Reliables and recoveries

I focus on recoveries and reliables because I think these situations are identifiable, and what happens next is fairly predictable. But there is a curious contradiction in backing companies that are doing well and companies that are doing badly.

Recoveries are companies that have performed poorly recently, either because of bungled management, or because of market conditions. Where the company is recovering from self-inflected damage, like expensive acquisition sprees, the company is a turnaround, it must be putting right what it formerly did wrong. When the damage is inflicted by falling market prices for a company’s products it’s a cyclical.

Reliables are stalwarts or defensive companies. They can reasonably be expected to keep churning out profits in most scenarios. All that is required of a stalwart is more of the same.

I think of these companies, reliables and recoveries, as being in the middle of a wider spectrum of opportunities that goes from the very cheapest stocks, outright bargains selling at below liquidation value on the left, then turnarounds and cyclicals, then stalwarts, and finally fast growth companies on the right, which are separate from stalwarts although they might well be growing too, because fast growth is rarely reliable growth. If you read my two minute monologues you’ll see these categories listed as a heading:

Bargain | Turnaround | Cyclical | Stalwart | Growth

With the conditions that don’t apply to the particular company struck out. It helps me decide what I expect from the company.

Unless you’re prepared to search globally, genuine bargain stocks are rare except when the market is in crisis, and you won’t find me writing much about cyclicals and fast growing companies often. Of all the situations I’ve listed they require the most industry and company expertise. The most important factor in analysing a cyclical company is the future price of the commodity it is selling. The most important factor in analysing a fast growing company is the size of the market it is growing in. There are experts on mining, say, or antibodies, that have opinions on the natural resources super-cycle or the prospects of Abcam, the Amazon.com of antibodies and a fabled ten-bagger. I’m not one of them.

So that leaves stalwarts, turnarounds, and the odd bargain for now, but the purpose of this post isn’t to explain how I identify these situations. I’ve done that before, for stalwarts, turnarounds, and bargains. I want to dwell on the contradiction in favouring both stalwarts and turnarounds.

A recent paper from GMO advocates quality, another word for reliables, defensives, or stalwarts. It says the competitive equilibrium model taken for granted by so many investors, often subconsciously, is wrong. That model proposes that the advantages a company has will be copied by competitors and the superior profits it earns as a result are eroded away over time. In fact, says GMO, the most profitable companies five years ago tend to be the most profitable companies today and the least profitable companies five years ago tend to be the least profitable companies today:

It’s a compelling argument for quality (one of two, it also says highly profitable companies tend to be financially strongest, challenging conventional financial wisdom that to earn a higher reward you must take more risk), although I can’t reconcile it with this chart, from SG, that shows proftis not reverting to the mean, but reverting towards it:

Let’s say profits persist strongly for now, at least for a while. That challenges the rationale for investing in turnarounds, which is that struggling companies will work out what it takes to compete and claw their way back to higher levels of profitability. In other words, the competitive equilibrium model is right. Companies may get their noses ahead for a while, but it’s ephemeral and profitability generally reverts towards the mean over time.

I don’t think there is a contradiction. Studies using naive value statistics, price to book or price to earnings ratios, generally show at least two things: struggling companies beat the market as a group, but mainly because of the spectacular performance of a minority of companies that actually do turn around. In a paper published in 2002 Joseph Piotroski observed:

However, the success of that strategy relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies. In particular, I document that less than 44% of all high BM firms earn positive market-adjusted returns in the two years following portfolio formation.

High BM means high book to market value. The BM ratio is the inverse of the commonly used price to book value ratio, which identifies companies selling cheaply in relation to the accounting value of their assets, less liabilities.  Generally the reason investors aren’t prepared to pay much for high BM/low PB shares is because they are in, or have been in some kind of distress.

If you bought a single random value stock because it was on a low price to book value, it would more likely lose than win, relative to the market, over a two year period.

Since prices tend to follow profits that seems consistent with the evidence presented by GMO, that in general struggling companies tend to continue struggling. To profit from them you’ve either got to discriminate between those in deep do-do, and those emerging from temporary difficulties, which Piotroski succeeded in doing, to a degree, by inventing the F_Score, or you have to buy a lot of the companies in the expectation that a minority of them will perform extremely well and more than make up for the deficiencies in the rest.

Both strategies, stalwart and turnaround, are exploiting popular investor misconceptions.

• GMO says investors naively accept the competitive equilibrium model and so they undervalue strong companies because they don’t think profitability persists.
• Value investors from Ben Graham to Piotroski say investors naively sell-off distressed companies almost at any price, ignoring the fact that some of them will turn around spectacularly.

That’s why I focus on recoveries and reliables. There’s no contradiction.