The market prices of practically all individual stocks have covered a lot of terrain since the start of 2020, accompanied by a deluge of new information for investors to consider. These considerations include new operating environments and fundamental performance reflecting the unique risks and opportunities impacting each firm’s business model, the overall macro forecasts related to the tenor of COVID-related restrictions shuttering certain industries while benefitting others, and economic forecasts related to the impact of low nominal interest rates against a backdrop of inflationary fears. In aggregate, many firms required external financing to navigate the last twelve-plus months; for some, this was required to provide emergency cash to offset the loss of near-term cash flows during the initial economic shutdown, and for others, this was required to invest heavily in the growth opportunities created by the accelerated digitization of the economy. For disciplined investors, this has certainly created a significant number of considerations to incorporate into a comprehensive valuation thesis. For investors without a systematic approach or competing workflow priorities, it has likely become convenient to abandon a rigorous valuation discipline and instead rely on thematic trades for exposure to “COVID/Work from Home” stocks into “Reopening Plays” when searching for new portfolio holdings. For many other investors, a sense of “valuation agnosticism” persists based on the structural increase in passive and factor-based strategies over the past decade.
With that in mind, we have observed a notable valuation gap form related to the use of external financing in each firm’s operations. Applied Finance’s Financing Yield factor (Financing Cash Flow / Enterprise Value) can be used to distinguish companies that return capital to shareholders due to excess operating cash flow above their investment needs vs. companies that require external financing to invest at rates unsupported by operating cash flow levels. Prior to 2020, the average difference in aggregate valuation characteristics of the “returning capital” portfolio (top half of Financing Yield) and “diluting owners” (bottom half of Financing Yield) had been near zero in the Russell 1000 (October 1998 to December 2019 average was 4.04%). This valuation gap has recently ballooned to levels in excess of 30% in favor of stocks returning capital to their shareholders, and we believe that this presents a unique tactical opportunity for investors.
Aggregate Intrinsic Value Upside: “Returning Capital” vs. “Diluting Owners” in the Russell 1000
The chart below plots the aggregate valuation characteristics of Russell 1000 constituents on a cap-weighted basis since October 1998, as well as portfolios formed on the top half and bottom half of the Financing Yield factor.
Stocks with low/negative Financing Yield representing the bottom half of the Russell 1000 have seen their intrinsic value characteristics plummet since the start of 2020, while high Financing Yield stocks continue to offer mild upside. The valuation gap between these portfolios is 32.8% as of the end of April 2021, slightly below the recent peak of 36.2% noted at the end of February. On this single-factor basis, the valuation gap between high and low Financing Yield portfolios exceeds any level observed since 1998 by a significant degree. (The z-score of this most recent observation is 3.11.) In aggregate, Financing Yield’s bottom half comprises 32.1% of the overall Russell 1000’s market cap, while the top half captures the remaining 67.9%.
Exploring the Low Financing Yield portfolio’s constituents in the Russell 1000 as of the end of April 2021, we can identify the largest contributors to the poor aggregate valuation characteristics in the table below.
The constituent table above highlights the dilutive firms that most contribute to the poor aggregate valuation levels of the low Financing Yield portfolio. To help interpret this data table, we can review the TSLA example as the largest contributor to the poor valuation characteristics of this portfolio. As of 4/30/21, Tesla’s Financing Yield was -1.4%, implying TSLA relied on external financing in their last fiscal year equivalent to 1.4% of their total enterprise value. With a market cap greater than $600B, Tesla is roughly 4% of the cap-weighted low Financing Yield portfolio, and its default intrinsic value estimate (assuming analyst forecasts through 2024 before the start of the Economic Profit Horizon) is 73% lower than its current market price. The external financing raised by TSLA last year appears to have come in the form of secondary share offerings, as the number of shares outstanding has increased by 6.7% over the previous 5 quarters (to capture changes since the end of 2019) while total debt levels fell by 12%. Using Russell 1000 Value and Growth portfolio characteristics as of 5/6/21, TSLA was fully held in the Russell 1000 Growth portfolio with a 2.6% allocation.
One additional item of note: several stocks in this table are highlighted in orange, and this reflects that the low Financing Yield characteristics in each firm’s most recent fiscal year were the first time since at least 2015 that the firm has raised external financing, while all other stocks seem to dilute their firm’s ownership more commonly. Based on this flag, we can likely assume that stocks with COVID-related external financing may see this infusion of external capital as a one-time event (i.e., DIS, PEP, INTU, SBUX), while other stocks are likely serial diluters since normal cash flow levels are not able to support their ongoing investment needs (i.e., TSLA, CRM, SQ, UBER). This remaining list of serial diluters captures many of the digital disrupters and COVID/WFH trades that dominated investor preference over the last year but are likely to lag during the reopening of the economy due to unrealistic implied expectations reflected in current market prices.
Aggregate Intrinsic Value Upside: “Returning Capital” vs. “Diluting Owners” in the Russell 2000
We can repeat this to study the aggregate valuation characteristics of Russell 2000 constituents on a cap-weighted basis since October 1998, as well as portfolios formed on the top half and bottom half of the Financing Yield factor.
In our large cap study, stocks with poor Financing Yield characteristics saw valuation levels plummet in early 2020. This trend started in early 2019 for Russell 2000 stocks. Further contrasting the large cap and small cap observations, aggregate intrinsic value characteristics for Russell 2000 stocks are -13.5% on a cap-weighted basis (compared to -0.5% in the Russell 1000). The common theme across each study is in the notable valuation gap between high and low Financing Yield stocks, which has recently hit all-time highs in the small cap space, as well, but the peak valuation gap occurred nearly a year earlier at the end of March 2020. In aggregate, the bottom half of Russell 2000 stocks based on Financing Yield comprise 43.1% of the overall Russell 1000’s market cap, while the top half of Financing Yield captures 56.9% of the Russell 2000’s market cap.
We can also explore the Low Financing Yield portfolio’s constituents from the Russell 2000 study in the table below.
Similar to our Russell 1000 example, the constituent table above highlights the dilutive firms that most contribute to the poor aggregate valuation levels of the Low Financing Yield portfolio. One notable distinction relates to the identification of COVID-related dilution, which was common in our large cap study. The largest contributors to poor valuation characteristics in the small cap space seem to much more commonly profile as serial diluters that were heavily reliant on external financing prior to COVID-related concerns.
Valuation Stewardship: Portfolio Construction / Tactical Considerations
Aggregate intrinsic value characteristics suggest that there is compelling valuation-based evidence to allocate away from serial diluters. As we noted earlier, aggregate intrinsic value upside of the Russell 1000 is slightly below zero and passive exposure to the Russell 1000 invests more than 30% into this basket of stocks with aggregate valuation characteristics 20% lower than current market prices. By tactically avoiding this dilutive basket, the valuation characteristics of the remaining 70% of the Russell 1000 sees its aggregate upside improve to 12.7% on a cap-weighted basis.
Passive exposure to small cap stocks is even less attractive with aggregate valuation upside of -13.5%. Low Financing Yield stocks in the Russell 2000 comprise an even larger allocation (43%) in the small cap space with worse valuation characteristics (-28.3%), so tactical avoidance of these dilutive firms improves the valuation characteristics of the remaining high Financing Yield names to 1.2% in aggregate.
Many investors likely associate higher yields as the domain of traditional value portfolios (and that tends to be the case when yield is measured as cash dividends paid). Financing Yield, however, expands this definition to include share repurchases and debt repayment captured through the total financing cash flows of a firm; the value/growth distinction in commonly used style methodologies do not reliably capture this expanded yield theme. (Stocks that repurchase significant shares tend to drift into a growth classification as book value converges to zero.) In the Russell 1000 (as of 5/6), low Financing Yield stocks represent 34.3% of the Russell 1000 Growth ETF (IWF) and 41.6% of the Russell 1000 Value (IWD) ETF. In the Russell 2000, low Financing Yield stocks currently account for 42.1% of the Russell 2000 Growth (IWO) ETF weightings but comprise 46.7% of the Russell 1000 Value (IWN) ETF.
Applied Finance’s Valuation Beta research advocates for the tandem application of valuation (Excess Intrinsic Value factor) and stewardship (Financing Yield factor) traits to form portfolios, and we can observe further divergence in the valuation characteristics between high and low Valuation Stewardship portfolios. While we believe that these factors warrant strong consideration for strategic allocation in any market environment based on the role of these factors in asset pricing laid out in our working paper, we believe that the exceptionally poor valuation characteristics of low Financing Yield and low Valuation Stewardship stocks offer a direct methodology to form portfolios on these themes to exploit this tactical opportunity.
In the Russell 1000, portfolios formed on the combination of independent sorts of Excess Intrinsic Value and Financing Yield can partition the overall universe into top half/bottom half Valuation Stewardship portfolios. By further merging a valuation overlay on Financing Yield, the high Valuation Stewardship portfolio currently reflects 20.4% upside, which is nearly a 21% improvement over a passive alternative and more than a 60% improvement over low Valuation Stewardship peers.
A similar theme is observed in the Russell 2000. The high Valuation Stewardship portfolio has aggregate upside of 12.2%, which is nearly 26% higher than its passive alternative and 57.5% higher than the low Valuation Stewardship portfolio.
Based on these studies, investors would be wise to allocate away from low Financing Yield stocks towards their high Financing Yield peers, while further maintaining a valuation-based discipline. An obvious consideration is to form actively managed portfolios on stocks with attractive intrinsic value and Financing Yield characteristics. This will help investors improve the meager returns reflected in passive large cap and small cap indices by avoiding the potential drag on overall benchmark returns as stocks that reflect these dilution characteristics lag the overall market due to their unrealistic implied expectations. Applied Finance also provides a number of turnkey mutual funds, ETFs, and SMA portfolios based on these research themes to help professional investors incorporate a valuation discipline into their strategic and tactical equity allocations.