These Bombs May Nuke Your Portfolio

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Includes: ACHC, ALNY, ARCC, BAM, BKU, BLL, BMRN, CHK, CLNY, CLR, CUZ, DXCM, EVHC, EXAS, FANG, FNB, FRC, GPN, HES, HOMB, HTA, ICUI, IRM, KMX, LDOS, LGF.A, LNG, LSI, MBFI, MPW, NBIX, NFLX, OPK, PBCT, PDCE, PE, PGRE, POST, PTEN, REG, RRC, RSPP, SLM, SO, STOR, STWD, TCBI, WEX, WPX
by: Francois Soto, CFA

Summary

We created a quantitative ranking system to help portfolio managers sell short or sell existing long positions that are likely to underperform.

The worst 5% ranked stocks of the Russell 3000 and Russell 1000 universe generated -17.3% and -9.5% of annualized return respectively.

We did a performance attribution of these 5% worst ranked stocks on phases of the business cycle using the Leading Economic Indicator (LEI).

With markets making new all time highs on minimal volatility, investors have an opportunity to replace skeletons in their closet with better prospects. This month we discuss a ranking system to help portfolio managers avoid stocks that are most likely to underperform. This exercise is even more important now as the late-stage economic cycle may shift in the next couple of months.

Russell 3000 Bombs

You will find the ranking system result below. As you can see, it is highly effective at sorting the bombs out of the Russell 3000 universe. For the 1999-2017 period, which corresponds to two business cycles, the worst 5% ranked stocks generated -17.3% of annualized return! Investors can take advantage of this awful performance by selling short or selling existing longs.

Source: Inovestor Asset Management

Ranking System Details

In this ranking system, the factors chosen are not typical of long only models but geared to identify the worst publicly traded companies. 25 factors are selected for this purpose and we classify them in twelve distinct categories. We provide the rationale behind each category and disclose the factor 1) sorting direction, 2) short definition and 3) cross sectional relationship.

Source: Inovestor Asset Management

Business Cycle Performance Attribution

Now let's proceed with a performance attribution by phases of the business cycle as shown on the chart below. Whenever the Leading Economic Indicator (LEI) is falling, the 5% worst ranked stocks produce a negative alpha of -35% or worse. As we are writing this report, the LEI just increased to 4.4% YoY in August from 3.9% YoY in July with no imminent reversal in sight yet.

Source: Conference Board

However, these 5% worst ranked stocks are outperforming when the LEI is rising & below 0. This means an investor shorting these 5% worst ranked stocks might lose money in the early innings of a new business cycle. As the expansion becomes more mature when the LEI is rising & above 0, these 5% worst ranked stocks more or less market perform vs. the benchmark.

Russell 1000 Bombs

The Russell 3000 universe is a good benchmark of the entire U.S. stock market but does the ranking system work even with large companies? For the 1999-2017 period, the worst 5% ranked stocks in the Russell 1000 made -9.5% of annualized return. The losses are not as huge because large caps have higher odds of refinancing, restructuring, surviving a legal battle, etc.

Source: Inovestor Asset Management

In conclusion, our ranking system is successful at highlighting companies that are most likely to erode alpha in the long run. The list below are companies you may want to avoid in a long only portfolio right now. We publish an Excel file containing the full list of companies in the Russell 1000 and Russell 3000 universe classified by this ranking system to members of our web site for free.

Ticker Name Rank Price MktCap Sector
WEX WEX 99.9 111.93 4,803 INFT
BAM Brookfield Asset Management 99.8 40.71 39,029 FINL
LNG Cheniere Energy 99.7 43.91 10,442 ENRS
WPX WPX Energy 99.6 11.20 4,458 ENRS
FNB F.N.B. Corp 99.5 13.29 4,296 FINL
BLL Ball Corp 99.4 40.80 14,345 MATR
BMRN Biomarin Pharmaceutical 99.3 93.42 16,372 HLTH
TCBI Texas Capital Bancshares 99.2 82.20 4,077 FINL
OPK Opko Health 99.1 6.48 3,625 HLTH
ACHC Acadia Healthcare 99.0 45.60 3,967 HLTH
CLR Continental Resources 98.9 37.66 14,130 ENRS
CHK Chesapeake Energy 98.8 4.17 3,777 ENRS
MPW Medical Properties Trust 98.7 12.97 4,722 REAL
IRM Iron Mountain 98.6 39.77 10,514 REAL
PDCE PDC Energy 98.5 46.32 3,051 ENRS
NBIX Neurocrine Biosciences 98.4 58.83 5,190 HLTH
STWD Starwood Property Trust 98.3 21.90 5,706 FINL
MBFI MB Financial 98.2 42.80 3,590 FINL
NFLX Netflix 98.1 188.78 81,506 COND
GPN Global Payments 98.0 96.34 14,697 INFT
SLM SLM 97.9 10.82 4,669 FINL
SO Southern 97.8 49.27 49,244 UTIL
PGRE Paramount Group 97.7 16.00 3,813 REAL
FANG Diamondback Energy 97.6 97.36 9,554 ENRS
LSI Life Storage 97.5 80.98 3,771 REAL
PTEN Patterson-UTI Energy 97.4 19.36 4,130 ENRS
REG Regency Centers 97.3 62.42 10,595 REAL
PBCT People's United Financial 97.2 17.41 5,876 FINL
HES Hess 97.1 43.63 13,868 ENRS
RSPP RSP Permian 97.0 32.83 5,206 ENRS
EXAS EXACT Sciences 96.9 45.00 5,357 HLTH
LDOS Leidos Holdings 96.8 58.27 8,799 INFT
KMX CarMax 96.7 68.84 12,658 COND
STOR STORE Capital 96.6 25.51 4,847 REAL
PE Parsley Energy 96.5 26.67 6,575 ENRS
EVHC Envision Healthcare 96.4 44.76 5,307 HLTH
LGF.A Lions Gate Entertainment 96.3 31.25 6,503 COND
HTA Healthcare Trust of America 96.2 30.15 6,050 REAL
DXCM DexCom 96.1 69.50 6,012 HLTH
RRC Range Resources 96.0 18.80 4,665 ENRS
ALNY Alnylam Pharmaceuticals 95.9 112.92 10,355 HLTH
BKU BankUnited 95.7 34.05 3,637 FINL
CLNS Colony Northstar 95.6 12.90 7,120 REAL
FRC First Republic Bank 95.5 100.80 15,895 FINL
POST Post Holdings 95.4 86.97 5,754 CONS
HOMB Home Bancshares 95.3 23.51 3,364 FINL
CUZ Cousins Properties 95.2 9.28 3,897 REAL
ARCC Ares Capital 95.1 15.77 6,718 FINL
ICUI ICU Medical 95.0 185.30 3,677 HLTH

Source: Inovestor Asset Management

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. I have no business relationship with any company whose stock is mentioned in this article.