KEEP GROWING THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS FOR PROFESSIONAL CLIENTS ONLY

Transcription

1 KEEP GROWING THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS FOR PROFESSIONAL CLIENTS ONLY

2 Executive summary WHAT DRIVES THE TOTAL RETURN OF A COMPANY S STOCK? Here, we examine the relationship between long-term stock returns, their starting valuations and medium- to long-term earnings growth. Our results show that both factors underpin returns, but that earnings growth is the predominant factor over a longer time horizon. This strongly suggests that to achieve outperformance in the long run investors need to focus on the fundamentals of securities. Our findings are not specific to a country or region, but appear to hold true globally. Key findings include the following: ``Over the long term, portfolios holding stocks with the highest earnings growth potential tend to generate above-market returns. ``Portfolios holding cheap companies can generally outperform in the long term, but only if these stocks also exhibit excess growth potential. ``Even expensive companies can make good investments if the growth prospects are sufficiently strong. ``The longer the investment horizon, the more company-specific factors such as earnings growth tend to determine returns. Conversely, the effects of changes in investor risk appetite or event-related factors tend to decrease with an increasing time horizon. ``Compared to earnings growth, valuations matter less. In general, there is little or no relationship between initial valuation and mid to long-term returns. Only when valuations are at extreme levels, do they become a more important component of return. ``In the case of both earnings growth and initial valuation, the recent past does not necessarily offer a strong indication of the future. A high growth company may lose its growth momentum over time. Similarly, a value stock may rerate over time. Thus, it is crucial to gain a strong understanding of the fundamentals that support expected rates of growth. ``It also follows that active managers need to re-assess their understanding of a company s fundamentals on a regular basis in order to generate outperformance. [2] KEEP GROWING

3 Contents What drives relative stock prices in the long run? 4 In the long run company growth dominates 6 Valuation matters most at extremes 10 Implications for long-term active investors 11 Long-term investing is a fundamental game 12 Conclusion 14 Appendix : Test methodology 16 Authors 18 THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [3]

4 What drives relative stock prices in the long run? The longer the investment horizon, the more important growth becomes as a determinant of return. What drives the total return of a company s stock over the long term? The question continues to prompt considerable debate among long-term investors, but it necessarily involves a combination of 1) a company s traded value relative to comparable stocks (valuation) and 2) its ability to grow its earnings (growth). By using historical equity data, we show how both earnings growth and initial valuations (subsequently referred to as valuation) are related to long-term returns but that excess growth is the predominant driver of excess return. Over the short term, changes in investor risk appetite or company-specific events such as company mergers or acquisitions are the main driver of returns. However, as the investment horizon increases, short-term market noise gives way to company growth as the key driver of returns. Exhibit 1 illustrates this concept. This means that portfolio managers with long investment horizons can maximise returns by seeking to identify companies with fundamentals that indicate strong growth potential. Our research was motivated by a desire to better understand the relationship between equity returns, valuation and the underlying company s growth potential. By examining historical data of a broad range of stocks from developed markets over a long period, we found that correlations between stock performance and earnings growth over the long term were very strong while the relationship between a stock s valuation and performance was low. In other words, contemporaneous earnings growth can be seen as the dominant long-term return driver. Cheap stocks can outperform, but in general only if they exhibit positive relative growth. The best performing stocks tend to be those that were both growing their earnings strongly and were cheaply priced. [4] KEEP GROWING

5 The practical implication for investors is that active equity strategies that successfully focus on fundamentals, specifically earnings growth, will generate better outcomes over the longer term. However, our research also indicates that active fundamental investors will need to monitor portfolios carefully because both earnings and valuations change materially over time. Although it is not explored in detail here, our findings further support the rationale for investing in private equity and unconstrained (benchmark unaware) funds, which overlook short-term price movements to focus on strategic investment objectives. Since it can take several years for the price of a stock to reflect a change in company fundamentals, investors who keep sight of value in real terms, rather than the performance of the market, are more likely to achieve their investment goals. EXHIBIT 1: FUNDAMENTAL GROWTH DETERMINES RETURN PRICE OF RISK GROWTH Determination of stock price Time Source: BlackRock THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [5]

6 In the long run company growth dominates MID TO LONG-TERM EARNINGS GROWTH DOMINATES LONG-TERM RETURN The position of the long-term mean (green line) in exhibit 2 suggests that there is a very strong, positive relationship between returns and earnings growth. Earnings growth over five years explains on average 42% of returns in correlation terms this is above If we had to split the earnings growth into periods of three to five years and up to two years, the explanatory power of each taken individually would still be high, albeit lower than the five year window. The higher the long-term earnings growth of a company, the higher the long-term return potential. This is the case regardless of starting valuation. Below we set out the analysis underpinning our findings: Step one The first step in our analysis is to gauge the extent to which long-term returns are related to realised earnings growth. To this end, for each point in time, we calculate the correlation between the long-term returns of a broad cross section of stocks and their earnings. A high correlation suggests that growth accounts for a high proportion of return and is therefore strongly related to excess return. Our sample consists of quarterly stock level data, using the constituents of the FTSE 350 ex Investment Trusts from 1987 to the end of For each point in time the correlation between earnings growth and returns is calculated. Returns are measured over a window of five years while earnings growth is measured over three separate time periods: a) over five years, b) over the first two years, and c) from year three through to year five. In exhibits 2, 3 and 4 [below and opposite page], the vertical axis shows correlation, which ranges from -1 to 1, and the horizontal axis shows time. A correlation value of one indicates that long-term return is entirely dependent on earnings growth while a correlation value of zero indicates there is no relation at all between the two variables. LONG-TERM EARNINGS GROWTH HAS A STRONG RELATIONSHIP TO EQUITY RETURNS EXHIBIT 2: THE CORRELATION BETWEEN EARNINGS GROWTH (OVER 5 YEARS) AND RETURN AT 5-YEAR HORIZON AVERAGE CORRELATION Year Source: MSCI and Thomson Reuters data, BlackRock calculations. Average Data correlation as end of Correlation CORRELATION [6] KEEP GROWING

7 EXHIBIT 3: THE CORRELATION BETWEEN EARNINGS GROWTH (3 TO 5 YEARS) AND RETURN AT 5-YEAR HORIZON 1.0 CORRELATION Year Average correlation Correlation Source: MSCI and Thomson Reuters data, BlackRock calculations. Data as at end of EXHIBIT 4: THE CORRELATION BETWEEN EARNINGS GROWTH (1-2 YEARS) AND RETURN AT 5-YEAR HORIZON 1.0 CORRELATION 0.5 AVERAGE CORRELATION Year Average correlation Correlation Source: MSCI and Thomson Reuters data, BlackRock calculations. Data as at end of THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [7]

8 In the long run company growth dominates Step two The second part of this analysis takes the same cross section of stocks to assess the effects of both earnings growth and valuation on the long-term performance of stocks over five years. We define starting valuation as the average of the FY1 and FY2 consensus earnings to price. Other valuation metrics such as book-to-price were also used, which led to the same conclusions. We sort first by starting valuation and then by earnings growth from year three through year five. In particular, stocks are sorted quarterly by those two variables into nine equally weighted groups: first into cheap, neutrally priced and expensive and then into low-, medium- and high-growth segments. The performance of portfolios is standardised at each point in time to enable a measurement of relative outperformance. This enables us to compare outperformance to the equally weighted market through time. Exhibit 5 illustrates the results of this analysis. Z-scores (assessing the statistical relationship with the mean) are used to indicate whether the return was below or above the average stock returns at each point in time and by how many standard deviations. A positive z-score means outperformance of average stock returns and a negative z-score suggests underperformance relative to average stock returns. From exhibit 5 we can conclude that in the long term, cheap stocks outperform expensive stocks and high growth stocks outperform low growth stocks 1. It is noteworthy that all high growth portfolios outperform on average irrespective of valuation. In contrast, among the cheap portfolios outperformance is observed predominantly by higher growth 2. More detailed results and the distribution of outcomes can be found in the Appendix. 1 The same analysis performed on US and European equity data lead to similar conclusions. Charts are available on request. 2 The same analysis performed on minimum, maximum, median and mean returns lead to similar results. Running a regression analysis also confirms that valuations and earnings growth are both statistically significantly related to long-term return. [8] KEEP GROWING

9 THE DISTRIBUTION OF 5-YEAR RETURNS SORTED BY GROWTH AND INITIAL VALUATION EXHIBIT 5: 5-YEAR ANNUALISED RETURN Z-SCORE High return HIGH GROWTH CHEAP HIGH GROWTH NEUTRALLY PRICED GROWTH DOMINATES. VALUE HELPS. In this exhibit we sort stocks first by valuations and then by future earnings growth. It shows that high growth outperforms low growth and that cheap outperforms expensive. Interestingly, high growth performs better on average HIGH GROWTH EXPENSIVE 0.21 MEDIUM GROWTH CHEAP MEDIUM GROWTH NEUTRALLY PRICED MEDIUM GROWTH EXPENSIVE LOW GROWTH CHEAP LOW GROWTH FAIRLY PRICED LOW GROWTH EXPENSIVE Low return Source: MSCI and Thomson Reuters data, BlackRock calculations Based on FTSE 350 ex Investment Trusts, quarterly returns since Data as at end of THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [9]

10 Valuation matters most at extremes VALUATION MATTERS BUT MOST AT EXTREMES Exhibit 6 seems at odds with any arguments for value investing. Many value-based strategies as well as academic publications have shown that over one or (maximum) two years, investors can consistently earn a value premium. However, our focus is different: here we consider holding for periods of five years in order to capture long-term performance. Our findings show that risk appetite has a decreasing explanatory power to returns over the long term. Ideally one would invest in cheap companies that display strong growth. However, buying a company that is valued expensively could still be an attractive investment if the growth prospects are sufficiently large. Conversely, investing in cheap companies is not a guarantee for generating alpha. Our empirical analysis from the previous section showed that a cheap company with low earnings growth will most likely underperform. However, the importance of valuation for long-term returns might change when valuations are extreme. To show this we take a step back and repeat the historical correlation calculation, but this time between long-term returns and valuations alone. The results are displayed in exhibit 6. The only time when the relationship between long-term returns and valuations strengthened materially is during the tech bubble, when valuations were extremely stretched, otherwise, the relationship between valuation and long-term returns is at best weak and sometimes negative for extended periods of time. During the tech bubble which peaked in 2000, valuations became unusually stretched, and expensive technology stocks performed strongly, a portfolio of value stocks bought five years prior to that date would have underperformed by 2000, indicated by the negative correlation at that point in time. Yet the material increase in correlation in 2005 indicates that cheap stocks bought in 2000 would have outperformed strongly over the next five year period. By contrast, value stocks bought during the financial crisis in 2008 would have underperformed over the subsequent five years. This indicates that valuation tends to impact long-term returns only in periods of market stress characterised by extended valuations. FIGURE 6: THE CORRELATION BETWEEN INITIAL EXHIBIT 6: THE CORRELATION BETWEEN INITIAL VALUATION VALUATION AND RETURN AT 5 YEAR HORIZON AND RETURN AT 5-YEAR HORIZON 1.0 CORRELATION 5 YEAR RETURN AND VALUATIONS Year Source: MSCI and Thomson Reuters data, BlackRock calculations. Data as at end of [10] KEEP GROWING

11 Implications for long-term active investors From this analysis it is clear that the relative returns of securities over a longer-time horizon tend to be dominated by relative earnings growth. Forecasting this growth is likely to be an important component of any successful active investment strategy as over the longer-term fundamentals will tend to cancel out price movements caused by changes in the price of risk. Many successful long-term investments tend to be fundamental investments. Valuations are important but only at extremes. Attention should be paid to entry price but only in certain market conditions. Consequently, short-term market turbulence and valuations should be of a lesser concern to active investors provided they are able to take a longer-term perspective (3-5 year minimum). The success of the strategy appears also to be predicated on the ability of active managers to identify companies that have strong growth potential over the longer term. It also points to the importance for active investors to give managers sufficient freedom to pick those companies even it if means taking positions that are meaningfully different from those held by the benchmark. An expensive portfolio can outperform in the long term if the underlying companies achieve growth. Valuations, we find, have a second order effect on return drivers. Value-oriented strategies can deliver outperformance but strong growth potential in the underlying company will greatly improve its chances of doing so. THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [11]

12 Long-term investing is a fundamental game While history predicts the future at shorter horizon it is no guide to the future in the long run. Historical data appear not to be a strong predictor of valuations or earnings growth in the future. Empirical research shows that long-term returns are driven by valuation as well as earnings growth, but how long do these characteristics last? In the case of both valuation and earnings growth, analysis confirms that both factors can change over time. As a result, ongoing fundamental analysis is essential, regardless of past performance. We can use transition probabilities over different time frames to see over which period valuations and earnings growth are persistent. For simplicity, we continue to refer to the same groups of cheap, neutrally priced and expensive stocks; as well as low, medium and high long-term earnings growth stocks as above. Exhibits 7 10 show the probability of a company which starts off in one group (e.g. low earnings growth) ending up in the same group or a different group (e.g. high earnings growth) after a) one year and b) five years. They can be interpreted as follows: Over one year: A low earnings growth company has the highest probability of staying in the same group over a year (exhibit 9). The same is true for cheaply valued companies (exhibit 7). More generally, earnings growth relative to the wider group of stocks and valuations are persistent, as suggested by the fact that the percentages along the main diagonal are higher than the off-diagonal ones. After five years: Cheap stocks have a higher probability of being more expensive (exhibit 8) and stocks in any earnings growth group have an almost equal probability of moving to any other group (exhibit 10). The non-persistence of earnings growth is a function of varying company productivity as well as the fact that there is no guarantee that a successful company will remain successful in the future. In short, historical data has not been a strong predictor of valuations or earnings growth in the future. Active managers need to re-assess a company s fundamentals on a regular basis in order to generate alpha. [12] KEEP GROWING

13 EXHIBIT 7: VALUATION TRANSITION PROBABILITY AT 1-YEAR HORIZON EXHIBIT 8: VALUATION TRANSITION PROBABILITY AT 5-YEAR HORIZON Cheap Score at year 1 Expensive Cheap Score at year 5 Expensive 73% 20% 6% 20% 35% 44% Score at year 0 24% 55 % 22% Score at year 0 33% 31% 36% 4% 27% 69% 37% 37% 27% Expensive Expensive EXHIBIT 9: EARNINGS GROWTH TRANSITION PROBABILITY AT 1-YEAR HORIZON EXHIBIT 10: EARNINGS GROWTH PROBABILITY AT 5-YEAR HORIZON Low Score at year 1 High Low Score at year 5 High 68% 29% 3% 36% 36% 28% Score at year 0 14% 59% 27% Score at year 0 35% 35% 31% 5% 33% 62% 38% 31% 31% High High High probability Low probability Source: MSCI and Thomson Reuters data, BlackRock calculations. Data as at end of THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [13]

14 Conclusion Over the long term, portfolios that hold stocks with above average earnings growth tend to outperform. We showed that both earnings growth and valuations are drivers of long-term returns, but that growth is the predominant driver. The longer the investment horizon the more important fundamentals, such as earnings growth, become in driving returns. Portfolios with companies that have inexpensive starting valuations generally also outperform, but not when the portfolio consists of low growth stocks. Although some industries tend to do better than other industries over longer periods, these are essentially due to differences in their growth patterns. Valuations matter over the long term but only at extremes. We also confirmed that historical data alone are no guide to future valuations and earnings growth, as there is no medium to long-term persistence in valuation or growth. Thus, our work highlights the need for regularly updated long-term fundamental prediction in the context of long-term equity investment strategies. This applies to both fundamental managers and quantitative managers searching for alpha signals. Our research also underscores the importance of active investors taking a long term view, and giving their portfolio managers the opportunity to focus on fundamentals. [14] KEEP GROWING

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16 Appendix ASSESSING THE EVIDENCE: TEST METHODOLOGY We examine the relationship between long-term stock returns, medium/long-term earnings growth and starting valuation using historical data. The stocks we assessed are constituents of major stock indices. We focus on the FTSE 350 ex Investment Trusts, but similar analysis performed on other markets such as S&P 500 or MSCI Europe constituents, give similar results. The data frequency is quarterly, from 1987 to We have used fundamental data as well as stock return data from Factset. All the calculations and methodology are proprietary to BlackRock. Returns are calculated using five-year total return data in local currency. Earnings growth is calculated using the percentage change in reported earnings over year three through year five. Valuations are determined by using an average of FY1 and FY2 consensus earnings figures to price at the beginning of the period 3. Exhibit 11 shows a schematic of the time series data used in our analysis and over which time window each data item is calculated. ANNUALISED RETURN EARNINGS GROWTH 0 VALUATION Year Source: BlackRock Step 1 is to sort stocks by their starting valuations using FY1 E/Ps. Step 2 is to allocate each valuation group into mid to long-term earnings growth as measured by year three to year five earnings growth. Finally, to measure performance, returns over five years are used from the starting year to year five. In order to examine drivers of return, we assume we know the earnings of a company before they have been announced. This enables us to statistically quantify a possible relationship between earnings growth and stock return. A strong positive relationship between the two indicates that excess return can be achieved by focusing on identifying companies that will yield positive earnings growth. 3 We also used book to price as a valuation metric which gave the same results as starting earnings to price. The first set of results focuses on the cross-sectional correlation between returns over five years and either earnings growth or valuations. A high cross-sectional correlation indicates that the two variables in question are related. For example, we show that companies with high earnings growth also historically tend to be the same companies that have higher returns compared to other companies. [16] KEEP GROWING

17 Next, we compare the effects of future earnings growth and starting valuation on stock returns. For each p oint in time, we sort stocks into three different valuation groups, ranging from cheap to expensive, and into three different groups of realised earnings growth, ranging from low to high growth. These double sorted portfolios have an equal number of stocks in each of the nine groups. To take into account market effects, the cross-sectional long-term returns are standardised by subtracting the mean return from each stock at each point in time and dividing it by the dispersion of returns at that point in time. This manipulation also enables us to compare outperformance over time. A standardised return above zero suggests that a stock or a portfolio outperformed the market, while a value below zero suggests underperformance. In our third step, we investigate whether growth or value stocks retain their investment characteristics over time. For simplicity, we continue to refer to the same groups of cheap, neutral, expensive stocks; and low, medium and high long-term earnings growth stocks. The box and whisker plot shows the distribution of standardised returns. The thick line represents the median, the box shows the upper and lower quartiles (25% to 75%), the whiskers show minimum and maximum and the points show outliers. A return above zero suggests that a stock or a portfolio outperformed the market, while a value below zero suggests underperformance. THE DISTRIBUTION OF 5-YEAR RETURNS SORTED BY GROWTH AND VALUATION EXHIBIT 12: MEDIAN RETURNS Z-SCORE FIVE YEAR ANNUALISED MEDIAN Z-SCORE RETURN Underperformance Outperformance Low Med High Low Med High Low Med High Earnings growth Cheap Neutrally priced Expensive Source: MSCI and Thomson Reuters data, BlackRock calculations. Data as at end of THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [17]

18 Authors KATHARINA SCHWAIGER, PhD Katharina Schwaiger, PhD, is a member of the Risk & Quantitative Analysis group. She is responsible for the risk management and quantitative analysis of Fundamental Equity portfolios. Prior to joining BlackRock in 2013, she has worked as a Financial Engineer in the City of London, as a Quantitative Researcher at a London-based hedge fund and as a lecturer in Operational Research at the London School of Economics. She earned a BSc degree in Financial Mathematics in 2005, and a PhD degree in Mathematics/Operational Research from Brunel University in EDWARD FISHWICK Ed is a managing director and Global Co-Head of Risk & Quantitative Analysis at BlackRock. In addition, he is a member of the firm s European executive and global operating committees. He has worked in quantitative finance for over 30 years in London, New York and Boston. He is a member of the editorial board of the Journal of Asset Management and an executive editor for Investment Insights, BlackRock s portfolio research journal, as well as being the Chairman of the London Quant Group. [18] KEEP GROWING

19 REFERENCES John S. Brush. Value and Growth, Theory and Practice. A fallacy that value beats growth. The Journal of Portfolio Management, 33, Eugene F. Fama and Kenneth R. French. The Cross-Section of Expected Stock Returns. Journal of Finance, 47 (2), Eugene F. Fama and Kenneth R. French. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics, 33, Benjamin Graham and David Dodd. Security Analysis. McGraw-Hill, Benjamin Graham. The Intelligent Investor. Harper and Brothers, Richard Grinold and Ronald Kahn. Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk. McGraw-Hill, Second Edition, THE IMPORTANCE OF FUNDAMENTALS TO LONG-TERM ACTIVE INVESTORS [19]

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