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Simple Quant Models Continue to Miss Inflection Points in "Low-Quality" and Cyclical Stocks

|Includes: ENIA, United States Steel Corporation (X)

 2009 marked a year where many quantitative stock strategy models failed and bold bottom market calls were rewarded.  Driving these results were huge swings in stock prices, and sharp disassociation of recent financial results to perceptions of an economic recovery.  While quantitative strategies will no doubt return to fashion as economic uncertainty dissipates, it shows the power that an analysts' experience and intuition should always play an important role going forward. 

Ascendere Model Portfolio -- Model 
For a pdf of this report with tables and charts, please visit us at  http://ascenderellc.typepad.com.

The quantitative-based Ascendere Model Portfolio contracted 0.71% for the month of December, ending the year with a dismal performance of -12.09%.  In comparison, the S&P 500 appreciated 1.78% for the month and 23.45% for the year (excluding dividends).  Over the 5-years of its backtested inception, the Ascendere Associates LLC Long/Short Model Portfolio Strategy is up 195.6% versus a 5.8% decline for the S&P500.  The model portfolio stayed net-long for the entire month based on technical momentum indicators, and enters 2010 also net long.

Ascendere Model Portfolio -- Cumulative -- 2009 12 31


Driving underperformance for the month was stock selection in the Consumer Discretionary, Industrials, Information Technology and Materials Sectors.  In these sectors, high-quality stock underperformed both the S&P 500 and low-quality stocks.  This was somewhat offset by the performance of high-quality stocks in the Consumer Staples and Utility sectors relative to the S&P 500 and low-quality stocks in these sectors. 

In the most egregious example can be seen in the Materials sector.  High-quality material stocks composed 12.5% of the long portfolio at the beginning of the month; this compares to a 24.5% weight of low-quality stocks in the short portfolio and only a 3.6% weight in the S&P 500.  In December, high-quality stocks in the long portfolio declined 2.41% on average while low-quality stocks appreciated 4.09% and the S&P Material sector was up 1.41%.  sector declined 3.68% while low-quality stocks appreciated 7.36%; this compares to the S&P 500 Industrial Index return of 1.12%. 

Ascendere Model Portfolio -- Sector Performance -- 2009 12 31 
Four "low-quality" stocks surged by double-digit percentages:  Allegheny Technologies (NYSE:ATI), United States Steel Corp (NYSE:X), Arcelor Mittal (NYSE:MT) and Nucor (NYSE:NUE) were up 31.6%, 23.4%, 16.5% and 10.0%, respectively.  Of the four "high-quality" stocks, Compania de Minas Buenaventura SA (NYSE:BVN) declined 16.6% in the month, while International Paper (NYSE:IP), Bemis (NYSE:BMS) and Lubrizol (LZ) only appreciated 5.2%, 1.2% and 0.6%.

Let's s take a look at the worst "mistake" this selection strategy made, United States Steel Corp.  This company showed poor relative value and poor ROIC momentum on the quantitative model because trailing 12-month EBITDA was negative; other stocks with at least positive EBITDA and evidence of ROIC momentum showed higher quantitative rankings.  However, evidence that the steel industry was seeing higher production levels, higher realized prices and evidence that steel imports would remain a low threat -- information not captured by basic quantitative models -- drove steel stock prices higher for the month.  Obviously, trend-oriented quant models will not capture turning points in cyclical stocks -- and unfortunately it seems, neither can many sell side analysts by taking a look at their estimates revisions trends. 

What was the best performing equity in the model portfolio for December?  Chilean-based utility Enersis S.A. (ENI).  This high-quality equity did very well in the model portfolio in December, moving up 19.1%.  On 11/30/2009 the ADR had a trailing Enterprise Value/EBITDA multiple of 6.0x, a 2010 PE of 11.5x versus 12.5x for the average utility universe.  It was one of the highest ranking utility stocks relative to all fundamental factors in the Ascendere ranking system.  Even accounting for its ADR status and country risk, this equity based on a number of statistics was significantly undervalued on a relative basis.  The low relative valuation coupled with an increasingly favorable macroeconomic backdrop for some Latin American countries in which Enersis runs its various operations helped drive the ADR higher in December along with some other Latin American utilities. 

The Ascendere Associates LLC Model Portfolio continues to be a valuable tool in selecting stocks based on published data.  As the markets settle and economic certainty returns, this model and others like it will return to favor.  For now, it remains a stock picker's market where intuition, experience and boldness will prevail.  For reports on our favorite stocks and other research, please visit our website at http://ascenderellc.typepad.com.



Disclosure: None