Sunday, May 24, 2009

Quantizing The S&P 500

There may yet come a time, when chasing Beta is no longer the preferred approach to generating returns, and together with Keno, Black-Jack, Craps and No Limit Hold Em, investors drop this most ridiculous of "investing" strategies. There may, indeed, yet come a time, when such old-school, boring, mundane and critical concepts as valuation, cash flow and profitability once again figure in research analysts' reports instead of trying to determine which is the next sector to be socialized under the guise of too big to fail, or where the short interest is highest, and ploughing enough cash in the most shorted stocks with hopes of destroying those who are reminded of the old maxim that when you are short, your downside is unlimited.

In what is likely a foolish exercise of rationality, Zero Hedge has performed the type of analysis which as recently as 9 months ago portfolio managers actually cared about. I have analyzed the stocks in the S&P 500, and have split the 500 companies into the following buckets: Enterprise Value (EV) to Projected EBITDA of 0-5.0x (44 companies); 5.0x-7.5x (186 companies); 7.5x-10.0x (121 companies); 10.0x and higher (101 companies), with the negative multiples ignored. P/E ratios are ignored as they are totally useless in the current (and pretty much every other) market, as every company merely tries to game accounting practices by dumping or adding a whole lot of "value" below the line. Instead, in this analysis I care mostly about EBITDA and its closest proxy, actual cash flow: the one truly relevant metric that is most difficult to be fudged, adjusted, modified, recasted, pro forma'ed, etc.

The first chart is a 1-6 month performance matrix relative to both the set's average and the S&P. The companies are segregated by market capitalization and scatterplotted by sector. Not surprisingly, the cheapest companies (lowest EV/Fwd EBITDA) are the ones that have performed the weakest on both an absolute and relative performance basis. In this chart the most glaring outlier is the large rose box in the right-most scatterplot, which has returned about 100% in the past 6 months, and represents Amazon, possibly the most ridiculously overpriced stock in the entire universe. Observant readers will note that the average of all 4 buckets is still below the 6 month average return for the entire S&P500, meaning that the highest returns within the index, were driven by companies that have an EV/EBITDA less than 0x, or in other words, companies projected to have negative cash flow outperformed every other company bucket. A personal observation: a fundamental value portfolio manager presented with two investment theses: one- to put money in a company that is valued sub 5.0x and another- to invest in a company that does not even have positive EBITDA, will likely only choose the latter if he has just consumed half a gallon of 151, suffers from Tourettes and Schizophrenia at the same time, is suicidal and really hates his LPs. This merely means that when it comes to actual investing decisions, neither quant value factors, nor fundamental asset managers would have been responsible for the run up in garbage stocks, once again demonstrating the miraculous results of a concerted rolling buy in, especially when the buck may have yet again been broken at certain very, very large stock lending custodians. But more on this topic over the next few days.

The next chart presents essentially the same data in a slightly different scatterplot, with the initial underlying sort again predicated by EV/EBITDA bucketing as per the categories described above.

Continuing the drill down, the next chart demonstrates the relative performance of specific sectors in the 4 EV/Fwd EBITDA buckets. What is obvious is that over the past month, the biggest pain was focused in the Consumer and Telecom sectors, especially for constituent companies that were already richly priced (over 10.0x EV/Fwd EBITDA). One curious observation is the large divergence of financials in the sub 5.0x bucket (20.3% outperformance) and the 5.0x-7.5x bucket (-5.4% underperformance). Two sectors that beat across the board were Energy and Materials, most likely due to the reincarnation of the inflation trade over the past month, and the rapid rise in commodity costs. Investors were much less sensitive to relative value in energy as a result and were buying stocks of both cheap and expensive companies.

Possibly the most interesting chart is the scatterplot of valuation buckets by beta bins. While one would expect merely a diagonal line by definition, as higher betas provide better returns in a rising market, the relative flat lining of the S&P over the past month may have provided a glimpse into some more relevant inner workings of the market. Whereas beta stacking was not surprising in the cheap bucket (<5.0x), the richest bucket demonstrated that the lowest beta companies generated nearly as high a return as those with the highest beta. And the lack of beta correlation in the other 2 buckets was just as evident. In other words, this demonstrates that over the past month, neither quant value and momentum factors worked, nor did signals based on any traditional reliance on beta. In yet other words, the confusion in the market is reaching dangerous levels... which of course is self-evident.

Lastly, more for amusement than any other reason, I present the performance of companies by valuation buckets scaterplotted by % hedge fund ownership. A curious observation here is that while hedge funds that had bought en masse cheap, sub 5.0x companies generated solid, 20%+ returns in the last month, overpriced companies, especially in the 10x+ projected valuation range, caused a lot of pain for their hedge fund masters, with the groupthink which accounted for anywhere between 40-60% of given companies' stock share count generated an ugly -10% return over the last 30 days. Then again, the best test for this metric is and has always been the performance of Carl Icahn favorite Federal Mogul, which at last count, had hedge fund ownership accounting for 70%+ of its share count.

Charts courtesy of CapitalIQ.

disclosure: short Amazon
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