Speculative Trading Returns with a Vengeance

An Update on Our Prior Warning of Reckless & Rampant Risk Taking

KCR is fond of highlighting the models where our methodologies are suffering. We do this as we think it shows intellectual honesty and highlights outsized opportunities to come. This piece is different.

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In our July 2021 missive The Low Value in High Volume, we focused on stocks with the lowest and highest volume. Reminder: “volume” measures the percentage of a company’s outstanding shares that have been bought and sold in a given month. So, if a company has 100 shares and 50 of them were traded in the last month, that means half of the company’s owners decided to sell to new owners in just 22 business days.

Our work highlighted that back in mid-2021:

• The 20% of stocks with the lowest volume were seeing only 5% of their shares change hands in a given month – a number suggesting stable ownership by investors rather than speculators
• In contrast, the 20% of stocks with the highest volume had hit an absurd level of trading, with nearly half their shareholder base changing every month – levels typifying the peaks of prior speculative frenzies
• We highlighted a group of the lowest volume stocks with stable investor bases that were favored by KCR’s models while panning a collection of the highest volume stocks that KCR’s models disliked

In the 12 months following our research, the results for those two groups of stocks were striking. The chart below shows the 1-year returns following our publication for:

1. The lowest volume stocks KCR’s models highlighted as terrific opportunities
2. The Russell 1000 Index
3. The highest volume stocks KCR’s models highlighted as speculative junk

The concept is hardly rocket science. When you see a group of companies where the trading volume is so high it means the entire company is being bought and sold every two months (50% monthly turnover). This indicates the investor base consists of low-conviction speculators. If you then identify the stocks with high volume, low quality, and impossible valuations, it’s only a matter of when, not if those stocks will collapse.

This paper updates the situation we first analyzed in July 2021 and finds the following:

• Speculative fever has returned, with people frenetically trading stocks in search of quick returns
• The returns high-volume stocks have recently delivered to those engaged in this speculative nonsense are, once again, near dot.com levels
• While the type and quality of stocks favored by speculators have improved, the value spreads are, once again, approaching levels of madness last seen at the peak of the dot.com bubble

At the end of the paper, we repeat the exercise from 2021 and then highlight the speculative highest-volume stocks with the worst fundamentals and the lowest-volume stocks with the best fundamentals. Let’s dive in.

The chart below updates our original lead-in chart. Once again:

• The light blue line shows the 12-month returns to the 20% of stocks with the highest volume
• The navy-blue line shows the 12-month returns to the 20% of stocks with the lowest volume
• The story today is similar to when we last highlighted this in 2021 and at the peak of the dot.com bubble

High-volume stocks have been on a furious run, rising 50% over the last year. Low-volume stocks have also done well but are up “only” 18% over the past year.

Let’s examine the exact same data in slightly different ways to clarify the magnitude of the performance spreads between high- and low-volume stocks and put it in historical context.

The chart below takes the navy-blue line from the chart above (the 12-month returns to low-volume stocks) and subtracts the light blue line (the 12-month returns to high-volume stocks). Therefore, this is simply the returns of low volume stocks minus the returns of high volume stocks.

What do we see?

Stocks with the lowest volume have underperformed stocks with the highest volume by -32%.

This big difference in returns is bouncing off one of the lowest levels in modern history. For the trend-following crowd, this could suggest that, like the last time we highlighted this, low-volume stocks may be in the early days of significantly outperforming high-volume stocks.

Reminder:
• Low volume stocks are companies where there isn’t much turnover. Investors in those companies seem reluctant to part with their shares.
• In contrast, high-volume stocks are companies where the investor base is constantly changing, which suggests the stock owners take a more speculative approach.

We can rephrase that in colloquial fashion as:

The line in the chart shows the 12-month return spread of stocks with healthy, stable shareholder bases minus the returns to stocks with the most speculative shareholder bases.

In the table below, from top to bottom, we show the fundamentals of:

• The lowest volume stocks with stable shareholder bases favored by KCR’s models
• The highest volume stocks with unstable shareholder bases that KCR’s models are flagging as high-risk

The disparity in quality and valuation is easy to see.

The first row shows the low-volume stocks KCR’s models like: they have stable shareholder bases, with only 7% of their shares trading hands in a given month. They also sport 10% FCF yields, trade at only 14x earnings, have 15% margins, and pay you 5% to wait and hold them.

The bottom row shows the high-volume stocks KCR’s models dislike: 54% of the entire company is being bought and sold every month, the stocks are burning -3% in cash every year, have negative earnings, and no yield.

Investing need not be complicated. Immediately below you will find:
• A list of the high-volume stocks KCR’s models suggest may collapse like they did in 2021
• A list of the low-volume stocks KCR’s models suggest have uncommon quality and value
• After that, a critical caveat about the quality and valuation of high- and low-volume stocks today

Caveats & Cautions:

The chart below uses Return on Assets (ROA) as a proxy for quality. Higher ROAs suggest higher quality companies. Lower or negative ROAs suggest lower-quality companies.

At the peak of the dot.com bubble, and when we highlighted this issue in 2021, the differences in ROAs (the quality spreads) between low-volume and high-volume stocks were enormous. Very simply, high-volume stocks had horrible ROAs while low-volume stocks were healthy. We have bracketed these areas with red labels.

Today, high-volume stocks are generating a 17% ROA as a group – the highest level in history. So, as a group, high-volume stocks have never been healthier, fundamentally, than they are today.

Unfortunately, what you pay for a stock matters.

The chart below shows the FCF yield to Enterprise Value (FCF/EV) of low-volume stocks and high-volume stocks over history.

Once again, we have bracketed the dot.com period and the moment in 2021 when KCR first highlighted these two groups. You can see that at those times, the high-volume stocks had FCF yields of ~0%.

Today, the FCF yield of high-volume stocks is 1.3%, which is 77x FCF. It’s not as expensive as the dot.com peak or when we last highlighted this group in 2021, but an unforgiving valuation, none-the-less.

So, what do we make of this? Well. Sorting by a single factor is not a great way to invest. That’s why KCR’s ranking tools and models take a dynamic and multi-factor approach.

At this moment, the case for going long a group of low-volume stocks while shorting a group of high-volume stocks is far less compelling than it was in 1999 or when we last discussed the topic in 2021.

Yet, as our picks and pans in the tables above show, by using a sophisticated, evidence-based approach based on fundamental data, one can indeed identify:

1. A group of overlooked stocks with very low turnover, stable shareholder bases, that have superb fundamentals and are trading at deep discounts and….
2. …a group of fundamentally flawed and overpriced stocks that have unstable shareholder bases.

Below, we provide a list of the high-volume stocks with the highest ROAs. Next to each,
we provide KCR’s Aggregate Model score. Higher numbers are better.

You can see that our models actually love some of these high-volume, high quality stocks (DECK, GDDY, WSM, UTHR, BLDR, TOL & APP) while disliking others (SAIA, TSLA, SMCI).