The ‘High-Low’ Approach to Identify Outperformers
RJ Steinhoff, CFA Investment Process High-Low Approach
Large swaths of the economy have come to a complete standstill. Nearly 10 million people in the U.S. have filed for unemployment in the last two weeks of March, a staggering number that eclipses any previous figure over a similar period. The timing around the cessation of COVID-19 remains uncertain; shelter-in-place conditions for parts of the world could remain in effect through the end of summer.
The market correction has punished virtually all companies, creating opportunities in high-quality businesses that are well positioned to thrive once the economy recovers. Differentiating the strong from the weak is critical as the trajectory of the global economy over the next several months is unclear. Businesses operating in the hardest hit sectors such as retail, travel & leisure, and capital goods may not survive.
A simple approach we call “High-Low” identifies companies that generate high return on invested capital (ROIC) with low year-to-year variability in their ROIC. These companies tend to have strong franchises with loyal customers and pricing power that enables them to generate healthy free cash flow even as the overall economic landscape is challenging. According to our review of factor performance during the 2008 Global Financial Crisis (from the S&P 500’s peak in 2007 to its bottom in 2009), the High-Low approach outperformed baskets based on other metrics such as low beta, low volatility, and popular leverage and profitability ratios.
Since the S&P 500 Index’s peak on February 19 through its recent bottom on March 23, High-Low stocks performed relatively better than most. We ranked the S&P 500 constituents, ex-financials, using a variety of approaches and created 50-stock portfolios as of February 19. As shown in Chart 1, the average stock fell 38.5% to March 23. While there is no substitute for holding cash and/or hedging with short sales, the top 50 High-Low stocks declined 30.7%, besting the low beta and low volatility portfolios. A key takeaway from Chart 1 is that value performed very poorly during this drawdown with the top 50 low P/E stocks returning on average -51.1%, substantially worse than the average stock. High dividend yielding stocks, often viewed as a safe harbour during turbulent times, also performed poorly.
CHART 1. PERFORMANCE OF 50 STOCK PORTFOLIOS BETWEEN FEBRUARY 19, 2020 AND MARCH 23, 2020
SOURCE: FACTSET, GENERATION PMCA CORP.
The advantage of the High-Low approach doesn’t just come from less downside during market declines. Our research of past cycles shows that High-Low stocks also outperform as the market recovers. While it has only been just over a week since the recent S&P 500 bottom, history appears to be repeating. From March 23 to April 2, the top 50 High-Low stocks returned on average 13.8%, above the average stock’s return of 13.1%. We look forward to updating the numbers in the near future.
High quality businesses tend not to trade at steep discounts to their intrinsic values unless a macro event such as a recession creates an overall market correction. Since our TECTM model alerted us to a U.S. economic peak in March 2019 and the market losses accelerated throughout February and March, we have been opportunistically purchasing high quality businesses at discounts to their estimated intrinsic values. The economic consequences of COVID-19 are still far from certain so sticking with strong franchises, generating high ROIC, will remain central to our investment strategy.
RJ Steinhoff, CFA
Head of Research
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
Large swaths of the economy have come to a complete standstill. Nearly 10 million people in the U.S. have filed for unemployment in the last two weeks of March, a staggering number that eclipses any previous figure over a similar period. The timing around the cessation of COVID-19 remains uncertain; shelter-in-place conditions for parts of the world could remain in effect through the end of summer.
The market correction has punished virtually all companies, creating opportunities in high-quality businesses that are well positioned to thrive once the economy recovers. Differentiating the strong from the weak is critical as the trajectory of the global economy over the next several months is unclear. Businesses operating in the hardest hit sectors such as retail, travel & leisure, and capital goods may not survive.
A simple approach we call “High-Low” identifies companies that generate high return on invested capital (ROIC) with low year-to-year variability in their ROIC. These companies tend to have strong franchises with loyal customers and pricing power that enables them to generate healthy free cash flow even as the overall economic landscape is challenging. According to our review of factor performance during the 2008 Global Financial Crisis (from the S&P 500’s peak in 2007 to its bottom in 2009), the High-Low approach outperformed baskets based on other metrics such as low beta, low volatility, and popular leverage and profitability ratios.
Since the S&P 500 Index’s peak on February 19 through its recent bottom on March 23, High-Low stocks performed relatively better than most. We ranked the S&P 500 constituents, ex-financials, using a variety of approaches and created 50-stock portfolios as of February 19. As shown in Chart 1, the average stock fell 38.5% to March 23. While there is no substitute for holding cash and/or hedging with short sales, the top 50 High-Low stocks declined 30.7%, besting the low beta and low volatility portfolios. A key takeaway from Chart 1 is that value performed very poorly during this drawdown with the top 50 low P/E stocks returning on average -51.1%, substantially worse than the average stock. High dividend yielding stocks, often viewed as a safe harbour during turbulent times, also performed poorly.
CHART 1. PERFORMANCE OF 50 STOCK PORTFOLIOS BETWEEN FEBRUARY 19, 2020 AND MARCH 23, 2020
SOURCE: FACTSET, GENERATION PMCA CORP.
The advantage of the High-Low approach doesn’t just come from less downside during market declines. Our research of past cycles shows that High-Low stocks also outperform as the market recovers. While it has only been just over a week since the recent S&P 500 bottom, history appears to be repeating. From March 23 to April 2, the top 50 High-Low stocks returned on average 13.8%, above the average stock’s return of 13.1%. We look forward to updating the numbers in the near future.
High quality businesses tend not to trade at steep discounts to their intrinsic values unless a macro event such as a recession creates an overall market correction. Since our TECTM model alerted us to a U.S. economic peak in March 2019 and the market losses accelerated throughout February and March, we have been opportunistically purchasing high quality businesses at discounts to their estimated intrinsic values. The economic consequences of COVID-19 are still far from certain so sticking with strong franchises, generating high ROIC, will remain central to our investment strategy.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.