Conclusions on the Quick

Conclusions:

  1. Shiller P/E works well for stock selection within Large Cap. Mean reversion for earnings growth seems to happen much more within the Large Cap universe than within SMID. The improvement in earnings growth for the Large Cap cheap slow growers tends to lead to multiple expansion while the decline in earnings growth for the expensive fast growth stocks tends to lead to multiple contraction within Large Cap. We see more economic momentum than mean reversion within Small & Mid Cap as the fast growers continue to grow quickly.
  2. In the Small & Mid Cap space we find that the Shiller P/E disappoints in aiding stock selection but find that substituting EV to 10 year inflation adjusted EBITDA is more effective. Unlike in Large Cap, the benefits of economic mean reversion are much less potent for Small & Mid Cap firms and, in the context of cyclically adjusted levels of valuation, economic momentum is actually helpful to future stock selection. This effect is particularly pronounced among potential shorts that have poor recent three year earnings growth and are in the most expensive quintile of cyclically adjusted EV/EBITDA.
  3. Recent (3 year) earnings growth seems to be a significant driver of cyclically adjusted valuation metrics like Shiller P/E or EV/EBITDA as there is a strong correlation between recent earnings growth and valuation based on historical earnings. In other words, there are relatively few slow growing but expensive companies and few fast growing but cheap companies based on the cycle adj. metrics like P/E and EV/EBITDA.
  4. Leveraging the cycle adj. valuation metrics, recent growth and our Core Models, we can create portfolios that can generate significant excess returns and other favorable metrics.

Summary:

  • Soaring corporate margins have driven valuations higher in both the Large Cap and Small & Mid Cap universes.
  • With profits near record highs we investigated if valuation metrics that capture full cycle earnings might help us find both compelling short and long opportunities overlooked by more traditional value strategies. This proved productive as the firms with low cyclically adjusted valuation tend to be firms that have suffered recent economic headwinds while firms with high cyclically adjusted valuation tend to be firms that have experienced the fastest trailing earnings growth.
  • We found that the biggest opportunities came from very different sources depending on if we are working in the Large Cap or Small & Mid Cap universes. In Large Cap we find that Shiller P/E helps find firms likely to experience economic mean reversion. On the long side, investors benefit from multiple expansion as firms with the weakest historical earnings growth tend to recover. On the short side, investors should consider firms whose recent strong growth in profitability has been erroneously extrapolated by the market and are likely to disappoint.
  • In Small & Mid Cap we find the best results on the long side come from exploiting economic momentum shrouded in investor uncertainty. On the short side, firms that have negative recent earnings evolution but are still expensive on our cyclically adjusted metric tend to put up catastrophic returns as these “story stocks” prove to be poor speculations.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

November 15, 2014 |

Categories: White Papers

November 15, 2014

Categories: White Papers

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