Sports are not merely recreational but educational — at least according to Research Affiliates equity analysts who derive some insights into successful investing in their current newsletter.
At issue is the allure of “quality” investing, an attractive proposition to finance academics and practitioners alike, albeit one that is ill defined.
Vitali Kalesnik and Engin Kose, two analysts with the Newport Beach, Calif., investment research firm known for its fundamentally weighted indexes, decided to test the idea that a premium can be obtained through quality investing.
But reviewing the approaches found among both academics and investment managers, they identified 10 different definitions of quality, including profitability, margins, growth in profitability, growth in margins, leverage, financial constraints and distress, earnings stability, net payout/issuance, growth activities and accounting quality.
All have something generally to do with profitability, but in any event the duo tested all the various expressions of quality and found them to be unreliable predictors of investment performance.
(The analysts note the methodological difficulties in comparing approaches that are implemented quite differently and which are biased by the elimination of strategies that have failed and then been discontinued.)
They found that, over a 48-year period, many quality strategies showed positive performance and many negative performance, and their volatility characteristics were similarly wildly scattered. None performed especially well.
Perhaps the most recognized quality investment strategy was the late ’60s, early ’70s investment craze known as the “Nifty Fifty.”
“Institutional investors became enamored of 50 large, stable, fast-growing companies including such household names as General Electric, Xerox, Polaroid and IBM,” the analysts write, adding that their strong record of growth impelled investors to find them still attractive at “50, 80, and even 100 times earnings.”
By the end of 1972, when the S&P 500 was trading at a price-to-earnings ratio of 20, Kalesnik and Kose report the Nifty Fifty’s P/E was 40.
This “growth at any price” investment model received a strong rebuke from the 1973-'74 bear market, when the S&P 500 fell 39% and Nifty Fifty fell by 47%.
The disparate results of those two investment choices can still be felt today:
“Around the end of 1976, the S&P 500 investors broke even with their initial 1973 investment," the authors write. "It took the Nifty Fifty investors nearly a decade to recoup their losses, and they never caught up with the broad market. Forty-one years later, the S&P 500 investors of 1973 would have earned about 23% more than the Nifty Fifty investors.”
And that’s where the business of sports has something to teach investors.
Kalesnik and Kose note that whereas some franchise owners hire quality players at high prices — the Colorado Rockies paid $121 million for star pitcher Mike Hampton, who delivered just one good year in his eight-year contract — a more successful approach is that taken by Oakland A’s manager Billy Beane, who had to make the most of a limited salary budget.
Beane therefore had to discover the overlooked metrics that counted when it came to athletic performance.
The authors quote Michael Lewis’ book Moneyball in what should sound like a familiar trope of value investing: “And the way to win games cheaply is to buy the qualities in a baseball player that the market undervalues, and sell the ones that the market overvalues.”
In baseball, that turned out to be a player’s on-base percentage and slugging percentage, whereas Kalesnik and Kose say various price-to-fundamentals ratios, such as price-to-cash-flow, similarly function as a value signal.
Provocatively, Kalesnik and Kose take a fresh look at quality through a value-investing matrix to see how those results fare. They accomplish this by looking at quality measures that have some success in predicting value — the likelihood of default, company profitability and growth, and the reliability of accounting variables.
Looking at these quality measures alone, they produce a negative annual return over the past 50 years. But in conjunction with value, the average annual return is 11.2%.
Their conclusion is that “quality is not a factor that reliably commands a premium in its own right. Nonetheless, value investing conditional on certain indicators of company quality is a promising strategy.”
This is just an update, they say, of Benjamin Graham and David Dodd’s dictum of finding quality stocks and buying them at low prices.
That approach was not followed by the English soccer team Chelsea Football Club, whose policy was to hire the best players at any cost. The team paid a record 30.8 million pounds for Andriy Shevchenko, whom Kalesnik and Kose say “was already 29 years old, and, frequently injured, he scored only 9 goals in two seasons with Chelsea.”
But rival Manchester United epitomized Graham and Dodd by (quoting the Economist) “knowing the value of money” in its hiring decisions.
“Just as hiring great ballplayers at rocket-high salaries may be bad business decisions, buying quality stocks at high prices are likely to be bad investment decisions,” the analysts write.
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