Interested in learning about a strategy that, from July 1953 to December 2015 if implemented, would have generated an annual return of over 20% (with a Sharpe ratio of 1.01)?
Jun Li from the University of Texas and Huijin Wang from the University of Delaware decided to look at an old investment-theory chestnut, the effect of a firm’s investment spending on it’s stock price, from a new angle. What if, instead of looking at a firm’s past spending, you looked at their future plans or Expected Investment Growth (EIG)?
Research on the effect of past spending on future stock prices is inconclusive. Some studies conclude it’s a positive for future stock price returns; but other work comes to the opposite conclusion. The work detailed in the paper highlighted here though seems unequivocal.
So how do you calculate EIG? Messers Li and Wang use a combination of three factors to generate a prediction of future firm behavior: investment growth, cash flow and observed stock return. By combining these observations they produce their EIG estimate that not only reliably predicts superior stock price performance but, where the EIG score is especially low, also flags companies headed for financial stress and therefore poor performance.
Their theoretical return of 20+% per annum comes from combining strong and weak EIG scoring companies in a long-short portfolio as the strategy appears to be reliable in both directions; an unusual combination in factor-based strategies they believe (their observations about lottery-preference overvaluation of poor companies is particularly interesting).
However, the strategy may be hard to implement in a real-world context.
First, they re-balanced their model portfolios every month, easy in theory but hard in practice. Second, they don’t appear to have made allowance for transaction costs; especially in earlier years these would have been very high. Third, they point out the strategy is especially effective for stocks that are poorly covered and understood; these stocks are notoriously difficult and expensive to deal in. Finally, the strategy has good predictive power for around a year but much after that it seems to fade (it works longer on the short side though).
I wonder if they’re not picking up something more behavioral with companies that talk a good story being preferred, at least in the short term?
Putting reservations aside the degree of out-performance evidenced is too big to swat away as being based on a data-mined conclusion; and it’s interesting to note they ran the same analysis on other G7 stock markets and achieved almost exactly the same results. So they’re on to something.
At the end of my read though I was left wondering if there was more wisdom than that which disciplined investors use already, i.e. stick to good companies with strong cash-flow investing in their business and whose share prices indicate a modicum of success with this strategy in the past?
You can review the paper in full via the following link EIG and Returns.
Happy New Year!