Right for the Right Reasons?

Our friend Woody Brock says that it should be the goal of investors to be “right for the right reasons.” But that’s been awfully hard for quantitative investors to do over the past decade.

Nobel Prize winner Eugene Fama and his research partner Ken French have identified four key factors that predict returns in the market: size, value, investment, and operating profitability. Over the long term, across many markets, smaller, cheaper companies that invest less cash than they produce and generate high profitability relative to their assets tend to return more than large, expensive companies that invest more than they produce and generate low profitability relative to their assets.

Below, we show how portfolios combining size with each of the other three factors performed from 1963 to 2020 and from 2010 to 2020. What’s noticeable about this graph is that in every case except for one (more on that later), the “wrong” portfolios worked this decade and the “right” portfolios lagged the market.

Figure 1: Factor Portfolios

Source: Ken French

Over the past decade, expensive stocks beat cheap stocks (LoBM beat HiBM), big stocks beat small stocks (BIG beat SMALL), and companies that invested more cash than they generated from operations beat companies that invested frugally (HiINV beat LoINV).

The investors we think have the best case to have been “right for the right reasons” over the past decade were those investing in large companies with high operating profitability (BIG HiOP), as this strategy both worked over the long term and over the last decade. This academic factor can be defined as gross profits divided by book value or by total assets and makes more sense when thought of as a measure of return on assets. These companies are often referred to as “compounders,” where incremental investments generate substantial future profits.

Large compounders (BIG HiOP in the chart) outperformed the S&P 500 by almost 2% per year over the past decade, whereas the large companies that scored poorly on this factor (BIG LoOP in the chart) dramatically underperformed the market over the past decade and were among the worst performers over the full period.

To make this more tangible, here’s a list of the top 25 S&P 500 constituents ranked by operating profitability at the end of 2009 and their compound returns over the subsequent decade. Note that unlike value and momentum, profitability levels tend to be stable, so it's possible to buy and hold a relatively stable portfolio for a long period. We can see a few of the best performing stocks of the decade on this list: Mastercard, Sherwin-Williams, Monster Beverage, Estée Lauder, Starbucks, Bookings Holdings.

Figure 2: Top 25 S&P 500 Constituents in 2009 by Gross Profitability

Source: Capital IQ

These stocks have significantly outperformed the S&P 500. The only two that lost significant amounts of money over the period were two companies in the for-profit education sector that got regulated out of existence. Almost everything else made money. Investors who specialize in these types of companies, like Terry Smith of Fundsmith, have very distinguished 10-year track records and a solid claim to be executing a strategy supported by academic evidence.

But what does this suggest investors should do today? Is it time to build a substantial portfolio of these large-cap compounders? Will the same pattern hold over the next decade? Or would investors just be piling into a popular approach, endorsed by experts, at high valuations?

We are cautious, particularly about these kinds of “compounders” in the United States. We fear this fundamental factor might be overbought and the performance above is in part the result of investors becoming more willing to pay a higher price for compounders over the decade. In 2009, the S&P 500’s top 25 “compounders” traded at a 30% discount to the rest of the S&P 500. Fast forward to today: the top 25 “compounders” trade at a 10% premium to the rest of the S&P 500 (the short list includes names like Intuit at 9.6x sales, Cadence Design at 8.4x sales, IDEXX Laboratories at 9.9x sales, Align Technologies at 9.3x sales, and Mastercard at a whopping 18.7x sales). Large growth compounders look about 30–40% more expensive today relative to low compounders in that universe.

However, investors looking for high capacity strategies that do not require significant turnover could consider international compounders, particularly those that are also value stocks.  The top large-cap international compounders trade at a 30-40% discount to the top large-cap US compounders.  Below we show a list of 20 of the top ranked international large-cap stocks on gross profitability, highlighting those that qualify as value stocks based on trading below the international market median valuation.

Figure 3: 20 Top Large-Cap International Stocks by Gross Profitability

Source: Capital IQ

We think these types of stocks could potentially represent an attractive opportunity for investors constrained to larger-capacity investments, particularly those looking to buy and hold.

 But investors historically have earned 2–3x the return premium by pursuing optimal factor strategies in small-cap stocks rather than large-cap. Over the long term, the best performing portfolios have been small companies that are cheap, generate a high return on assets, and invest less cash than they generate from operations. Those strategies may have been the worst performing over the past decade, but that also means that the discount these stocks trade for in the market is near all-time highs, which has historically been a very positive signal for future returns.

Small-cap value investors have been “wrong for the right reasons” for a long time now, but we have seen time and again over long periods that market feasts follow market famines and that patience can be rewarded in the “right” strategies, particularly when they are out of favor and thus undervalued.