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How to Make Money in a Bear Market. Part 2.
The seven characteristics of stocks that have vastly outperformed the market in every investment downturn since 1974
Two weeks ago, you read about a specific investment crisis strategy that does really well in bear markets. It has proved its mettle in-sample in 7 crises 1974-2018 - meaning the strategy was created by looking at these seven crises to determine what works and what doesn't, on a holistic basis. This can be a problem if you overfit the strategy to ensure it works with the specific historical data, but our process focuses on creating and evaluating general investment hypotheses - and scrapping them, not tweaking them, in the case of failure.
The strategy has started proving its worth out-of-sample during the 2020 COVID crash, almost doubling the S&P's returns as the financial world returned to rosy way before the real world did.
A tl;dr if you missed it:
The crisis strategy has seen 8 "crisis years": 1974, 1980, 1986, 2000, 2008, 2012, 2016, 2020
It defines a crisis as the month when the high-yield spread hits 6.5%. That's the difference between the interest on debt issued by less-than-stellar companies, and the US Treasury rate. Intuitively: in bad times, it's harder for bad companies to raise debt, so they need to offer higher incentives to do so
The strategy invests in a crisis portfolio 3 months after hitting the signal, then stays invested for 2 years
The signal is at 5.88% currently (!!)
The portfolio is built of 50 stocks, equal-weighted and re-weighted monthly
New stuff - lot's to cover. There are three main parts to any investment strategy:
When to invest. This is the signal. How do you split the market into different time periods? Lots of strategies split time up into risk-on and risk-off modes.
What to invest in. When you've found an effective split of market time periods, you want to know what does best in those time periods. That's the asset allocation, and it's what I'm focusing on today, having spent the last article on the signal.
How to weight the portfolio based on what your signal and asset allocation tell you. Lots of managers do equal-weighted portfolios, some do factor-weighting, and others make their own weighting systems. There's still a lot of research we're doing here, but because this fund has done well equal-weighted (on a theoretical and real basis), it's what we stick with.
The Crisis Fund Allocation
As hinted at last time, this fund considers seven factors, or unique characteristics of companies. Each one is weighted equally (14.3%) as we rank the 5,000+ stock universe for ones that fit best for all combined factors.
This characteristic turns out to be among the most important predictors for a stock's potential during an investment crisis. Asset turnover is the revenue a company generates divided by its total assets. The higher this number, the better. This makes sense intuitively: a company that is able to generate lots of money off a small number of assets (that might require lower replacement/maintenance capital expenditure), is better off when it expects lower revenue streams and more volatile costs.
A company that makes more money than it spends has a positive net income (negative net income companies are spending venture capital or other outside capital to grow their businesses before their top-line has really caught up). This isn't bad news for a company in a bull market - growth companies are expected to put every earning they generate, plus anything else they can find, into continuation of their growth.
Negative net income is more likely to be bad news when there's less macro demand, meaning fewer earnings generated even if the company is doing otherwise well, and much less outside capital to help them continue to grow their business. In an investment downturn, you intuitively want to stick with companies that are making more than they are spending.
Based on research and insight from a global asset manager, stocks with low trade volume during a crisis vastly outperform stocks with a higher volume. 55% more in the first 12 months, and 75% in a 24-month range. Intuitively, this is a little harder to understand at first sight, but it's a straightforward hypothesis: at the start of crises, everyone is selling, owners of large-volume and small-volume stocks. Large-volume stocks are traded much more often, and thus are much more liquid in a crisis. There's enough buyers at the current price that liquidating isn't usually a concern. Lower-volume stocks are gonna be harder to find buyers for in a crisis, so sellers are ok selling at a lower price than the current. So buying small-volume stocks at a lower low than what might be expected for a large-volume stock means you're getting a lot more of the upside once other buyers come back.
Operating cash flow
So many investment banking interviews ask the question - "if you were trapped on an island and could only have access to one financial statement to determine a company's health, which would it be?" The answer is the cash flow statement, and the situation's a really funny one to think about. In crises, we invest in companies that have generated positive operating cash flow (for the last quarter and/or the last year) at the point of our investment/rebalance. A positive operating cash flow is similar to net income, but it's tied to business operations. It means a company has cash that it can actually use that comes from the business itself (and not loans, investments, interest, and other market-tied activities). A company with positive operating cash flow can pay its bills with its own business operations.
This is just the change in a company's leverage. Is it deleveraging (ie paying off debt)? If so - great. Intuitively, this is especially good in a crisis, when a struggling company might need to take on excess debt to pay off its day-to-day. This goes back to the crisis signal In the first place. We know that a crisis is occurring because bad companies are issuing debt at high interest rates because they're willing to pay a really high rate for debt that will help them survive bad times. Deleveraging companies, then, are generally not these bad ones.
Value stocks tend to show these ratios:
Low Enterprise Value / EBITDA. The stock market is pricing them low compared to the amount of gross profit they're generating. It means the market is generally not excited about the company's future, and/or it's an un-sexy company. Value investing (doing research into companies like these) is what made Warren Buffett.
Low price/book. A P/B of 1 means the stock's price is $1 for every $1 of assets the company owns. Theoretically (and there are more complexities here), if the company was just liquidated today and all of its assets were sold to the highest bidder, each shareholder would get $1. That ratio’s incredibly low, and it’s harder to find companies with a ratio of 1 or lower today, because it means for some reason the market assumes that a company isn't going to actually be making money in the future with those assets at all.
Low price/earnings. The same idea as above, but comparing stock price to dollars of net income.
High FCF yield (%). Compares the cash flow a company has per share to its market price per share. A FCF yield of 100% means that the company is generating a dollar of cash (after taxes, required operating costs, and everything else - this is cash that it can do whatever with, like reinvest into business segments) for every dollar of its market cap. That's pretty crazy. A good yield is usually considered to be above 7%.
This is the weirdest characteristic to wrap your head around. Stocks that are more highly-leveraged, compared to their assets, perform better than lower-leveraged ones. In general, leverage is a multiplier of returns - if we consider a number of highly-leveraged companies that rank well for the above six factors, all things considered, many will default, but enough ought to have knockout returns to make a bet on this factor worth it.
These are the seven factors that the Quantbase Crisis Fund ultimately settles on while choosing how to allocate a portfolio of 50 equal-weighted stocks. The investment universe for this fund is pretty large. Unlike many of our other funds, we even invest into micro-caps here, with the smallest companies in the universe at around $50M in market cap. And because of the way we've set up our factors, namely low volume and value, we're exposed to a lot more of these micro/small-cap stocks.
The small-cap value effect is pretty interesting - small value stocks have historically outperformed other value stocks and larger stocks in general. Lots of people talk about the effect being dead, and there's definitely a possibility there. But at the size and volume of these companies, there's necessarily less competition/efficiency as there is further up the capitalization chain - larger funds just can't allocate meaningfully into micro/small caps, where the crisis fund has historically made its winners - and as long as we’re small, we’re going to exploit that.
And because we filter our universe to be able to invest in stocks that have as low volume as 50,000 shares traded biweekly, and have a market cap as low as $50M, we're even potentially able to beat the performance of global asset management firms that are running the same, or similar strategies.
We're now waiting to test this strategy's mettle for a second time. The fund first rebalanced into crisis stocks in June 2020 (so it went down with the S&P but went back up way more), and just rebalanced out in July 2022. The fund has not yet hit the signal yet that determines that a crisis is afoot, despite already seeing major volatility in the S&P. This might mean that there's more bad news on the way.