufacturers

UTHR

United Therapeutics Corp

143.99

135.38

-5.98

6,119

Biotechnology

WCG

WellCare Health Plans Inc

136.9

140.21

2.42

6,072

Managed Health Care

DAL

Delta Air Lines Inc

49.28

45.96

-6.75

36,223

Airlines

GILD

Gilead Sciences Inc

73.59

67.92

-7.71

94,668

Biotechnology

JBLU

JetBlue Airways Corp

22.39

20.61

-7.95

7,258

Airlines

UAL

United Continental Holdings Inc

72.71

70.64

-2.85

23,169

Airlines

BBBY

Bed Bath & Beyond Inc.

40.78

39.46

-3.24

6,109

Homefurnishing Retail

TX

Ternium SA

24.47

26.12

6.74

4,741

Steel

AAL

American Airlines Group Inc

46.2

42.3

-8.44

24,240

Airlines

ANTM

Anthem Inc

142.68

165.38

15.91

37,868

Managed Health Care

GPS

Gap Inc

23.26

24.06

3.45

8,954

Apparel Retail

SHI

Sinopec Shanghai Petrochemical Co Ltd

54.06

55.76

3.14

5,846

Commodity Chemicals

SPLS

Staples Inc.

8.77

8.77

0.04

5,887

Specialty Stores

RIG

Transocean Ltd

15.33

12.45

-18.79

5,387

Oil & Gas Drilling

LEA

Lear Corp

132.45

141.58

6.89

9,295

Auto Parts & Equipment

KORS

Michael Kors Holdings Ltd

43.08

38.11

-11.54

7,059

Apparel, Accessories & Luxury Goods

ALK

Alaska Air Group Inc.

87.73

92.22

5.12

10,937

Airlines

ERIC

Ericsson

5.68

6.64

16.87

19,036

Communications Equipment

BBY

Best Buy Co Inc

42.44

49.15

15.8

13,356

Computer & Electronics Retail

VVV

Valvoline Inc

21.44

24.55

14.49

4,408

Commodity Chemicals

CX

Cemex SAB de CV

7.9

9.07

14.81

11,247

Construction Materials

HPQ

HP Inc

14.74

17.88

21.33

25,407

Technology Hardware, Storage & Peripherals

LUV

Southwest Airlines Co.

49.89

53.76

7.75

30,681

Airlines

GT

Goodyear Tire & Rubber Co

31.09

36

15.79

8,059

Tires & Rubber

MGA

Magna International Inc.

44.01

43.16

-1.94

16,683

Auto Parts & Equipment

HLF

Herbalife Ltd

49.19

58.14

18.19

4,482

Personal Products

TRN

Trinity Industries Inc.

27.92

26.55

-4.91

4,225

Construction & Farm Machinery & Heavy Trucks

SPR

Spirit Aerosystems Holdings Inc

58.82

59.22

0.68

5,702

Aerospace & Defense

HUM

Humana Inc.

196.95

206.14

4.67

30,421

Managed Health Care

(Source: Portfolio123.com data and Author Table)

The highest industry concentration is in airlines (6 of 30, or 20%). That said, the average return from the airlines was -2.2%. Otherwise industry coverage is fairly distributed.

Only 11 of the holdings lost value over the period, 4 of which were airlines. The biggest loser in the period was oil and gas firm, RIG at -18%.

While 9 of the holdings performed at a 10% return or greater over the period, only one stock managed a return of more than 20%.

What is to come?

While this strategy underperformed the benchmark over Q1, it did perform better than its Large/Mid Cap cousin. Interestingly, this division also exists in the Magic Formula strategy for the quarter; the Large Cap version not only beat out the Large/Mid Cap version, but also beat its benchmark.

Recall that the large & mid cap version of the low EV/EBIT strategy did considerably better in 2016 compared with the Large Cap version. It is possible that with the recent unknowns in Q1 in the market (Trump Trade developments, rate hikes and Middle East uncertainty), investors are attempting to find refuge in larger cap stocks.

Also recall from our first graph in the article that this strategy, like most quant strategies, behaves cyclically over time. After an outstanding 5 year performance ending in 2013, the large cap version of this strategy has been slowing down, until its decent performance in 2016. Whether 2017 and 2018 will revert back to underperformance, or signal a new period of outperformance still remains to be seen. That said, this is a long term strategy that has historically outperformed over time, and ideally should be looked at with a long term view. Stay tuned for more updates.

Until next time, happy investing.

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Disclosure: I/we 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.

Additional disclosure: I am a user of Portfolio123.com, and have included affiliate links in the article. Should investors sign up for a paid membership through my link, I will receive a nominal commission, with no extra fee to the investor. Thanks in advance.

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