04/28/2017

10 Ways to Beat the S&P 500

10 Ways to Beat the S&P 500

The Efficient Market Hypothesis (EMH) and Random Walk Theory (RW) suggest that the most successful investment strategy should be a passive index, and that any performance above market returns are attributed merely to luck. The Efficient Market Hypothesis suggests that market prices reflect all available information. Thus, as new information becomes available, investors react by buying and selling until the asset price reflects the newly available information. According to this philosophy, equities should be priced at their intrinsic value. Random Walk Theory argues that stock prices follow a random pattern over time and cannot be protected. If these ideas hold true, then it should be impossible to consistently outperform a stock index. In the US, one of the most common indices for investors is the S&P 500. For EMH and RW to hold within the S&P 500, then anomalies should not exist. However, there are many ways to outperform the S&P 500 using a purely quantitative approach. Below, AFG Research has identified 10 different strategies that have outperformed the S&P 500 for nearly 20 years:

1) Equal Weight instead of Market Weight

Investors underestimate how limited their diversification is in the S&P 500 when using a market cap weighting basis. In fact, using that common weight system, roughly 20% of investors’ money is exposed to the 10 largest companies. Expanding, nearly 50% of assets are limited to the top 50 companies. Cutting the index in half, the top portion represents 86.3% of the market cap, while the bottom half would be only 13.7%. In this way, investors tracking the S&P 500 market cap weighted index are exposed mainly to the largest companies within the index.

JH1

*As of 8/31/16

By simply altering the weighting method for an index, performance can be dramatically improved. Using an equal weight approach in the S&P 500 as opposed to the more popular market weighting metric, investors could have improved performance by around 350 bps annually since 1998. Investors are exposed to the same companies, only the weights are changed.

JH2

*9/30/98 – 7/31/16

2) Buy the Smaller Firms

Historically small cap companies have outperformed large cap companies over longer periods of time. Traditionally, this is determined by comparing on a market cap basis or by using an index such as the Russell 2000 relative to the S&P 500. Rarely though, do investors focus on market cap differences within the S&P 500. Dividing the index into quintiles by size, we can measure the performance of the bottom quintile, the smallest companies within the index. The bottom quintile within the S&P 500 has historically outperformed the broad index.

JH3

*9/30/98 – 7/31/16

3) Low Growth Companies

Growth stories constantly gain the attention of investors and the media. However, asset growth is inversely correlated to equity performance: the fastest growing companies tend to underperform, while slow growers tend to outperform. For companies with high growth, investors tend to expect that growth to last over long periods. In practice though, only a small portion of companies can sustain a period of rapid growth longer than a few years. When companies fail to meet lofty expectations set by analysts, equity prices underperform. For companies with slow growth, expectations are generally low enough that firms can meet or exceed these forecasts, leading to outperformance. Investing in the quintile of companies with lowest asset growth can lead to outperformance.

JH4

*9/30/98 – 7/31/16

4) Value Companies

Investors pay premiums on the cash flows companies earn for a stake in ownership. Additionally, investors pay a range of premiums based on a number of factors including growth, industry prospects and others. In general, the investment community has divided firms into categories based on these phenomena. The most popular groupings are Value and Growth. AFG tracks the Market Value investors are willing to pay for a given unit of Invested Capital (MVIC). Firms with a higher MVIC are classified as Growth and firms with a lower MVIC are Value. The lowest quintile of firms by MVIC tends to trade at a low level relative to their Invested Capital base. These firms have also tended to outperform over time.

JH5

9/30/98 – 7/31/16

5) Buy Winners

An interesting phenomenon present in equities is momentum. Stocks that outperform tend to continue to outperform while stocks that underperform tend to continue to underperform. A common metric used to measure momentum is to group companies by price returns over one year. However, returns over the most recent one month tend to be noisy, having little predictive power for future returns. By taking returns from 12 months ago to one month ago, a more accurate measure of momentum can be found. Grouping the array of these returns into quintiles, the top quintile shows outperformance of 380 bps annually. Here, the top performing companies from 12 months to one month ago tend to continue to outperform.

JH6

*9/30/98 – 7/31/16

6) Buy Positive Analyst Revisions

Analysts upgrade and downgrade estimates for companies regularly. Another momentum characteristic in markets is that these upgrades and downgrades tend to move equity prices. AFG tracks these movements and how they affect forecasted cash flows. Companies with positive analyst revisions tend to outperform their respective index over time.

JH7

*9/30/98 – 7/31/16

7) Low Accrual Companies

Accruals are a simple concept in GAAP and IFRS accounting. The difference between net income and cash flows is an accrual. Theoretically, net income and cash flow should be fairly similar. Therefore, firms with smaller accruals should have a higher quality of earnings. Instead of using a cash flow approach, a balance sheet approach measuring the change in net assets can also be used. Tracking the group of stocks in the quintile with smallest accruals, a return of 12.3% annually could have been realized from October 1998 through July 2016.

JH8

*9/30/98 – 7/31/16

8) High Economic Margin Companies

The focal point of AFG’s research is the Economic Margin (EM) Framework. By measuring Operations Based Cash Flows less a Capital Charge, and normalizing by the Capital Base, AFG can better understand the Economic Profitability of a firm. Investing in companies with higher EM’s, and therefore higher economic profitability, is a strategy that has outperformed over the long run.

JH9

*9/30/98 – 7/31/16

9) AFG Valuation

AFG’s Valuation method studies the diminishment of economic profits over time. Firms that earn cash flows in excess of their cost of capital will see those surplus profits lessen over time due to competition. By measuring diminishing economic profits over time, and using a market derived discount rate approach, AFG can more accurately calculate the value of a firm without relying on traditional discount rate estimates or speculative perpetuity assumptions. Performance of the top quintile using AFG’s Valuation metric is shown below.

JH10

*9/30/98 – 7/31/16

10) AFG Investment Grade

AFG’s Investment Grade combines Valuation, Quality and Momentum characteristics in a multifactor model to find attractive companies. By combining these factors into one model, AFG can identify undervalued, high quality firms that also have good momentum traits. Over time, this strategy shows outperformance ability and is more consistent than valuation alone.

JH11

*9/30/98 – 7/31/16

*AFG Research Database – Custom Strategy Results

About John Holt 4 Articles

Research Analyst at The Applied Finance Group

Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2015

About John Holt 4 Articles

Research Analyst at The Applied Finance Group

Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2015