Alpha Preservation. Using Valuations to Identify Style Risk. Benjamin Graham

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1 RESEARCH RESOURCES RESULTS Alpha Preservation Using Valuations to Identify Style Risk If you have formed a conclusion from the facts and if you know your judgment is sound, act on it even though others may hesitate or differ Benjamin Graham At Principal Global Investors, our equity investment philosophy focuses on selecting stocks that benefit from favorable fundamental change and rising investor expectations while still trading at attractive relative valuations. In this paper we report key findings of our factor research as it applies to risks to our investment style, specifically with regard to fundamental change characteristics such as sustainable earnings improvement, margin trends and earnings surprise. These are desirable investment attributes that tend to be associated with relative outperformance under most market conditions, but can become a source of significant underperformance risk when the valuation premiums paid become excessive. Our focus is on the development of objective measures for determining market conditions under which market participants tend to overpay for certain style characteristics. We also discuss our newly developed proprietary Style Risk Monitor tool used to identify and manage style risks in the market. This tool provides a systematic means to identify upcoming problem areas in the market when one s alpha process becomes at risk. Contributing Authors 1 Mustafa Sagun, Ph.D., CFA Christopher Ibach, CFA Scott Leiberton, CFA 1 Mustafa Sagun is chief investment officer, equities, Scott Leiberton is a managing director, equities, and Christopher Ibach is a portfolio manager, equities, at Principal Global Investors. The views expressed herein are those of the authors, and may not reflect those of the Principal Financial Group, its affiliates and subsidiaries.

2 Background Investing in stocks that are expected to provide positive trends in earnings and cash flows and purchasing these stocks at attractive relative valuations is a successful investment strategy in the long-run. However, over short periods, especially amid abrupt swings in general market risk sentiment, the reverse can be true. As a result, we have seen significant short-term draw downs to this style of investing, particularly amid the early stages of market recoveries such as those in 1992, 2003 and We analyzed commonalities of these time periods including the events leading to rebounds from periods of major market distress such as the recent global financial crisis or the technology bubble a decade ago. We find that market participants willingness to pay for certain characteristics changes over time, and as a result, creates significant short-term opportunities for some characteristics. For example, during the heart of the financial crisis in February 2009, the market was focused on being defensive and started to pay a significant premium for defensive, safer stocks with low earnings volatility when compared to stocks that had high bankruptcy risk and high earnings variability. This also started a reversal of this trend in March 2009 with a snapback of stocks with significantly high earnings risk profiles. Learning from these observations, we have developed a comparative framework focused on aggregate valuation based style risk indicators to help us identify where market extremes are occurring and which styles would be at risk or benefit from significant market dislocations. Key Insights Our research indicates that whenever investors start to overpay for an asset or a characteristic, the potential for trouble begins to loom. We have seen this, for instance, with internet stocks at the top of the 1990s technology bubble; with mining stocks amid the 2008 commodity price surge; and repeatedly with defensive stocks amid the bottoms of recessions (which was especially prevalent in the 2009 market rebound). What holds true for individual stocks or groups of stocks also can be seen in style characteristics such as earnings estimate revisions, beta, return on equity, etc. For example, earnings estimate revisions are an important style risk characteristic which has historically been an effective leading indicator for future earnings surprise. In turn, stocks enjoying positive earnings trends generally command valuation premiums over the market average. However, those valuation premiums can vary considerably over time in response to changing investor sentiment, see Exhibit 1. BOOK TO PRICE VALUATION DIFFERENTIALS FOR ESTIMATE REVISIONS (HIGHEST 10% VERSUS LOWEST 10% OF STOCKS) EXHIBIT The chart illustrates the differences in book-to-price ratios for the top 10% of stocks with the best revision profiles to 10% with the lowest revisions. A lower level on the chart implies a rising valuation premium and vice versa. Conversely, stocks with these earning characteristics generally command higher price/ book valuations /1/90 12/1/90 11/1/91 10/1/92 9/1/93 8/1/94 7/1/95 6/1/96 5/1/97 4/1/98 3/1/99 2/1/00 1/1/01 12/1/01 11/1/02 10/1/03 9/1/04 8/1/05 7/1/06 6/1/07 5/1/08 4/1/09 3/1/10 Source: Principal Global Investors Global Research Platform ALPHA PRESERVATION 2

3 As a corollary, this evaluation of changing valuations spreads is similar to the analysis of yield spreads widely used among fixed income investors. The context is comparable in the sense that desirable investment attributes, such as relative stability, command premium valuations over time, but the degree of the premiums will vary. Conceptually, this can be seen in the comparison of high grade versus high yield corporate bonds over various economic conditions. The premium for quality is persistent but highly variable. To extend our analysis, we convert the time series for estimate revisions to research its effectiveness across the valuations spectrum organized from the highest level of premiums to the lowest. This allows us to estimate the effectiveness of earnings revisions and other fundamental change and earnings trend characteristics at different levels of valuation. BOOK TO PRICE VALUATION DIFFERENTIAL SORTED LARGEST TO SMALLEST (SOLID LINE RHS) COMPARED TO CUMULATIVE RETURN TO ESTIMATE REVISIONS, HIGHEST 10% VS LOWEST 10% (DASHED LINE LHS) EXHIBIT As illustrated in Exhibit 2, with the solid line representing the valuation spread (right scale) and the dashed line showing the relative forward six-month performance differential (left scale), the upward sloping blue line in the majority of the periods is consistent with the expectation that favorable earnings trends are generally rewarded. However, as seen in the sharp downward slope on the far left of the distribution, this does not hold true when the valuation spreads become extreme Cumulative Return to Estimate Revisions Source: Principal Global Investors Global Research Platform Book to Price Spread Once more, although we expect the market to pay a premium to the highest estimate revision stocks when compared to the lowest estimate revision stocks, the extent of this premium changes over time. Interestingly, we found that when this valuation premium is moderate to low, the cumulative returns of this style characteristic are very favorable and consistent. This holds true in a wide majority of market environments. However, we observe that as the valuation premiums reach extreme levels, this effectiveness dissipates and sets the stage for the stocks with the lowest estimate revisions to significantly outperform the stocks with the highest estimate revisions. In other words, the valuation differences between the highest and lowest earnings revisions groups become so large that valuation considerations overwhelm the earnings considerations. This is often described by some observers as a junk rally phenomenon in which investors bid up stocks with deteriorating earnings relative to those with favorable earnings, which exemplified the market environment in the early stages of the rebound in ALPHA PRESERVATION 3

4 Remarkably, when we evaluate other factors such as beta, earnings volatility, profit margin expansion, return on equity, price momentum, etc., we find similar patterns with varying degrees indicating that valuation anomalies manifest themselves in different style characteristics over a market cycle. Most importantly, these anomalies provide opportunities or risks for investors at different points of the market cycle. Multiple Perspectives on Valuation Just as we evaluate the valuation characteristics of individual stocks from multiple perspectives, it is also important to do so with regard to the analysis of style factors. For instance, in a majority of market environments, valuations metrics based on earnings and cash flows tend to be the most effective differentiators. However, this does not hold true during periods of heightened economic stress and uncertainty where solvency concerns escalate. In such environments, differentiation based on asset-based metrics such as price-to-book proves far more effective. When we broaden our style risk analysis to additional metrics, valuation dispersions across the various metrics tend to consistently highlight similar themes, but to varying degrees. For example, we find the valuation anomaly within estimate revisions in 2008 and 2009 was not nearly as extreme when measured in terms of price-to-earnings (P/E) and price-to-cash flows as it was in terms of price-to-book (P/B). Specifically, the market anomaly has been created by excessive optimism in earnings expectations for inherently inexpensive cyclical commodity-based companies. As a result, although P/E ratios seemed reasonable, P/B ratios highlighted extreme stress. Since we cannot foresee where the next market anomaly will emerge, it is important to develop a perspective that takes into account multiple valuation perspectives. As such, the observation is that style valuation spreads based on asset values are most pertinent amid periods of high economic and market distress, just as they are for individual stocks. Putting It All Together We have developed a proprietary Style Risk Monitor tool used to identify and quantify risks specific to key characteristics that our portfolios tend to exhibit over time. We used the same intuitive process explained above to develop a regression model to help assess the expected future returns to various style characteristics based on their relative valuation. Using this approach, we are able to generate excess return estimates for various style characteristics that appear to us to be reliable over a three to six month horizon. Specifically, we are interested in predicting extreme moves in factor returns that usually correspond to high valuation dispersions for a particular style characteristic. We are now generating factor return predictions for 10 primary characteristics and more than a dozen supplemental characteristics in the areas of fundamental change, expectations and volatility. We are specifically interested in returns to characteristics that are most relevant to our investment style and process. As a result, we are able to evaluate risks to our equity investment process. Our monitoring encompasses multiple groupings, including the global developed markets and global emerging markets universes in aggregate, as well as segmentation between developed large/mid-cap and small-cap universes for the United States, Japan, Europe and the World ex-u.s. markets. Although we continuously monitor the output of our Style Risk Monitor, we plan to take action only when the style risk is expected to overwhelm our alpha process. For example, historical simulations indicate that our portfolios would have incorporated the risk control ideas that have come out of this process only 10-20% of the time since ALPHA PRESERVATION 4

5 Currently, the output of our Style Risk Monitor is reassuring. These results indicate we have minimal risk to our style due to valuation dislocations over the next three to six months since our portfolios are tilted towards positive expected return factors. In this instance, we continue to implement our philosophy and process to the fullest extent without worrying about style risk and market extremes. However, if we look at the output of this model in early 2009, we would see a different picture. The model predicted extreme negative excess return to estimate revisions and earnings momentum. These characteristics are related to our style and preferences in stock selection. This created a need for action to lower the style factor risk that was created in the market. With the use of the Style Risk Monitor, we can identify stocks that have extreme characteristics to counteract the risks to our particular investment process and stock selection strategies. This can help mitigate the style risk in our portfolios as we continue to implement our philosophy and process. This is not to suggest that we would abandon our focus on earnings trends and cash flows in stock selection. However, at the margin we would look to moderate our style profile, and as a result, would likely underperform to a lesser degree when our style is out of favor. In summary, the new Style Risk Monitor marks a natural evolution of our disciplined and robust risk management framework, consistent with our commitment to continual improvement through ongoing research and development. We have long maintained a rigorous approach, utilizing sophisticated tools to identify and avoid unintended systematic biases such as geographic and economic sector concentrations, market capitalization distribution, overall beta positioning, etc. We now have extended our analysis of style characteristics to a level that is far more detailed and customized to our process than any tool previously available to us through widely used commercial risk models. These research efforts have already accrued benefits to our portfolios in the form of greater transparency and improved communications among our team. In turn, we expect longer-term benefits to accrue in the form of greater performance consistency and improved risk/return profiles. About Principal Global Equities Principal Global Equities, a specialized investment management group within Principal Global Investors provides client-focused investment solutions spanning equity markets worldwide. We are fundamental investors focused on bottom-up stock selection within a sophisticated comparative framework. Our research universe encompasses over 10,000 companies, large and small, in emerging and developed markets. We provide expertise in active-core and specialty strategies, with risk profiles aligned to distinct client objectives and preferences. ALPHA PRESERVATION 5

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