Sunday, 31 January 2010

Relative quality often a matter of time

Luukko: Relative quality often a matter of time

Published On Sat Jan 30 2010

By Rudy Luukko
Mutual Funds Columnist

As any investing textbook will tell you, good stocks with superior fundamentals will eventually outperform bad stocks. What you also need to realize – as a direct holder of stocks or as a fund investor – is that stock markets don't always reward good stocks.

Paradoxically, stocks whose characteristics are exactly the opposite of what the textbooks advise you to look for are sometimes the biggest winners. At least over shorter periods.

This is what happened after the 2008-09 bear market, says fund manager James O'Shaughnessy, who is based in Stamford, Conn., and manages about $3.4 billion for RBC Asset Management Inc.

A practitioner of enhanced indexing (he calls his methodology strategy indexing), O'Shaughnessy employs quantitative screening techniques to try to beat market benchmarks. The criteria vary for the various mandates, but among his key factors are stock-price momentum, stock price to book value and dividend yield.

During the past two years of mostly bearish markets, O'Shaughnessy's screening methods flopped. All six of his RBC fund mandates with at least two years of history lagged in their peer groups. Five performed in the dreaded fourth quartile, meaning the bottom 25 per cent of fund rankings.

As O'Shaughnessy explains, no stock characteristics will consistently protect portfolios in down markets. His funds also suffered because the types of stocks he held weren't the ones that rebounded most strongly after the bear-market low of March 2009.

Instead, the market recovery was led by stocks that had been "priced for extinction," meaning they had fallen the most on fears that the issuing companies' very survival was threatened.

Historically, the shorter the holding period, the less likely it is O'Shaughnessy's funds will have outperformed their market benchmarks.

For example, RBC O'Shaughnessy Canadian Equity outperformed the S&P/TSX over all rolling 10-year periods dating back to its inception in late 1997. But it did so in just over half of all the three-year periods. And over all the one-year periods, the fund beat the index only 37 per cent of the time.

Of the three oldest funds, RBC O'Shaughnessy Canadian Equity and RBC O'Shaughnessy U.S. Value both rank in the top quartile of their peer groups over 10 years, and RBC O'Shaughnessy U.S. Growth performed in the second quartile. "We take solace from the fact that, over long periods of time, we can have the odds on our side," O'Shaughnessy told me.

More evidence that the ugliest-looking stocks will sometimes be market darlings comes from the so-called "Dangerous Portfolio," a demonstration model created by the CPMS division of Morningstar Canada. It's designed to illustrate the perils of choosing overpriced, debt-laden stocks with deteriorating earnings.

Yet in 2009, this portfolio returned 85.3 per cent, more than double the 35.1 per cent of the S&P/TSX Composite Total Return Index. Over 10 years, however, the Dangerous Portfolio has been the hypothetical wealth destroyer it was designed to be, losing an annualized 16.8 per cent, while the index gained an average 5.7 per cent.

Since you can do so badly over time with a portfolio of lousy stocks, it follows that there are merits in screening techniques that seek to identify the good ones. But as we've seen both with hypothetical portfolios and with real-life funds such as those managed by O'Shaughnessy, this is a game of probabilities. The only certainty is that no stock-picking system will work all the time.

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