U.S. Equities: 13TH – 17TH April, 2020

The stock market continued its impressive run last

week with the S&P 500 gaining 3.04%. Since March

23rd, the index has risen more than 28% in 18

sessions. The equity market tends to be a leading

indicator and is forward looking, explaining why we

are seeing a continuation of the rally that began in

March despite news reporting historically bad

consumer confidence and manufacturing productivity. As an indication of how bad the broader economic data has

been, 22 million Americans have filed first-time jobless claims- more than the amount of jobs lost in the whole of

2008. As we mentioned last week, there is not a lot of faith in the sustainability of this rally and a lot of investors are

expecting earnings seasons to surprise to the downside. That’s despite estimates suggesting earnings could fall >90%

YoY. Despite the last couple of weeks of positive returns, extreme volatility remains in the system. In 2020 so far

there has been 24 daily moves greater than 3%. That’s in comparison to one in 2019 and zero in 2012, 2013 and

2014.

Growth & Quality Outperform

Recently in this note we have focused a lot on which

stocks typically outperform during a crisis. Historically,

the stocks that outperform after 20% drops in the S&P

500 have been small value stocks1. Admittedly the

sample size is insignificant, but so far in the recovery

since March 23rd, whether it is merely a bear market

rally or not, that has definitely not been the case.

Growth stocks, just as they have done since 2009,

continue to beat the market. In an article posted last

Friday the WSJ explained, “This time is different so far.

Rather than breaking the habits investors fell into

during the bull market, the coronavirus crisis and

economic shutdown have reinforced two of the biggest

trends in stocks: U.S. technology and “quality” stocks,

those with a steady earnings record, continue to beat

the market.”2 The criteria that define what counts as

‘quality’ is ever-evolving, and we will discuss this in

1 https://verdadcap.com/archive/making-good-decisions-in-uncertain-times 2 https://www.wsj.com/articles/how-to-play-coronavirus-bear-market-exactly-like-the-bull-market-11587123831

Aravis Research

U.S. Equities Weekly Note 13th – 17th April

Sam Wood, CFA

In this note we cover:

A summary of U.S. market movements in the prior week.

The extent of the return premium in growth and quality stocks in 2020.

How we define ‘quality investing’ and the criteria that have generated excess returns.

Rich pickings for active investors in the most disperse market since 2009.

Index Week % Change

S&P 500 3.04%

Russell 2500 Growth 1.41%

Russell Mid Cap Growth 3.02%

Market Prices Week April 13th - 17th

more depth later, but in the mainstream

quality has a big overlap with the high-growth

stocks, as technology makes up almost half of

the MSCI USA Quality index. There are plenty

of examples of the extent of the valuation

spread between technology stocks and the

rest. The chart to the right compares the

Nasdaq 100 index with the Russell 2000,

which is representative of the small cap

universe in the U.S. The difference between

the two indices is the greatest it has been

since the 2000-2002 tech bubble. To some

observers, this relationship shows why tech is overvalued and that this spread will revert to the mean. To others it is

a fair representation of the premium that tech stocks demand due to their role in the new economy, their typically

asset-light, low-debt balance sheets and high margin business models.

Not only has the NDX dominated smaller cap stocks, but it dominates any comparison with a value index as well.

Using the Russell 1000 Value as our value

benchmark, the Nasdaq 100 has beaten value

by 30% over the past year, and is already

ahead close to 25% in 2020. Despite history

being on their side in the aftermath of market

crashes, small cap value stocks are still

lagging large cap growth stocks at levels last seen twenty years ago and we have seen no evidence yet that points to

a reversal.

Quality Investing

The rotation in outperformance between growth and

value is a familiar pattern and is closely followed by

market participants. ‘Quality’ investing, though, tends to

be overlooked as there is yet to be a widely accepted

definition of what constitutes quality stocks. The MSCI

USA Quality index that I have used to demonstrate the

stellar performance of quality stocks in the last decade

uses the following criteria: high return on equity (ROE),

stable year-over-year earnings growth and low financial

leverage. This formula feels like a straight forward short-

cut to finding great businesses. In a paper that examined

how predictive quality criteria were to returns, Robert

Novy-Marx found that gross-profitability (revenues –

cost of goods sold scaled by assets) was the most

powerful indicator of excess return, “all of the quality

measures appear to have some power predicting

returns, especially among small cap stocks, and when used in conjunction with value measures. Only gross

profitability, however, generates significant excess returns as a stand-alone strategy, and has the largest Fama and

French (1993) three-factor alpha, especially among large cap stocks.”3 I thought this was an interesting conclusion, as

gross profitability has a large growth bias in comparison to other quality criteria such as those based on current

ratios and earnings stability, which tend to be more biased towards value stocks. Despite this Novy-Marx’s paper

3 Robert Novy-Marx, Quality Investing, http://rnm.simon.rochester.edu/research/QDoVI.pdf p.3

Period Russell 1000V Nasdaq 100 NDX - R1000V

1 month 12.64% 24.83% 12.19%

Year-to-date -22.60% 0.58% 23.18%

1 year -14.63% 15.63% 30.26%

Relative Performance: Russell 1000 Value vs Nasdaq 100 as of 16th April

2020

Year MSCI USA Qual. MSCI USA

2019 39.11% 31.64%

2018 -2.65% -4.50%

2017 26.00% 21.90%

2016 7.97% 11.61%

2015 7.04% 1.32%

2014 11.81% 13.36%

2013 33.51% 32.61%

2012 13.97% 16.13%

2011 8.40% 1.99%

2010 12.65% 15.45%

2009 32.04% 27.14%

Annualised 16.00% 13.44%

Annual Performance: MSCI USA Quality vs. MSCI USA

advises combining value investing with quality investing, perhaps as growth investing apparently captures a lot of

the quality premium already- especially in large cap stocks with low net debt. His reasoning mirrors the factors that

have accounted for Warren Buffett’s alpha over several decades- which was examined in a paper by AQR and was

concluded to be buying quality companies cheaply4. It all sounds so simple, as Novy-Marx explains, “Buying high

quality assets without paying premium prices is just as much value investing as buying average quality assets at

discount prices.”5 Although this conclusion is hardly novel, implementing this type of strategy is very difficult-quality

stocks aren’t often found in the bargain basement, and are expensive for good reason. Similarly cheap stocks are

normally cheap for very good reason. However, certain periods do offer investors the ability to buy undervalued

quality companies, and we might be in one now.

Rich Pickings for Active Managers?

Due to the historic market volatility this year, active investment managers have been quick to claim that active

strategies will outperform passive index funds in the forthcoming period. Clearly, active managers have a vested

interest in making this claim and there is ample evidence for us to be sceptical. Information ratios, which measure

active return per unit of active risk, are a widely used measure of true skill for active investors. In the three years

ended March 31, 2020 the mean IR for U.S. mutual funds was -0.26, suggesting that the average U.S. mutual fund

manager generated negative alpha per unit of active risk in the time period. That isn’t good. However, is this a

function of a lack of skill on behalf of active managers or of highly efficient markets negating the impact of any

investment skill? In a recent paper on the link between dispersion of returns and alpha, Michael Mauboussin and

Dan Callahan explained the ‘paradox’ of skill among investment managers, “skill is obscured if the opportunity does

not offer differentiated payoffs. In this case, skill is high but uniform among competitors. Imagine two tennis players

of excellent but identical skill. The outcomes of their matches will appear to be random even though they are highly-

skilled players. This is what happens in an efficient market: the ability of investors to gather, process, and reflect

information means that security prices accurately reflect expected values.”7

A key conclusion the paper draws is that there is a great deal of variance in how ‘efficient’ equity markets are year-

to-year and which styles and sectors have the

greatest dispersion. Dispersion of returns are

highly correlated to the ability of active

managers to generate alpha, and in sectors and

styles where dispersion is high the relative

opportunity to prove investment skill will be

greater, “…there is a bountiful opportunity to

pick the winners, avoid the losers, and create a

portfolio that meaningfully beats the benchmark

if the dispersion of the constituent stocks is high.

Research shows that dispersion is a reasonable

proxy for breadth and that the results for skilful

mutual fund managers are better when dispersion is high.”8 For example, in the exhibit on the left it is clear to see

that there have been more opportunities to generate alpha in tech stocks and health care stocks than there has in

utilities or financials in the past twenty five years.

4 https://www.aqr.com/Insights/Research/Journal-Article/Buffetts-Alpha 5 Robert Novy-Marx, Quality Investing, http://rnm.simon.rochester.edu/research/QDoVI.pdf p.1 6 Michael J. Mauboussin & Dan Callahan, CFA, Dispersion and Alpha Conversion: How Dispersion Creates the Opportunity to Express Skill, https://www.morganstanley.com/im/publication/insights/articles/dispersion-and-alpha-conversion.pdf?1586895497145 p.2 7 Ibid., p.3 8 Ibid., p.6

Similarly, you can see in the second chart where the best opportunities are for active managers in different asset

classes and styles. Both of these charts help

allocators and investment managers’ fish in ponds

where there are plenty of fish.

However, as we outlined above, information ratios

for the average U.S. mutual fund manager in the

last three years have been negative, so why have

active managers struggled? Part of the reason

could be that the years 2017, 2018 and 2019 had

historically low dispersion of returns. In contrast,

2020, on an annualized basis, has exhibited the

greatest amount of dispersion in stock returns

since 2009. Intuitively, this is why active investors

are excited about the opportunity set to display

their skill in the current market environment.

Returning to our discussion of the building blocks of information ratios (active return/active risk) it is worth focusing

on the numerator in the ratio and the different methods that active managers can take to achieve that active return.

The two methods worth focusing on (rather than market timing) are security selection and position sizing. The idea

of a ‘batting average’ to judge security selection is a familiar one, but a more novel measure for position sizing is

introduced in the Mauboussin piece as the ‘slugging ratio’ or win/loss ratio. This measures the average gains for the

successful investments divided by the average losses for the unsuccessful ones- you want bigger positions in winners

and smaller positions in losers. Combining the slugging ratio and batting average sheds light on how different

investment managers implement skill in the investment process, “One of the crucial observations is that an investor

can be correct much less than half of

the time and still deliver a high IR if the

slugging ratio is sufficiently high. It’s

not how often you are right that

matters, it’s how much money you

make when you’re right versus how

much money you lose when you’re

wrong.”9 Momentum investors, for

example, cut losses and let winners

run. By scaling their winners and trimming their losers their skill level is reflected in a high slugging ratio rather than

in great security selection. Value investors, by contrast, do the opposite as they seek to find investments with gaps

between price and intrinsic value and they will add to those bets if the spread widens. Bill Miller, the CIO of Miller

Value Partners, explains, “For most investors if a stock starts behaving in a way that is different from what they think

it ought to be doing—say, it falls 15%—they will probably sell. In our case, when a stock drops and we believe in the

fundamentals, the case for future returns goes up.”10 The table above shows the skill required for different

investment strategies. Concentrated equity managers, for example, have typically displayed excellent security

selection and their winners have outweighed their losers by more than 1.5x. In contrast, high frequency strategies,

such as quant hedge funds, require lots of breadth/dispersion to demonstrate skill.

9 Michael J. Mauboussin & Dan Callahan, CFA, Dispersion and Alpha Conversion: How Dispersion Creates the Opportunity to Express Skill, https://www.morganstanley.com/im/publication/insights/articles/dispersion-and-alpha-conversion.pdf?1586895497145 p.3 10 David Rynecki, “How To Profit From Falling Prices: Interview with Bill Miller,” Fortune, September 15, 2003.

Strategy Batting Average Slugging Ratio Breadth

Venture capital Low (< 50%) High (>2.5) Low

Buyouts High (>70%) Medium (>1.5) Low

Concentrated equity High (>70%) Medium (>1.5) Low

Russell 1000 Medium (50%) Medium (>1.5) Medium

Diversified momentum Low (< 50%) High (>2.5) Medium

High frequency Medium (50%) Low (>1.0) High

The data used by Mauboussin and Callahan supports the consensus that 2020 should be a year in which active

managers can exploit high dispersion of returns to display skill and generate positive information ratios. The

opportunity for active equity investors to do so in prior years has been greatly reduced due to record low dispersion.

What is also apparent is that there are different ways for active managers to express skill, primarily via a high batting

average or a high slugging ratio, and each approach is valid depending on the manager’s style and philosophy. What

is most clear is that when markets are a lot less efficient than normal, like they are now, investment managers with

true skill have much greater opportunity to differentiate themselves and generate significant alpha.

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