What This Strategy Aims To Do
This model invests in stocks we believe will, over time, appreciate due to their high margins, conservative investments in the business and favorable valuations. The model seeks to benefit from higher potential returns relative to the equity market, while at the same time keeping the risk in line or lower than the markets thanks to exposure only to profitable companies.
Why It’s Worth Considering
Traditional stock investment strategies look at low stock prices (value), improving margins (growth) and recent positive price action (momentum) in order to identify stocks with higher return potential.
This strategy instead exploits a direct link between stock returns and firm characteristics from the production side.
When picking which stocks to buy, investors are essentially looking for companies with high cost of capital. High cost of capital means a higher expectation of returns in the form of dividends and price appreciation.
Given a certain expected cash flow, a company's level of investments predicts returns because high costs of capital imply low net present values of new capital and low investment. On the flipside, low cost of capital implies high net present value of new capital and high investment.
In this context, profitability (we can for now assume ROE) predicts returns because high expected ROE relative to low investment must imply high discount rates (and more free cash flow for investors). The high discount rates are necessary to offset the high expected ROE to induce low net present values of new capital and low investment. If the discount rates were not high enough, firms would instead observe high net present values of new capital and invest more.
How We Do It
An extensive line of research (particularly the work of Professor Lu Zhang, such as “Digesting Anomalies: An Investment Approach”) simply take ROE and yearly change in total assets to construct long short portfolios. While this approach does work in theory and can be acceptable for a cross-sectional analysis of the market, it is missing many nuances a solid and concrete investment strategy needs.
First, ROE (net income / shareholders equity) is an imperfect proxy of profitability. The denominator is notably susceptible to accounting distortions (among other things, M&A and buybacks can even turn it negative). For this reason, on top of ROE, we use a more comprehensive set of factors to assess profitability.
Also, yearly change in total assets as a proxy for investments can raise doubts. For example, if a company borrows significantly to boost its cash balance, it doesn’t mean the company is increasing investments in the business, all else being equal. In assessing the level of investments, we use more capital expenditure related factors, retained earnings, and cash levels.
Once identified through screening a sub-universe of companies with a low level of investments and high profitability, we then apply a more conventional multifactor ranking system, which picks among conservative and profitable stocks taking into consideration value, quality, and low volatility factors.
Is It Suitable For You?
For those who want and are able to take on exposure to the equities asset class, this offering provides an interesting risk-return profile, with lower market risk and same or higher return potential. To further reduce risk you would need to focus on low volatility models or entirely on fixed income. Assuming the model performs as we expect (we try, but neither we nor anybody can ever guarantee this), you should expect a slight overperformance of the market over a period of 2-3 years, both in terms of return and drawdown.
Investing In This Model
This model has a very low turnover. This is quite unusual in rule-based models that depend on data to keep positions aligned with strategy. Due to the turnover and monthly rebalance, commissions shouldn’t play a major factor in the returns.
Although it is preferable to follow this model in a tax-deferred account to avoid paying some short-term capital gains taxes, it is also suitable for regular accounts thanks to low turnover. However, due to the relatively high number of positions, contributing small amounts each month can be very inefficient depending on stock prices.
You can start following this model here.