Using required return (the risk side) of the MyClime Equation to identify stocks for the long term investment

As investors we tend to search for stocks by focusing upon the “normalised return on equity” filter. Our focus is on companies which have a high or rising return on equity (ROE) in coming years. Whilst there is nothing wrong with this, we believe that searching for stocks solely from the return side can sometimes be misleading and especially so if one is not considering the risks, the volatility and cyclical nature of the business. Further, high ROE is difficult to maintain for long periods and a approach solely based on ROE will eventually lead to high portfolio turnover as ROE’s of some companies inevitably slow or are affected by normal economic cycles.

However, we believe that the risks to a specific business do not vary significantly over a period and thus a “required return” approach may identify stocks with consistently high total returns over time. This “risk side” approach for an investor focuses upon stocks which can and do justify a lower required return when compared to the market as a whole.

The “Risk” Approach to Investing (Selection Criteria)

You may recall that we have a quantitative approach to determine the required return of all stocks we cover in MyClime. In calculating the required return for each stock, we have used more than 20 attributes / factors. Half are external and half are internal factors. In this analysis the market capitalisation of a company is excluded as an input. Each factor will impact on the measure of risk of a business. From all of these factors, we derive the required return of each individual stock without considering its size or market liquidity.

In order to select stocks using the risk side of the equation, we have looked at more than 100 profitable companies. We then calculated the effect (represented by a value) of the internal and external factors for each company. We then aggregate these into just one number, called the risk number. As there are more than 100 profitable companies’ spanning over large and small capitalised stocks, we can then calculate the average risk number for this population.

So how do we identify the more “attractive businesses” from the “average businesses”? Fortunately, mathematics has taught us how to do that. There is a term used in statistics, known as the standard deviation. The standard deviation is a widely used measurement of variability or diversity used in statistics and probability theory. It shows how much variation or “dispersion” there is from the “average”.

Thus, the idea is that in addition to the calculation of the “average business” risk number, we also calculate the standard deviation of this risk number from this population of more than 100 profitable companies. Thus, to identify the best companies we choose those in which the risk number is at least one standard deviation from the average risk number on the lower risk side. In other words, we pick attractive businesses which stand out from the average ones.

Under this approach, there are only 19 stocks out of the more than 100 stocks in which satisfy these selection criteria. We list the 19 stocks below.

Candidates based on risk factors
AGK, ASX, ANN, ANZ, BKL, CBA, COH, CSL, IRE, IVC, QUB, NAB, ORG, ORL, RHC,SAI, TLS, WBC, WOW

An immediate observation of this list is that there is no resource or resource related stocks. This is because resource stocks are much leveraged to global growth. As we know, resource booms come and go and have been doing so for more than 200 years. Thus, it is not possible to gauge with great confidence how long this cycle may last. Thus, the required returns for holding resources companies are much higher and none of them made it into the list of “attractive business” over a long time frame. (+10 years for example).

It should also be emphasised that the above is not the only possible selection process using the risk or required return. For example, one may decide to segregate the external and internal factors and seek out stocks with good external and/or internal attributes separately and any other combinations to suit one’s strategy.

We should emphasise that we have not paid attention to the valuation or price here, but have merely tried to identifying good quality companies based on risk factors in our quantitative required return model (QRRM). To prove this is a good strategy for the long term (+10 years), we now turn to back testing of the performance of these stocks over the past decade. To our surprise, they also have proven to be very strong performers in the short term – 1 year time frame!

Back Testing

The 1, 3, 5 and 10 years performance return for these 19 stocks are tabulated in Figure 1. Also shown is the average total return for the whole portfolio of 19 stocks with equal weighting as well as three other accumulative indices; the All Ordinaries Accumulative (XAOAI); ASX200 Accumulative (XJOAI) and ASX200 Industrial Accumulative (XJIAI) indices.

Image: Annualised Performance Return

- indicated, not listed then

Figure 1. Annualised Performance Return (including dividend) to 31 Dec 2010 for selective 19 stocks
Source: Calculated using data from IRESS

We see that the 1, 3, 5, and 10 year’s performance has consistently outperformed the market as shown in Figure 1 and 2.

For example, in Figure 2 below, we see that these 19 stocks have outperformed the All Ordinaries Accumulative Index by 13.15% p.a; 11.29% p.a.;  8.07% p.a. and 4.63% p.a. respectively and even better for the other listed indices.

Image: Annualised Performance Return

*All Outperformances are annualised

Figure 2. Outperformance by strong and investment grade stocks against market indices.  
Source: Calculated using data from IRESS

Image: Annualised Performance Return

Figure 3. The performance to 31 Dec 2010 of the 19 attractive stocks compared to XAOAI, XJOAI and XJIAI.

Even without the strong performing resource stocks, it is clear the list of 19 attractive stocks based on a risk filter have consistently outperformed three common benchmarks for the 1yr, 3yr, 5yr and 10yr.

What have we learnt from this exercise?

  1. Using the risk filter we can identify a portfolio of stocks that not only consistently outperform the market significantly in the short term (+1y to +3y) but also for the long term (+5 to 10y).
  2. The price performance of these stocks pre and post global banking crisis is consistently good. Whilst it is clear that some of these stocks are trading at a premium to or at our MyClime valuation, a portfolio of these stocks still managed to generate a absolute positive return against a negative market. This provides strong evidence that they are:a. Resilient in a negative market; andb. Sufficiently well diversified to provide a positive return.
  3. Post GFC, when the market took off again, we note that these investment grade stocks outperformed a rising market.

Conclusion

Whilst it is important to identify companies that are consistently profitable, it is also important to identify companies who over the longer term have a lower risk profile than the broader market. Many commentators and advisors fail to understand risk and fail to understand how it is calculated.

In essence, a portfolio which has a healthy exposure to both highly profitable and low risk companies will outperform over the long term.

Read Part II: Using the “risk side” of the MyClime Equation to identify stocks for the long term investment

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