A Portrait of Quantitative Failure From Bank of America

A portrait of quantitative failure as published on the front of a recent Bank of America research report. Presented without comment.

Quantative failure

And chart highlighting how strong the UK’s position is in the EU. It also shows the staggering difference in unemployment across the continent.

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Diversification: What Is It Good For?

The investing world can be a complicated place.

There are two main approaches to portfolio management when it comes to concentration. The first approach is broad diversification, favoured by value investors such as Benjamin Graham (Graham’s advice of having a well-diversified portfolio of 30 or more deep value stocks) and more recently Noble Prize winning economist Harry Markowitz in his Modern Portfolio Theory, and Dr John Lintner, both of whom strongly advocated diversification.

On the other hand, there’s the highly concentrated approach favoured (and popularised) by the likes of Warren Buffett.

Both strategies have their advantages. For most investors, the majority of their portfolio’s returns will come from one or two critical investments (for both Benjamin Graham and Warren Buffett GEICO was the one investment that immortalised their position in the investment world).

It’s impossible to pick these winners at first glance (most investors don’t have the time or experience) that’s why it’s so key to let your winners run cut losers.

Unfortunately, the hard data shows that most investors are chasing an illusion by looking for these home run stocks. According to a recent report by JP Morgan, 75% of all concentrated investors would benefit from diversification.

According to the report, titled “The Agony & Ecstasy: The Risks And Rewards Of A Concentrated Stock Position.” The return on the median stock since its inception vs. an investment in the Russell 3000 Index is -54%. Two-thirds of all stocks underperformed vs. the Russell 3000 Index over the period studied and 40% of all stocks delivered negative absolute returns.

Furthermore, the report highlights that since 1980, 320 companies were deleted from the S&P 500 due to “distress” reasons. So, during the past three-and-a-half decades, 64% of the index has been turned over. To put it another way, if you piled into just one S&P 500 stock 30 years ago, there’s a one in three chance that particular equity would still be in the S&P 500 today.

But don’t despair there are some winners to be found out there — the odds are just stacked against you when it comes to finding them.

JP Morgan calculates that the chance of actually finding an extreme winner is just 7% (generated lifetime excess returns more than two standard deviations from the mean). In comparison, since the 1980s 40% of all companies experienced a severe loss and never recovered.

According to these figures, for most people, trying to be clever and running a highly concentrated portfolio will likely end in disaster.

If you think the odds of becoming a successful investor are stacked against you, it’s because they are. 

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A Sneak Preview Of My Interview With Boyle Capital

In the middle of April, I interviewed Brian Boyle, the founder and portfolio manager of Boyle Capital as part of ValueWalk’s Value Fund Interview Series. The interview’s scheduled to be published over the next week but here’s a sneak preview of our discussion on Berkshire Hathaway and Fairfax Financial:

“Rupert Hargreaves: Alongside Fairfax you own the value investor’s staple stock Berkshire Hathaway. Both Berkshire and Fairfax are relatively similar businesses but if you had to pick one of the two, which would you pick?

Brian Boyle: If I was to pick just one based on growth prospects alone, I would have to go with Fairfax. Fairfax is the smaller company and has more room for growth going forward, but that growth potential comes at a cost which is greater volatility. Berkshire is a relatively stable investment. As we are doing this interview, the stock is currently trading at around $143 per share. Book value is around $104. Buffett has stated that he is willing to buy back stock at around 1.2 times book value, around 12% to 13% below the current price, which gives you a pretty sizeable margin of safety. The downside is limited to 13%, and there is also plenty of upside as the company continues to grow steadily. Berkshire’s earnings are likely to grow at a compound annual rate of around 8% to 10% going forward, and the conglomerate has a fortress balance sheet which can be used for both acquisitions and to reward shareholders.

The flipside of this is the fact that Warren Buffett won’t be around forever — that’s the main key man risk here. With Fairfax, this is a smaller company, and it doesn’t take much in the way of growth to move the needle. The group also has emerging market exposure and we think this can really fuel long-term growth. For me, if I had to pick just one I would pick Fairfax because it has a better long-term growth potential. That said, I like to own both Berkshire and Fairfax in a portfolio. The thing with Berkshire is that the group’s very large equity portfolio can lead to volatility, so results tend to be irregular. Fairfax’s insurance operations produce steady growth, so the company’s shares are likely to perform better in rocky markets. Still, over the long-term both companies are likely to produce impressive returns for shareholders, provided that investors buy them at appropriate valuations. Right now, we believe Fairfax is fairly valued while Berkshire is undervalued.

RH: You believe Berkshire Hathaway is undervalued at present levels?

BB: Yes, we believe Berkshire Hathaway’s B shares have an intrinsic value of around $185 per share. That’s based on the value of the company’s investments and cash, plus operating businesses valued at 12 times earnings.”

Should You Buy A Company After A Dividend Cut?

First published at ValueWalk.com

Should you buy a company after it has cut its dividend? That’s the question Morgan Stanley’s analysts have tried to answer in a European Equity Strategy research note sent to clients today and a reviewed by ValueWalk.

Morgan’s research has been prompted by renewed investor interest in dividend cuts. Against a depressed earnings base, the market’s dividend payout level looks high in a historical context and the median stock’s payout ratio is close to a 20-year high. On a pan-European level, the payout ratio has exceeded 2009 levels. It’s also important to note that this is not an anomaly that is limited to a few key sectors, the percentage of stocks with a payout ratio in excess of 60% of earnings per share has reached the highest level in 20 years.

As European investors have seen over the past few months, even those companies that were considered dividend aristocrats aren’t in any way immune from payout cuts with companies like Rolls-Royce, BHP, EDF, RWE and Repsol all cutting their dividends during the past six months.

An updated study 

This isn’t the first time Morgan’s investigated this question. Back in 2008, the bank conducted a similar research exercise and found that dividend cuts can indicate powerful inflection points in share prices. At the time, the research showed that investors could do well by buying stocks on dividend reductions, particularly those that are stressed.

In the 2008 version, Morgan’s research showed that UK companies that cut their dividend tended to outperform thereafter, especially if the shares had previously been poor performers, the payout cut was large or the starting yield was high.

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In this updated version, Morgan examines 372 instances of dividend cuts in Europe over the last ten years. The stocks are based on the current constituents of MSCI Europe IMI, with a current market cap bigger than $2 billion. To qualify as a dividend cut, the company’s dividend payout has to be reduced by 5% or more.

Should you buy a company after a dividend cut?

The results of this study are rather interesting.

It appears that dividend cuts are indeed, often inflection points for stock performance. Morgan’s research on the 372 instances of dividend cuts in Europe over the last ten years shows that the median stock underperforms the market by 19% in the preceding 12 months but then outperforms by 11% in the subsequent 12 months, and by 19% by the end of year two. The probability of a stock beating the market in the following 12 months after a dividend cut is 65%, and 66% of the subsequent 24 months.

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The research also showed that the strongest outperformance comes from stocks where the dividend yield ahead of the cut was 12% or higher with a hit ratio of 83% in the subsequent 12 months and 88% in the following 24 months. The weakest performance came from stocks trading on a dividend yield of 4% to 6% ahead of the announced cut.

Stocks that underperformed the market ahead of the dividend cut announcement tended to outperform the most after a cut. Among the stocks that underperformed more than 60% prior to the cut, 74% outperformed on a 12m basis and 86% outperformed on a 24m basis. The weakest subsequent performance came from the group that underperformed less than 20%, with a hit ratio of 61%, even on a two-year basis.

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And lastly, the size of the dividend cut has an effect on performance after the event. In the 372 cases studied by Morgan’s analysts, the average dividend cut is more than 80%. Stocks that cut their payouts by more than 60% outperformed the most post the cut. The weakest performing group is the one that cut the dividend by 20% to 40% – even on a 2-year view, only 56% of such companies outperformed the market.

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Dividend Cut – The bottom line 

All in all, this analysis from Morgan presents a pretty compelling argument: investors should buy stocks on dividend cuts, particularly those that have underperformed significantly ahead of the announced dividend cut, that previously had a very high yield, and those that cut their dividend by 60% or more.

This analysis is aimed at European investors and Morgan also provide some investment ideas in the form of stocks that cut their dividends in the last year and are ‘stressed’.

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Dividends And Buybacks: Frequently Asked Questions

Dividends and buybacks split investors. Both are a form of cash return to shareholders, but both also have their drawbacks. Company executives view these two methods of cash return very differently and are often unsure which is the best strategy to adopt.

Three ways to return cash

When it comes to capital returns, a company should retain its earnings if it can earn a rate of return that is above the cost of capital. But if shareholders can earn a higher rate of return on capital than the company can, the firm should disburse the cash.

There are three ways a company can transfer cash to its shareholders:

  1. The company can sell itself for cash. Rewards all shareholders.
  2. A company can pay a dividend. Rewards all shareholders.
  3. A company can buy back its shares. Only shareholders who sell can cash in.

The topic of how best to return cash to investors through dividends and buybacks is especially relevant in today’s environment as corporate cash levels reach record levels.

However, the case for, and against buybacks and dividends is complex. Some investors swear by dividends, and others want buybacks only. Few have carefully and rigorously thought through their positions.

Credit Suisse’s Michael J. Mauboussin tried to answer some of the fundamental questions sounding buybacks and dividends in a research note issued to clients of the investment bank back in 2014. The following summary is a summary of Mauboussin’s research.

Question 1:  How are share buybacks and dividends the same?

Buybacks and dividends are fundamentally the same; they’re both methods of distributing cash to shareholders. What’s more, assuming that taxation is identical, there are no transaction costs, dividend funds are reinvested at the same rate, and the stock is trading at a fair price, then there’s no clear, identifiable difference between buybacks and dividends.

However, in the real world, these assumptions do not hold. Therefore, from the point of view of the shareholder, buybacks offer more flexibility than dividends because they allow the shareholder to control the timing of taxes.

Question 2: How are share buybacks and dividends different?

The data shows that the most fundamental difference between buybacks and dividends is the attitude of executives. Specifically, executives tend to believe that maintaining the dividend is on par with investment decisions such as capital spending while buybacks are linked more to residual cash flow. As a result, dividends provide a strong signal about management’s commitment to distribute cash to shareholders and its confidence in the future earnings of the business. Buybacks tend to be viewed as a lever that can increase earnings per share under the right conditions.

As noted above, another key difference between buybacks and dividends is the fact that dividends treat all investors the same. Buybacks only benefit those that sell.

Question 3: What are the philosophies that motivate share buybacks?

The simple answer is there are three main philosophies that motivate buybacks, fair value, intrinsic value, and accounting. The first two philosophies help to create shareholder value while the third is a side effect of performance-based pay packets.

The first philosophy, fair value takes a steady and consistent approach to buybacks. Management recognizes that buying back stock is not an exact science and doesn’t try to time purchases. However, management also acknowledges that by distributing funds it’s less likely to do something foolish with the funds. Research suggests that most companies would have been better off buying back stock consistently versus their actual behavior of buying heavily in some periods and lightly, or not at all, in others.

The second philosophy, intrinsic value is based on the notion that a company should only buy back shares when it believes that they are undervalued.

And the third opinion is usually based on management’s desire to increase company EPS. This means that the goals of the program may not be aligned with shareholders. Increasing EPS may help management reach a financial objective that prompts a bonus.

Question 4: Share buybacks add to earnings per share, isn’t that good?

It’s important to note that buybacks do not necessarily increase EPS. The company has to pay for the buyback, which means that earnings are lower with a buyback program than they would be without it. As Mauboussin explains:

“A company can fund a buyback one of two ways. Either it can use excess cash, or it can borrow money. Whether a buyback is accretive or dilutive to EPS is a function of the relationship between the after-tax interest rate (either foregone from cash or incurred from debt) and the inverse of the price/earnings (P/E) multiple.”

Take the following example:

(click to enlarge)


Question 5: How should you assess the merit of a buyback program?

The golden rule of buybacks is that a company should only repurchase its shares when its stock is trading below its expected value, and no better investment opportunities have been identified.

Unfortunately, it’s difficult for shareholders to assess accurately the merits of a buyback program without access to additional (inside) information on the company’s operations and investment opportunities.

Question 6: Aren’t companies that overpay for their stock harming their shareholders?

“Only if a stock trades exactly at intrinsic value do buybacks and dividends treat all shareholders the same. If a stock is over- or undervalued, the effect of a buyback is different for selling shareholders than it is for those who continue to hold. “

Since management’s key focus should be on building value per share for continuing shareholders, it should always try to buy back shares that are undervalued. Therefore, buying overvalued stock does indeed harm shareholders. That said, assuming you own shares of companies that you think are undervalued buybacks will, by definition, increase value per share.

Question 7:  Does it ever make sense to repatriate cash, pay taxes, and then buy back shares?

There’s a surprisingly simple answer to this question: Only if the stock price’s discount to intrinsic value exceeds the incremental tax rate of the repatriated funds.

The matrix below provides a guide to the analysis required for this calculation assuming an 8% cost of equity.

PEs and buybacks 2


Question 8: Isn’t it true that the majority of total shareholder returns are the result of dividends?

No. According to Mauboussin, this is one of the great misconceptions of the investing industry as price appreciation is the only source of investment return that increases accumulated capital over time.

The key to understanding this comment is to distinguish between the equity rate of return and the capital accumulation rate. The capital accumulation rate, often measured as total shareholder return (TSR), is a multi-period measure that assumes all dividends are reinvested in the stock. The equity rate of return is a one-period measure that merely adds price appreciation to dividend yield.

The value of the compounding reinvested dividends means that the TSR, or capital accumulation rate, is always higher than the equity rate of return as long as the stock has a achieved a positive return.

But the problem is, almost no one reaches the full TSR potential available to them. As Mauboussin explains:

“First, most individuals do not reinvest the dividends they receive from the stocks they hold directly. While no definitive public statistics exist, individual investors appear to reinvest just 10 percent of the dividends they collect…Second, unless investors own individual, dividend-paying stocks in a tax-free account, they have to pay taxes on their dividends. This means that they can only reinvest a fraction of the dividends they receive, which prevents them from earning the TSR.”

The bottom line

Overall, buybacks and dividends have similar qualities but treat different groups of shareholders differently. Buybacks only benefit continuing shareholders when the stock is undervalued while dividends treat all investors equally.

You can read Michael Mauboussin’s full PDF at ValueWalk.com where the original version of this article was first published.

What You Should Look For In The Perfect Dividend Stock

If you’re a regular reader of this blog, you might have noticed that I’m not a big fan of dividends. Personally, I would rather invest in a company that’s using excess cash to pay down debt or buy back stock — a more tax efficient method of returning cash to investors.

Buybacks and dividends are fundamentally the same; they’re both methods of distributing cash to shareholders. What’s more, assuming that taxation is identical, there are no transaction costs, dividend funds are reinvested (by the investor) at the same rate, and the stock is trading at a fair price, then there’s no clear identifiable difference between buybacks and dividends.

However, in the real world, these assumptions do not hold. Therefore, from the shareholders point of view, buybacks offer more flexibility because they allow the shareholder to control the timing of taxes.

The data shows that the most fundamental difference between buybacks and dividends is the attitude of executives. Specifically, executives tend to believe that maintaining the dividend is on par with investment decisions such as capital spending while buybacks are linked more to residual cash flow. As a result, buybacks tend to be viewed as a lever that can increase earnings per share under the right conditions while dividends provide a strong signal about management’s commitment to distribute cash to shareholders and its confidence in the future earnings of the business.

Unfortunately, management’s commitment to dividends can also damage a company’s prospects. Indeed, as I’ve covered before (here) enterprises that are set on returning the majority of earnings to investors via dividends chronically underinvest in growth. As management seeks to protect the dividend at all costs, growth spending takes a back seat.

Dividends are key

Having said all of the above, an overwhelming volume of research shows that dividends are the most significant driver of equity returns over the long-term. This research can’t be ignored.

For example, according to investment bank Société Générale since 1970 US equities with dividends reinvested have produced an annualized real return of 5.2%. However, if dividend payments were spent instead of reinvested over the same period, the average investor’s real return would be 3% per annum. Excluding dividends entirely, equities have produced an annualized real price return of only 2.2% since 1970. The compounding effects of the dividends really do dominate returns in the long run.

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Unfortunately, picking the best income stocks to help you reap the benefits dividend compounding isn’t as easy as it may first appear. Contrary to popular belief, if you want to achieve the best long-term returns from dividend stocks you should be looking for the companies with the lowest dividend yields.

According to SocGen’s research, on average, the spread between the expected dividend yield (the payout analysts expect) of a particular stock, and the realised yield (the payout that investors actually receive) starts to widen above 4%. In other words, if a stock’s expected dividend yield is greater than 4%, the chance of the actual payout being less than the market expects, increases with every 100bps increase in yield, as the chart below illustrates.

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SocGen’s research appears to show that high dividend yields should be avoided. Even index trackers can’t be trusted. Take the FTSE World High Yield index for example. As shown below the index has consistently produced a realised yield below what has been expected. Many of the stocks in the index yield more than 4%.

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Dividends: Hunt for quality

Unsurprisingly, SocGen’s research on dividends concludes that the companies with the most secure dividends have two key qualities; 1) strong balance sheets; 2) high-quality businesses.

SocGen’s preferred methods of calculating a company’s balance sheet strength and quality, (as a result its dividend sustainability) are the Merton model (balance sheet strength) and Piotroski F-score.

The Merton model looks at the equity of a firm as being a call option on the firm’s assets. SocGen employs the model to determine a company’s ability to service its debt, meet its financial obligations and to gauge the overall possibility of credit default. Companies with the highest Merton model scores have produced the best returns for investors over the long-term with the least volatility.

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Also, the evidence shows that the shares of companies with higher F-scores have outperformed those of lower quality peers.

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The bottom line

So all in all, the evidence is pretty clear. If you want to achieve the best returns buy quality dividend stocks and don’t chase yield. Chase quality and the returns should follow.

Nine Value Picks For 2016

First published at ValueWalk.com

2015 has been the year of the FANGs, (Facebook, Amazon, Netflix and Google), which collectively are up 86% in 2015. FANG names plus six other high-growth plays added 74 points or 3.6% of S&P 500 returns as investors followed the ‘growth at any price strategy.’

But Fundstrat’s Tom Lee believes that the FANG group will struggle in 2016 as value is set to stage a comeback.

See also: Is Value Set For A Comeback?

FANGs rarely repeat outperformance in the following year

Tom Lee highlights several key points which support his argument that the FANGs will underperform in 2016, and let value lead the market instead.

First off, since 2005 the top 10 winning stocks of one year, always underperformed the following year by an average of 290bp (48% win-ratio). For example, last year, the best-performing stocks of 2014 subsequently turned into the worst drags in 2015.

FANG stocks3 FANGs

Since 2005, the top ten stocks underperformed the S&P 500 by 290bp on average in the following year. Figures show that the odds of FANGs outperforming again is 48%. That means the group as a whole has a 52% chance of underperforming the S&P 500 by 290bps next year. The odds are against further outperformance.

Value is set for a comeback next year

With the figures suggesting that FANGs will underperform next year, Fundstrat’s Tom Lee sees value outperforming for the year. Why? Well, FANG names now trade at an eye-watering average forward P/E of 100 and each FANG name is a member of the Growth Index. These stocks account for 9% of the Growth index, which means that they’ve done much of the heavy lifting for the index during the past twelve months.

If the FANGs underperform next year, the headwind against value should be significantly lessened, which could ultimately translate into improved performance for value stocks. Once again, figures going back to 2005 show that when growth struggles, value usually outperforms.FANG stocks2 FANGs

Stock Strategy: 9 Stocks

With value set for a comeback next year, Fundstrat screened the market for those stocks that are most likely to benefit and chalk up a positive performance. Tom Lee and his team screened the market for the stocks that met the following criteria:

  1. Stock is one of the bottom 25 contributors to S&P 500 point change YTD 2015;
  2. Stock’s dividend yield is greater than its bond yield (hat tip to Benjamin Graham);
  3. Market cap is, at least, $10B; and,
  4. Positive implied upside (based on analyst price targets).

Here are the nine stocks that qualify. At the time of writing the author is long IBM and CVX.

nine stocks