Quarterly Market Review: 2020 Q1

The themes of this past quarter are certainly difficult to capture in a short write-up. As the COVID-19 virus and its accompanying fears circled the globe with drastic health care system and economic consequences, investors have frantically repriced securities based on increased risks and changing operating environments. This uncertainty will continue as we are left to ponder the lasting impact of contagion fears on consumer demand, workplaces, infrastructure, city life, leisure and all other facets of our society that may be materially impacted over the coming year.

While these themes will certainly be fascinating to follow in real-time, we simply want to use this write-up to dissect market performance over the course of the quarter to better understand recent investor preference. We hope that this can instill confidence while continuing to perform stock selection and portfolio construction duties on the other side of the coronavirus peak, while also providing further ex-post evidence of an emerging best practice in portfolio construction that applies Applied Finance’s valuation framework in a manner that defies cheapness measures to optimize risk-adjusted outperformance.

The theme in investor preference that will dominate this quarter’s analysis is simply rooted in market cap. In typical market sell-offs, a “flight to safety” or “flight to quality” is commonly observed, which also tends to result in high yield stocks outperforming while other stocks sell-off more steeply. With unique risks causing a steep sell-off of many higher yield Real Estate, Financial, and Energy stocks, “flight to safety” was simply observed through investors holding onto megacap stocks while selling out of smaller stocks believed to be less capable of surviving an extended shut down of the economy. Because of this, we observed an astounding 11% spread last quarter between the cap-weighted returns of the top 100 stocks by market cap as of 12/31/19 and the rest of the Russell 3000. The Russell 3000 Index outperformed the average return of Russell 3000 forecast stocks by 12.5% in 2020 Q1, the largest calendar quarter performance gap on record in favor of cap-weighting over Applied Finance’s live research horizon (since September 1998) by almost 440 bps!

In last quarter’s write-up, Applied Finance focused on the Valuation/Cheapness Gap in portfolio construction, and this theme continues to be useful in understanding recent investor preference in 2020 Q1. It will also be useful to stratify factor performance within market cap tiers to best control for the recent megacap dominance and its skew of benchmark returns. In addition, highly leveraged stocks drastically underperformed, attractive price momentum stocks continued to outperform, and investors continued to display a significant preference towards “growth” stocks (based on Applied Finance’s MVIC metric and index style methodologies).

As of the end of March, US equity markets appear attractive based on median percent to target levels across large cap, small cap, and ADR universes. While volatility will certainly continue as we balance the trade-offs between health and economic priorities over the coming quarters, equity investments will likely perform well on a forward-looking basis over longer horizons as contagion fears dissipate and the benefits of lower interest rates and energy input costs are eventually realized.

In this write-up, we will also review recent performance of Applied Finance’s turnkey strategies, including the Valuation 50, Valuation Dividend and Strategic Valuation portfolios, and review Applied Finance factor performance globally. Please contact your Applied Finance representative if we can lend a hand with any questions or training needs. We hope you and your family navigate this season safely!

Analyzing Valuation vs Cheapness in Bull and Bear Markets

Applied Finance’s previous quarterly write-up introduced the Valuation/Cheapness Gap, a theme that we will continue to explore in our ongoing research efforts. This theme is rooted in applying a valuation discipline that emphasizes defying the commonly-applied industry convention of market multiples.
The tables below highlight Applied Finance’s approach to forming portfolios based on classification error between Book to Price LFY as a measure of cheapness and Applied Finance’s Percent to Target factor as a measure of intrinsic value. The green-shaded boxes are preferred by Applied Finance’s valuation approach, while the orange-shaded boxes are preferred by cheapness measures. This version of analysis aims for classification error of at least three quintiles to form portfolios with a level of diversification consistent with most active managers (~40 stocks).

Since 1998, Valuation Preference stocks have outperformed the S&P500 by 4.6% per year, while Cheapness Preference stocks have underperformed by -3.6% per year through 3/31/20.

Given the recent market turmoil and fears of recession and a possible longer-term recovery, we explored the Valuation/Cheapness Gap research through the lens of bull and bear markets (using S&P 500 total return peaks and bottoms at close to form regimes). The table below highlights the Valuation Preference and Cheapness Preference portfolios, as well as the Strategic Valuation turnkey portfolio developed on the Valuation/Cheapness theme through each bull/bear cycle, as well as each bear market combined with the 12-month recovery after a bottom was identified.

Valuation Preference stocks tend to navigate various regimes well (additional risk-adjusted cumulative stats are available on the next page), noting mild underperformance during several recent crises more than recaptured in following recoveries. Cheapness Preference stocks tend to consistently lag the S&P 500, but they have delivered occasional seasons of significant outperformance following sharp market sell-offs as market fears stabilize and equity markets recover to the benefit of the most oversold names. More recent milder market sell-offs did not deliver cheapness outperformance in ensuing recoveries, and cheapness has continued to mildly lag in the recent recovery that started on 3/23.

The table above provides risk-adjusted summary statistics for the Valuation Preference and Cheapness Preference portfolios relative to the S&P 500, as well as Applied Finance’s Strategic Valuation Portfolio. Note that, in aggregate, the Valuation Preference and the Strategic Valuation Portfolios deliver substantial outperformance alongside minimal negative tracking error and beta coefficients slightly above 1. The Cheapness Preference portfolio, on the other hand, delivers substantial underperformance, massive negative tracking error to the benchmark, and significantly inflated beta coefficients near 1.35.

It is clearly reasonable to form a disciplined equity allocation towards the Valuation Preference theme over long-term time horizons, given the attractive performance characteristics we have observed across various market regimes, as well as its risk-adjusted characteristics. While cheapness preference stocks have outperformed in several recoveries over the last two decades, the application of that investment style is certainly not suitable for a disciplined manager due to its long-term underperformance and poor risk-adjusted characteristics. The recent track record of cheapness preference underperformance in milder recoveries since 2015 also highlights that it is possible investors may not be as willing to bid up high book to price stocks on a rudimentary basis in market recoveries, especially when Cheapness Preference stocks have not experienced dramatic underperformance in preceding market corrections.
For reference, the tables below highlight the positions included in the Valuation Preference and Cheapness Preference portfolios based on Percent to Target – Current and Book to Price LFY with a Quintile Delta >= 3 as of 3/31/2020.

Top 100 US Stocks by Market Cap (within Russell 3000)

Over long-term time horizons, it is expected that smaller cap stocks will outperform large cap stocks to satisfy required compensation for their increased risk. The nature of “increased risk” became apparent in Q1 as investors were less inclined to hold on to smaller cap stocks, likely due to lessened capacity to weather a long-term economic shut-down relative to megacap peers. The 100 largest stocks reflected roughly 55% of the total Russell 3000 by market cap as of 12/31/19, and these stocks have sold-off by only 15.9% on a cap-weighted basis compared to 26.9% for all other firms over the course of Q1.
The top 100 stocks and the YTD performance of each is highlighted in the table below. These stocks have been buoyed by AAPL, MSFT, GOOGL, and AMZN due to their significant benchmark weights, as well as strong relative performance from JNJ, WMT,INTC, ORCL, ADBE, ABT, NVDA, NFLX, COST, LLY, NEE, GILD, TSLA, and TMUS. Large banks, energy stocks, and Boeing tend to define the significant laggards of this megacap group.

Market Cap Stratified Factor Performance in Q1 (S&P 500)

Due to the Q1 performance skewness in cap-weighted benchmarks related to the market-cap analysis on the previous page, it is useful to review factor performance stratified within market cap tiers to attempt to understand investor preference over the previous quarter. We have also included long-term performance from 9/30/98 through 3/31/2020 for comparison purposes to Q1 data.

Main Observations:

Company Grade A/F spreads were +2.6% in largest market cap quintile, -4.5% in second highest quintile of market cap and +6.5% in middle quintile of market cap before deteriorating to -5.5% in second lowest quintile of market cap and -13.1% in smallest market cap quintile.

Percent to Target A/F spreads were negative across all market cap quintiles, as valuation was significantly out of favor in Q1 while price momentum dominated. Large market cap quintile A/F spreads were -4.6% for Percent to Target – Current compared to -13.7% for Book to Price LFY. Percent to Target offered better A/F factor spreads across all quintile tiers compared to Book to Price (outside of the second lowest market cap quintile), with overall A/F spreads of -12.3% compared to -16.7% for Book to Price.

No yield stocks outperformed high yield peers across all market cap strata. Investors clearly favored larger cap no- to low-yield stocks. (F= 0%, D=0-1%, C=1-2%, B=2-3% and A=3%+)

Top quintile price momentum stocks outperformed bottom quintile price momentum (11 month lagged 1 month) stocks across all market cap strata. Investors clearly favored larger cap stocks with strong price momentum characteristics.

Over long-term horizons, disciplined investors should continue to expect allocation towards A-graded Company Grade and Percent to Target will help fuel outperformance as stock prices recover.

S&P 500 Market Cap Stratified Factor Analysis:

Index Valuation Analysis – Percent to Target Median Levels

S&P 500, Russell 1000, Russell 2000 & US ADRs: Percent to Target Median Analysis

Recent market volatility and lingering concerns of potential extended shuttering of many businesses and industries has been further accompanied with uncertainty regarding “normal” once the economy reopens. This has clearly led to many investors either rotating away from equities into other asset classes, holding larger cash positions, or remaining in equities while applying higher discount rates to offset this uncertainty. While this tactical allocation decision may certainly be reasonable for investors with shorter investment horizons and immediate liquidity needs, attractive normalized valuation levels are present across each major US index (including the S&P 500, Russell 1000, and Russell 2000), as well as the universe of ADR stocks with a market cap greater than $500M USD.

Investors willing and able to stomach excess volatility over the coming months as this pandemic slows and eventually passes should benefit from their longer-term investment horizons, noting that on the other side of this crisis we will observe historically low interest rates and energy input costs to assist many firms in delivering rapid recoveries.

US Sector & Industry Analysis – 2020 Q1

US Markets, based on cap-weighted returns of Russell 3000 constituents as of 12/31/19, declined by -20.8% in Q1, despite appreciation of more than 5% by mid-February. All GICs sectors sold off; Healthcare, Tech, Staples, and Utilities declined less sharply while Energy, Financials, Materials, and Industrials lagged the most. Equal-weighted returns were significantly lower than cap-weighted returns in Q1.

The tables below highlight top and bottom performing industries on a market-cap weighted basis. Top performing industries delivered returns greater than -12.5%, while worst performing industries declined by at least -44% last quarter.

Valuation 50 Quarterly Performance Update

Valuation 50: A 50 stock, sector-neutral portfolio selecting stocks from the S&P 500 and benchmarked against the S&P 500. Buy and sell decisions are completely driven by comprehensive due diligence provided by Applied Finance’s analyst team.

In 2020 Q1, strategy performance trends in the Valuation 50 strategy included the following:

• Stock selection on a sector basis was weakest in Consumer Discretionary, Consumer Staples and Financials. Stock selection on a sector basis did not deliver positive relative returns against any sectors this period.

• Active sector weights did not impact relative performance in a meaningful way. Overall sector allocation effect impacts were 0.00%.

• Stock selection on a size basis was weakest in Large (6B+). Stock selection on a size basis did not deliver positive relative returns against any size tiers this period.

• Active size weights reflected weighting towards Mid (2-6B) stocks away from Large (6B+) stocks. Overall size allocation effect impacts were -0.49%. Allocation effects were negative in Mid (2-6B).

• Stock selection on a style basis was strongest in Value and weakest in Growth.

• Active style weights reflected weighting towards Value stocks away from Growth stocks. Overall style allocation effect impacts were -1.58%. Allocation effects were negative in Value and Growth.

Valuation Dividend Quarterly Performance Update

Valuation Dividend: A 35 stock portfolio selecting high dividend yield stocks from the Russell 1000 and benchmarked against the Russell 1000 Value. Buy and sell decisions reflect dividend analysis and capital appreciation characteristics, offering diversification across all sectors but no sector-weight mandate to mirror the broader benchmark or high income peer group.

In 2020 Q1, strategy performance trends in the Valuation Dividend strategy included the following:

• Stock selection on a sector basis was strongest in Energy, Communication Services and Health Care and weakest in Financials, Real Estate and Consumer Discretionary.

• Active sector weights reflected weighting towards Consumer Discretionary, Information Technology and Health Care away from Communication Services, Communication Services and Energy. Overall sector allocation effect impacts were 0.10%. Allocation effects were positive in Energy, Health Care and Information Technology and negative in Consumer Staples, Consumer Discretionary and Communication Services.

• Stock selection on a size basis was weakest in Large (6B+) and Mid (2-6B). Stock selection on a size basis did not deliver positive relative returns against any size tiers this period.

• Active size weights reflected weighting towards Large (6B+) stocks away from Mid (2-6B) stocks. Overall size allocation effect impacts were 0.27%. Allocation effects were positive in Mid (2-6B).

Strategic Valuation Quarterly Performance Update

Strategic Valuation: A 30-60 stock, sector-neutral portfolio selecting stocks from the S&P 500 and benchmarked against the S&P 500. This strategy is tailored to exploit the Valuation/Cheapness gap created when the application of cheapness measures reflect a misrepresentation of valuation that can be exploited by more robust estimates of intrinsic value.

In 2020 Q1, strategy performance trends in the Strategic Valuation strategy included the following:

• Stock selection on a sector basis was strongest in Financials, Materials and Health Care and weakest in Information Technology, Consumer Discretionary and Energy.

• Active sector weights did not impact relative performance in a meaningful way. Overall sector allocation effect impacts were 0.00%.

• Stock selection on a style basis was weakest in Growth and Value. Stock selection on a style basis did not deliver positive relative returns against any style categories this period.

• Active style weights reflected weighting towards Growth stocks away from Value stocks. Overall style allocation effect impacts were 0.49%. Allocation effects were positive in Value.