Sexy Stocks, Not so Sexy Returns
Arrowhead Pharmaceuticals hopes to cure intractable diseases by silencing the genes that cause them. HortonWorks, the creators of Hadoop, can deal with data-in-motion and data-at-rest, regardless of whether it’s in the cloud or the data center.
Arrowhead Pharmaceuticals might cure intractable diseases and HortonWorks might do something cool with computers that’s beyond my understanding, but neither company has yet been able to turn a profit. Over the last 12 months, Arrowhead spent $64 million on cash from operations and issued $56 million of common equity, while HortonWorks burned $100 million in cash from operations and issued $98 million of stock.
Both companies also share a dubious honor in common: scoring near the very top of a screen for companies likely to issue new stock and generate low future equity returns. My mentor at Stanford, Charles Lee, has developed a new model aiming at identifying these stocks along with research partner Ken Li. These companies have high investment needs, low or negative profitability, and a high propensity to issue shares to the public.
According to the model, firms that score highly on this metric are not only more volatile than the broader market but produce much lower returns: an average of -30% future returns per year. Below is a graph from Lee’s paper that shows the base rate of return for this reference class of stocks, which he labels high predicted stock issuers (high PSI), as compared with companies that are highly profitable with low investment needs (low PSI).
Figure 1: Returns from Long Value Stocks vs. Short Glamour Stocks
Source: Lee and Li, “Sexy or Safe.”
So it leads us to wonder, why would investors continue to put money in these types of companies? Traditional models would require investors to be compensated for taking so much risk with some sort of excess return, but that’s not what these types of companies are expected to provide.
Lee’s explanation for this anomaly is that these companies are sexy. Like HortonWorks or Arrowhead, these companies make big promises about the future. And, sadly for investors, these high expectations are rarely ever met. These stocks are likely to miss earnings, and the subsequent price drops can be precipitous. Below is a graph showing abnormal earnings announcement returns for the firms that score on the extremes of Lee’s model.
Figure 2: Average 2-Day Returns after Earnings Announcements over Subsequent Two Years
Source: Lee and Li, “Sexy or Safe.”
These findings challenge current thought regarding risk in investing: that it is associated with higher potential returns. Lee’s research suggests that firms most likely to issue stock are far from “safe.” Investors are investing in them primarily because of their sex appeal and salience.
This model predicts that these high investment low profit firms will be poor performers in the equity markets. Fortunately for value investors, the converse is also true: buying highly profitable, highly cash generative businesses at low prices is a well-proven strategy for generating superior returns.