Bottom-up Stock Selection: The Drivers of Investment Returns

How to select stocks that will outperform - from the bottom up

This week, we put aside considerations of top-down or factor-based approaches, and focus on bottom-up stock selection. What are the drivers of idiosyncratic equity performance, and how should investors seek to identify the stocks that will outperform?

In considering different approaches to bottom-up stock selection, we've categorised papers into five categories: those with a focus on determining fair stock valuations, papers which examine stock anomalies from a behavioural finance standpoint, lessons to be drawn from the stock selection of great investors, selecting stocks which will benefit from long-term supertrends, and the impact of selecting stocks with strong ESG credentials.

How purpose-driven employees help power profitable companies (Eaton Vance, 2019)

(For compliance reasons, this paper is only accessible in the United States & Canada)

A recent research study found that there is a link between corporate purpose and corporate profitability. This paper attempts to codify 'purpose' as an input metric that can be utilised for stock analysis and valuation.

Equity Earnings and Valuations

Scenarios analysis for equity valuations (HSBC Global Asset Management, 2018)

(For compliance reasons, this paper is only accessible in Certain Geographies)

In the context of a transition to a lower carbon economy, HSBC Global Asset Management explores six possible scenarios, modelling the equity-level impact of each possibility.

When paying a high multiple makes sense (Robeco, 2017)

When are high valuations justified? Although markets may occasionally base valuations on inaccurate expectations, these expectations are seldom biased. Therefore, high valuation multiples are a reflection of strong fundamentals in the vast majority of cases.

Company Valuation Methods (Pablo Fernandez)

The author describes the main groups of financial statement-related company valuation methods. Of these, cash flow discounting methods are considered to be the most conceptually correct.

Equity Anomalies and Behavioural Finance

The Perils of Idol Worship: Kraft Heinz Lessons! (Aswath Damodaran, Mar 2019)

In this blog post, Aswath Damodaran examines some of the lessons to be learned from Kraft-Heinz, which recently released news relating to disappointing earnings, a huge goodwill impairment, and a dividend cut of nearly 40%.

Market Efficiency: Who is on the Other Side? (Michael J. Mauboussin, 2019)

When trading, knowing the specific source of the inefficiencies that you are trying to capitalize on is important. This paper categorizes market inefficiencies as either behavioral, analytical, informational, or technical.

Popularity: A Bridge Between Classical and Behavioral Finance (2018)

CFA Institute Research Foundation examines the differences between classical finance and behavioral finance and introduces 'popularity' as a framework for bridging the gap between the two fields.

Equity selection: People and Processes

Buffett's Alpha (Financial Analyst Journal, 2018)

Warren Buffett’s Berkshire Hathaway has realized a Sharpe ratio of 0.79 with significant alpha to traditional risk factors. The alpha became insignificant, however, when we controlled for exposure to the factors “betting against beta” and “quality minus junk.” Furthermore, we estimate that Buffett’s leverage is about 1.7 to 1, on average. Therefore, Buffett’s returns appear to be neither luck nor magic but, rather, a reward for leveraging cheap, safe, high-quality stocks. Decomposing Berkshire’s portfolio into publicly traded stocks and wholly owned private companies, we found that the public stocks have performed the best, which suggests that Buffett’s returns are more the result of stock selection than of his effect on management.

Keynes the Stock Market Investor: A Quantitative Analysis

This paper reconstructs and then deconstructs the investment activities of John Maynard Keynes, including a quantitative analysis of his stock picking abilities through looking at active risk and underlying factor tilts. It also provides unique insight into the evolution of equity investing in the early 20th century.

Let's talk about actual investing - Q4 2018 (Baillie Gifford)

Baillie Gifford advocates a return to 'actual' investment - relying less on trading models, big data, and factors and returning to an environment of investments that provide financing to great ideas and projects within companies.

Supertrends and Equity Selection

Artificial Intelligence: Real opportunity (Franklin Templeton, 2019)

(For compliance reasons, this paper is only accessible in Certain Geographies)

Rising amounts of computing power, along with the rapidly expanding universe of available data, has increased utilisation of AI/machine learning techniques across multiple industries.

Artificial Intelligence: It's Not the Future, It's Now (Capital Group, 2018)

(For compliance reasons, this paper is only accessible in Certain Geographies)

Artificial Intelligence is a powerful and disruptive force. In this paper, Capital Group describes the next wave of innovation to be brought on by advancements in AI technology, and considers the opportunities this presents for investors.

The Industry 4.0 Paradox: The path to digital transformation (Deloitte, 2018)

Industry 4.0 combines and connects digital and physical technologies such as AI, IoT, and cloud computing. This paper is based on a Deloitte survey of 361 corporate executives worldwide on how companies are currently investing in Industry 4.0.

ESG, Equity Valuation and Stock Returns

How ESG Affects Equity Valuation, Risk, and Performance (MSCI, 2017)

Instead of focusing on how ESG characteristics are positively correlated with financial performance, this paper attempts to understand how these ESG characteristics lead to effects that are financially significant.

ESG: Ethics and Alpha (Aviva Investors blog, 2018)

(For compliance reasons, this paper is only accessible in Certain Geographies)

What is the relationship between performance and responsible investing? The debate over ESG has arguably been raging for 50 years, ever since Milton Friedman's seminal article in the New York Times in 1970.

Podcast: Harnessing the Alpha-Generating Power of ESG (State Street, 2018)

Anna Lester and Chen He of State Street Global Advisors' Active Quantitative Equity team discuss the informational edge potentially provided by ESG-related considerations.

ABOUT THE AUTHOR

Andrew Perrins is a former Actuary and Asset Allocator. as an Actuary, he worked for 15 years in, serving as Director of Asset Allocation for Abbey Life Chase Manhattan, before setting out on a more entrepreneurial path. 

To contact him, email [email protected]