Should Investors Avoid Melting Ice Cubes?
The easiest way to improve your odds of winning is to choose less competitive contests. It’s much easier to be the best male figure skater in the nation than the best male football player, and much easier to be the best female ice hockey player than to be the best female tennis player.
My father wanted his children to achieve excellence – and to differentiate us when it came time to college admissions. So I spent my childhood at ice rinks, watching my sister shoot pucks and my brother land triple salchows. It was my first lesson in strategy.
And my father’s brilliant strategic insight has shaped my approach to investing, a constant voice in my head reminding me that it’s easiest to win where competition is thinnest.
And so whenever I hear a simple reason to avoid a segment of the market, I start investigating. Investing happens to be a field uniquely suited to this approach, because investing is a game of meta-analysis, not analysis. The goal is not to choose companies that do well, but to choose companies that do better than expectations. And if people have a simple heuristic in their heads like “don’t invest in heavily indebted firms” or “avoid declining businesses,” you can bet that there’s an opportunity in that segment of stocks.
This week, I wanted to examine the particular case of so-called “melting ice cubes.” These are companies that have suffered years of consistent revenue declines and are often in industries most people assume are dying: newspapers, internet ISPs, yellow pages, commercial printing, etc.
Ask most fundamental analysts and they’ll tell you that you’re crazy to even look at these businesses: Wall Street loves growth, after all, and hates a decliner. But is this investment orthodoxy correct? Or is it, rather, a rule like “men should play ice hockey and women should figure skate” that provides opportunity to the savvy contrarian?
I tested this hypothesis quantitatively using Portfolio123, which is the best commercially available back-testing software. First, I asked the software to rank stocks historical performance based on a combination of three-year, five-year, and ten-year historical revenue growth rates. In the below graph, the far left is the return of the Russell 2000 (in red), then as the bars move from left to right we go from the highest growth to the lowest growth businesses.
Figure 1: Historical Returns Based on Historical Revenue Growth
Source: Portfolio123
This chart suggests the danger lies not in the low-growth businesses, where even the worst 5% of companies on historical revenue growth outperform the broader index, but on the 20% of fastest growing businesses, which all underperform the broader index significantly. This is because many fundamental investors are trend extrapolators, who overvalue historically high-growth businesses expecting the growth trend to continue.
I then created a backtest of a strategy that buys the 50 companies with the worst historical revenue growth, rebalancing the portfolio quarterly. As you can see below, the returns of an only melting ice cube portfolio don't look dissimilar from the returns of the broader index.
Figure 2: Backtest of Melting Ice Cube Strategy
Source: Portfolio123
Looking at this backtest, it's clear that the idea that investors should - as a rule - avoid companies with sharply negative historical revenue trends is not supported by evidence. It's the investing equivalent of an old wives tale.
Having now identified a segment of the market that other investors dislike for reasons that have nothing to do with returns, we are now faced with the normal questions of which melting ice cubes to buy and when to buy them. And here, the Verdad approach shows great promise.
I took the quantitative rules that Brian Chingono and I developed in our paper Leveraged Small Value Equities and applied these rules to the universe of companies with a negative 3-year revenue growth CAGR.
Figure 3: Leveraged Small Value Investing Applied to Melting Ice Cubes
While restricting our quantitative screen to only choosing stocks that have had revenue declines hurts performance relative to our broader leveraged small value equities universe, you can see from the above that applying our leveraged small value approach to these declining companies produces returns significantly in excess of the broader benchmarks. And, unsurprisingly, these stocks tend to dramatically outperform when high-yield spreads are tightening and underperform when spreads are widening:
Figure 4: Performance of Leveraged Small Value Melting Ice Cubes vs. High-Yield Spreads
Just as my father asked each of his children to play unpopular sports in order to increase our odds of achieving excellence, investors should hear opportunity whenever stern voices offer caution without evidence about a particular market segment.
In my portfolio of leveraged small value stocks, I have a sleeve dedicated to just this sort of declining business – it’s just one component of my larger strategy of taking highly leveraged bets that widely-disliked stocks will beat expectations. I'd be welcome to chance to discuss individual decliners that meet Brian's and my rigorous quantitative rules and have passed the high bar of scrutiny to make it into the Verdad portfolio.