Tag Archives: models

If ROIC Is So Great, Then Why Doesn’t Everyone Use It?

That’s the question we get when we argue that return on invested capital ( ROIC ) does a better job of explaining changes in shareholder value than any other metric . Why do investors, executives, and the financial media focus on reported earnings and other metrics such as EBITDA that ignore the balance sheet? Why aren’t executives around the world adopting ROIC in order to boost returns? Anyone asking those questions should read the 1996 CFO Magazine article ” Metric Wars .” Back in the mid-90’s, ROIC-based models such as Economic Value Added (NYSE: EVA ) and Cash Flow Return On Investment (CFROI) were all the rage, with corporate giants such as Coca-Cola (NYSE: KO ), AT&T (NYSE: T ), and Procter & Gamble (NYSE: PG ) linking them to executive compensation and highlighting them in communications with shareholders. Fierce competition ensued, as a variety of consultants developed and marketed their own shareholder value models, all, at their core, based around the idea that companies need to earn a return on capital above their cost of capital. That revolution was short-lived. Coca-Cola and AT&T stopped regularly highlighting EVA in filings after 1998. Some of the consulting companies mentioned in the CFO piece no longer exist, such as Finegan & Gressle, while others like The Boston Consulting Group no longer highlight the same metrics. It would be easy to assume that ROIC-based models had their chance in the marketplace and failed because they weren’t good enough, but that would be wrong. The story of the “Metric Wars” shows that it was the marketing strategy, not the underlying model, which was flawed. The Consultant’s Concoction The lack of resources and technology available at the time required the proponents of these metrics to do many hours of manual work to provide the metrics for the client and its comp group. As a result, the firms wanted to differentiate their models or build barriers to entry around them so that competitors could not piggyback on their original work. Transparency was not in the consultants’ best interests. If everyone could see the inner workings of their formulas, clients wouldn’t have any incentive to pay big money for their model over a competitor’s. As a result, the various firms guarded their models and would attack a competitor’s formula as a “consultant’s concoction.” This was an understandable development, as the recurring revenue stream from a consulting client can be very valuable. Unfortunately, it also led to lot of significant problems for the ultimate end-users of that data. Excess Complexity: consultants needed to make the work seem really difficult so clients would not replicate and competitors could not decipher it. Lack Of Transparency: since each company’s formula was its bread and butter, they kept the details of how they were calculated hidden. It was hard for those on the outside to understand or trust the process. No Comparability: with no single standardized formula, it was impossible for companies or investors to benchmark results to their peers. Short Shelf Life: the analyses were only as fresh as the last engagement, and since the “proprietary” formulas could change from year to year, clients might not always have the most up-to-date analysis. Little Differentiation: While all the different consultant’s formulas had their own tweaks, they were based around the same basic idea. With so little fundamental differentiation, the various consultants spent a great deal of time and effort tearing each other down and nitpicking competing formulas, ultimately spreading more confusion. Add this to the tech bubble attitude of the late 90’s, when stock valuations became more about stories and potential rather than any fundamental research, and the work these consultants were doing fell by the wayside. Today, only Stern Stewart and Credit Suisse (which bought CFROI or HOLT in 2001) remain as survivors from the Metric Wars. Neither has had a ton of success monetizing their formulas since then, in part because they remain committed to their “concoctions” for consulting business, and also because they rely on inconsistent and limited data feeds that lack analysis of the financial footnotes or management disclosure and analysis. A Different Strategy What New Constructs does today is not so different from what Stern Stewart, The Boston Consulting Group, and others did 20 years ago. We’re working off the same conceptual framework and implementing many similar calculations. What’s changed is the level of rigor we put into building technology to gather high-quality data and build best-in-market models with scale. Our point of differentiation is the scale and speed with which we can build the models and provide analytics. Our highly educated and trained analysts leverage our proprietary technology to deeply analyze 10-Ks and 10-Qs in a matter of seconds on average. While we make thousands of adjustments in our models to close accounting loopholes and portray the true economics of the underlying business, every adjustment is not only 100% transparent but also overrideable by clients. Anyone can go to the Education tab of our website and get detailed explanations of the metrics we use, how we calculate them, and the various adjustments we make to accounting data. Our data is comparable across different companies, so anyone can easily use our screeners to compare profitability and valuation. During the Metrics Wars, the technology simply didn’t exist to create such a large database and deliver that much information without charging a prohibitively large fee to clients. Because of these limitations, those companies failed even though their underlying framework was sound. In the intervening years, the burgeoning financial punditry has helped propagate the myth that the market only cares about reported earnings. The rise of the E*Trade baby and amateur investors only furthered the focus on simplistic data points that could be easily calculated and consumed. More sophisticated fundamental research became harder and harder to find. Today, there is a noticeable gap for the many investors out there that want high-quality fundamental research. Most of the available research out there doesn’t attempt to assess the true drivers of value. Wall Street analysts lack the independence to deliver truly objective research, and what little truly high-quality research exists tends to be too expensive for the average investor to access. Our goal is to remove the noise that clouds the connection between corporate performance and valuation by providing an analytical framework that is intuitive yet rigorous. For over 95% of the world’s market cap, we provide apples-to-apples corporate performance and valuation metrics. We are ready to join the Metric Wars. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Forecasting Returns: Simple Is Not Simplistic

“It is far better to foresee even without certainty than not to foresee at all.” -Henri Poincaré 1 Another year, another body blow delivered by the market to “cheap” investments. One popular definition of cheap (i.e., value) has now underperformed growth on a total return basis for six of the last nine years. Can we blame the investor who is considering throwing in the towel, dropping to the canvas, and taking a 10 count on value strategies? Is it now time to leave the ring, sell value, and pick up the growth gloves, or is a better option to stay in the ring and buy even cheaper cheap assets? To make this important determination, a reliable expected returns model is a good referee. The choice of model is important. After all, a model’s forecasted return for an asset class is only as good as its structure, assumptions, and inputs allow it to be. In this article, we compare three models. Each can be classified as simple in contrast to the quite complex models used by many institutional investors. One of the three is the model used by Research Affiliates, which although simple has performed well, not only in terms of making long-term asset class forecasts, but in combining undervalued asset classes to build alpha-generating portfolios. This latter consideration is a prime attribute of a successful model. The Rational Return Expectation Let’s begin our analysis with the return we should rationally expect from the investments we make. Whether an investor practices top-down asset allocation or bottom-up security selection, investing is about nothing more than securing cash flows at a reasonable price. After all, the price of an asset is simply the sum of its discounted cash flows, which can be affected by two forces: 1) changes in the cash flows and/or 2) changes in the discount rate. If the cash flows and discount rate remain constant over the holding period, the asset’s value will remain the same throughout its life as on the day it was purchased. Therefore, it is a change in the cash flows and/or the discount rate that ultimately drives an asset’s realized return over time, and the possibility of such changes that drives an asset’s expected return over time. As mentioned in the introduction, the implementer of a value strategy would have experienced a long string of annual negative returns over the past several years. Figure 1 illustrates quite vividly the disappointing returns associated with a U.S. equity value strategy compared with a U.S. equity growth strategy since 2007. Click to enlarge Although this period of underperformance may be disheartening for many value investors, the precepts of finding, and then investing in, undervalued assets will, tautologically, 2 be rewarded with outperformance in the long run. The question then becomes, does “cheap” mean undervalued? To aid in answering this question, a variety of expected return models are available in the marketplace, including the model on the Research Affiliates website. 3 From the first day we published our long-term expected returns on the site, we have received questions from clients and peers on the efficacy of our model. The question usually posed is: “What’s the R 2 of your expected return model for [insert favorite asset class here]?” 4 Granted, it seems like a pretty obvious question, but we would argue it is actually not all that relevant. A better question, and the one we address here, is how our model compares with other commonly used models. Because investors need some method or modeling system to estimate forward returns, the issue is not just a matter of how “good” a single model is, but also how it compares to available alternatives; simply improving on the alternatives can be quite beneficial. A Comparison of Expected Return Models The first model is a simple rearview mirror investment approach in which we assume returns for the next 10 years will equal the realized returns of the previous 10 years. Although this is a very simple model, it also happens to be the way that many investors behave. The second model assumes that in the long run all assets should have the same Sharpe ratio, and calculates expected returns based on the realized volatility of each asset. The third model is the Research Affiliates model, as described in the methodology documents on our website. For the comparison, we’ll use expected and realized returns for a set of 16 core asset classes, over the period 1971-2005. Asset returns are included in the analysis as they historically became available. 5 All returns are real returns. Model One . Figure 2 is created using the first model. It compares the 10-year forecast, which is based on the past, to the subsequent 10-year return. On the x axis, 10-year expected returns for each asset class are grouped into nine buckets. Each blue bar represents a 2% band of expected return in a range from −4% to 14%. The height of the blue bars represents the median subsequent 10-year annualized return for the assets in that bucket. The 10-year realized return is calculated using rolling 10-year periods, month by month, starting in 1971. The orange diamonds and gray dots represent the best and worst subsequent returns, respectively, for each bucket. Click to enlarge The first model clearly underestimates the returns of assets that have performed poorly in the past, and overestimates the returns of assets that have recently performed well. For example, the actual median return for assets with a forecasted return between −2% and 0% was an amazing 11.6% a year! This pattern of bad forecasting is consistent across the range of forecasted returns. Although common sense argues that past is not prologue, using past returns to set future return expectations is the norm for many practitioners who attempt to “fix” the problem by using a very long time span. But let’s consider the half-century stock market return at the end of 1999 that was north of 13%, or 9.2% net of inflation. Many investors did expect future returns of this magnitude to continue! But because 4.1% of that outsized return was a direct consequence of the dividend yield tumbling from 8% to 1.2%, the real return for stocks was a much more modest 5.1%. Model Two . Figure 3 shows the results of the second model, which assumes a constant Sharpe ratio for all assets. In this case, we assume a Sharpe ratio equal to 0.3. This model performs better than the historical returns model. The median realized return grows as the expected return grows, however, the long-term forecasted returns are constrained on both the upper and lower ends of the forecast range (i.e., no forecasted returns less than 0% nor greater than 12% are generated). Negative returns in this model are impossible to get without a very negative real risk-free rate, and by definition, large expected returns are not possible without very high volatility. Click to enlarge Model Three. Let us now turn to the Research Affiliates model. Figure 4 shows our 10-year forecasted returns 7 for the 16 core asset classes compared to their actual subsequent 10-year returns. The trend of rising expectations and rising subsequent returns is what we should expect from a model, although it’s not perfect. Click to enlarge As Figure 4 shows, when our return expectations have been less than 2%, realized returns have often been higher than expected. Although we were apparently overly bearish, our return forecasts were well within the bounds of best and worst realized returns. It is also worth mentioning that market valuation levels have been generally rising, and yields falling, since 1971, so it is possible that our forecasts were correct, net of the (very long) secular trend in valuation levels. For forecasted returns higher than 2%, the median return for each bucket is in line with expectations, with the gap between the minimum and maximum returns becoming smaller as the expected return gets larger. It’s important to recognize our expected returns are based on yield, a contrarian signal which echoes our investment belief that the largest and most persistent active investment opportunity is long-horizon mean reversion. Investing using a yield-based signal does not come without its challenges. One big challenge is that a yield signal is a valuation signal that does not come with a timing signal. Because the yield is signaling an asset is attractive today does not mean it will not continue to get more attractive. If the asset’s price falls further, increasing the long-term return outlook, unrealized losses in the portfolio can be uncomfortable. This discomfort is not due to dollars actually lost, but by the sickening feeling that accompanies downside volatility. As American investor and writer Howard Marks has said, “The possibility of permanent loss is the risk I worry about.” We agree. Volatility should not be confused with risk. The permanent loss of capital, 8 which happens when investors succumb to fearful thoughts and thus sell at inopportune times, is the investor’s true risk. Putting It All Together The primary purpose of an expected return model is to classify what we know about assets in an economically intuitive framework for the purpose of building portfolios . Or said a different way, a model’s value is in the collection of forecasts it encompasses – that is, the system itself – and not in the individual forecasts. Figure 5 shows the results of an equally weighted portfolio using our forecasts. In this case the median realized returns line up very well with expectations, and the dispersion is smaller than that observed in Figure 4 for the individual asset classes. Are our expectations perfect? Absolutely not! Is our methodology a crystal ball for the future? No way! Can there be a ton of variability in our forecast returns versus realized returns? Most certainly, yes! But instead of lamenting these uncertainties, we believe there is value in measuring them. Click to enlarge For a visual representation, Figure 6 shows our expected return for the commodities asset class along with the variability (unexpected return) around the expectation. This variability could be due to changes in the shape of future term structures that differ from the past; faster or slower reversion of spot prices to expected means; or a plethora of other unknown idiosyncratic criteria. Click to enlarge Risk & Portfolio Methodology document 10 on our website describes an approach to constructing portfolios that incorporates the variability around each return expectation. A Simple Forecasting System Can Win the Round Jason Zweig noted in his commentary to The Intelligent Investor that “as [Ben] Graham liked to say, in the short run the market is a voting machine, but in the long run it is a weighing machine.” 11 We concur. We are not interested in attempting to navigate short-term price fluctuations and the random chaos that causes them. We seek instead to discern an asset’s currently unacknowledged investment heft and the likelihood that the market will recognize this value over the subsequent decade. We are long-term investors. Asset classes with higher long-term expected returns are generally unloved and overlooked for quite some time before their fortunes reverse. Uncovering value does not require a complex model. We find that a simple, straightforward returns-modeling system for constructing multi-asset portfolios works quite well. We have chosen to stay in the ring for the long term, holding today’s undervalued and unloved asset classes, confident in the compelling opportunities signaled by the simple and straightforward metric of yield. Endnotes 1. Poincaré (1913, p. 10). 2. If it fails to eventually outperform, it’s not undervalued! 3. http://www.researchaffiliates.com/assetallocation . 4. Although measuring the R 2 of our models is possible, the result is not very useful because samples overlap over long-term horizons. Take U.S. equities for which data are readily available since the late 1800s, roughly 150 years. We analyze 10-year returns, calculated monthly. As a result, we have only 15 unique samples. Any regression using monthly data points for 10-year returns will show misrepresented R 2 values, because each data point shares 119 of its 120 months with the next data point. Going to non-overlapping returns means we don’t have enough samples for robust results. For example, imagine the same test for the Barclays U.S. Aggregate Bond Index, which started in 1976-four samples anyone? 5. Indices were added as data became available: 8/1971, Russell 2000; 12/1988, MSCI EAFE; 1/1990, Barclays Corporate High Yield; 1/1992, Barclays U.S. Treasury Long; 5/1992, Barclays U.S. Aggregate; 5/1992, JPMorgan EMBI+ (Hard Currency); 4/1994, Barclays U.S. Treasury 1-3yr; 1/1997, Bloomberg Commodity Index; 3/1997, JPMorgan ELMI+; 1/2001, Barclays U.S. Treasury TIPS; 7/2003, FTSE NAREIT. Analysis is monthly and ends in 2005, the most recent date for which 10-year subsequent returns can be calculated. 6. The range for each of the bars in the chart should be interpreted as including the lower bound but not the upper bound of the range. For example, the range −2% to 0% includes returns from, and including, −2% up to, but not including, 0%. This standard also applies to the charts in Figures 3-5. 7. These forecasted returns represent return expectations that our methodology would have delivered in past decades. The core elements of the methodology were first described by Arnott and Von Germeten (1983); thus, the methodology is not a data-mining exercise of fitting past market returns. 8. Marks (2013, p. 45). 9. The 4% to 6% bucket is an outlier here; however, this result only occurred in 13 months of the entire 34-year period. 10. http://www.researchaffiliates.com/Production%20content%20library/AA-Asset-Class-Risk.pdf?print=1 . 11. Graham (2006, p. 477). References Arnott, Robert, and James Von Germeten. 1983. ” Systematic Asset Allocation .” Financial Analysts Journal, vol. 39, no. 6 (November/December): 31-38. Graham, Benjamin. 2006 (1973). The Intelligent Investor-Fourth Revised Edition, with new commentary by Jason Zweig. New York: HarperCollins Publisher. Marks, Howard. 2013. The Most Important Thing Illuminated. New York: Columbia University Press. Poincaré, Henri. 1913. The Foundations of Science. New York City and Garrison, NY: The Science Press. This article was originally published on researchaffiliates.com by Jim Masturzo . Disclaimer: The statements, views and opinions expressed herein are those of the author and not necessarily those of Research Affiliates, LLC. Any such statements, views or opinions are subject to change without notice. Nothing contained herein is an offer or sale of securities or derivatives and is not investment advice. Any specific reference or link to securities or derivatives on this website are not those of the author.

How Much Should You Hedge Currencies Today?

By Jeremy Schwartz Currency-hedged exchange-traded funds (ETFs) have been THE story in ETFs over the last three years as one of the leading categories for ETF flows. This has caused some critics to say the movement into currency-hedged ETFs is overdone. First and foremost, we think this assessment underestimates the investment thesis for strategic currency-hedged allocations . More on that below. Second, even based purely on flows, these would-be contrarians are missing the bigger picture. The flows toward currency-hedged ETFs have occurred in two of the smaller pieces of the asset allocation pie-Europe and Japan. When we look at Morningstar categorization for non-U.S. equities, Europe had approximately $88 billion in assets under management (AUM) as of November 2015, Japan had approximately $48 billion of AUM and the foreign large-cap category was approximately $1.3 trillion. 1 While we think Europe and Japan can become bigger categories over time as investors view them more favorably, broad international allocations are more common. In the dedicated European and Japanese category of investments, the adoption of currency hedging has been staggering. Currency-hedged ETFs, which were nonexistent six years ago, now represent as much as one-third of total European-focused AUM in the U.S. and 40% of total Japanese AUM-when including both mutual funds and ETFs. 2 Yet in the broad international category, the trend toward hedging, in our view, hasn’t even started, with only 2% to 3% of the total $1.3 trillion in the category being strategically hedged. WisdomTree believes currency offers uncompensated risk and that most of the $1.3 trillion in assets is taking on more risk than necessary to deliver the returns of international equities. Myths about Hedging Many active managers propagate a generalization and myth that it is expensive to hedge currencies. We see interest rate differentials as the most important cost to hedge. For certain markets, such as Brazil, it could be expensive to hedge because short-term interest rates in Brazil are approximately 14% 3 , and this creates a high hurdle for how much currency has to decline to break even from the hedge. Being Paid More to Hedge But in general, over the last 30 years, an investor was paid on average about 40 basis points (bps) per year to hedge developed world currency exposures 4 . In Japan over the last 30 years, an investor was paid on average almost 2.5% per year to hedge currency exposures simply from the interest rate differentials in the forward contracts. 5 With the U.S. Federal Reserve now raising its Federal Funds Rate, and other central banks continuing to pursue stimulative policy, an investor is now being paid more to hedge foreign currencies in the short run, making hedging even more attractive from an interest rate perspective in 2016 and 2017 than it was in 2015, 2014 or 2013, when currency hedging first took off. This is a reason hedging is becoming more attractive . Is It Too Late to Hedge the Euro and Yen? We argue that currency hedging should serve as the baseline and that investors should add currency risk whenever they view it as less attractive to hedge (or more desirable to have the currency exposure). Investors can switch from hedged to unhedged exposures or blend such strategies together-but now there is a new solution through our dynamically hedged family. This index family solves the challenge of trying to time when currency hedging should be in place. WisdomTree Investments partnered with Record Currency Management to build an index family that incorporates Record’s hedging signals into a dynamically hedged index. 6 Record has been evaluating currency risk and return trade-offs for more than 30 years, and research showed the most important hedging signals for developed world currencies are threefold: The Interest Rate: If the implied interest rate in the United States is higher than that in the targeted currency, it is more attractive to hedge. This signal helps manage the cost to hedge when it is more expensive to do so (like in Australia today). Momentum: Simply put, a downward trend in the targeted currency would signal to put on the hedge, whereas an upward or appreciating trend would signal to take it off. Value: When the targeted currency is overvalued compared to “fair value,” as determined by purchasing power parity (PPP), it is attractive to hedge, and when deeply undervalued, it is less attractive to hedge. Importantly, this is a long-run signal, and a wide band is used in applying this signal. Monitoring the Hedge Ratios by Currency & by Signal Click to enlarge For definitions of terms in the chart, visit our glossary . The currency-hedge signals are determined on an individual currency basis, but in aggregate, for the developed world currency exposures in the WisdomTree Dynamic Currency Hedged International Equity Index , the models suggest hedging 71.05%, and for the WisdomTree Dynamic Currency Hedged International SmallCap Equity Index , they suggest hedging 64.57%. These models are by nature dynamic, and when it is more/less favorable to hedge, some of these hedge ratios will come up/down. While many investors think they missed the opportunity to switch to currency-hedged strategies, we reiterate that we believe the most important drivers of long-term currency movements suggest hedging a majority of your currency exposures today. Sources Morningstar Direct. Europe refers to the universe of U.S.- listed mutual funds and ETFs within the Europe Stock peer group. Japan refers to the universe of U.S.- listed mutual funds and ETFs within the Japan Stock peer group. Broad international refers to the universe of U.S.- listed mutual funds and ETFs within the Foreign Large Value, Foreign Large Blend and Foreign Large Growth peer groups. Data is as of 11/30/2015. Morningstar Direct. Same universes and as of date as the prior footnote. Bloomberg, with data as of 12/31/15. Developed world currency exposures refer to those defined by the MSCI EAFE Index universe from 12/31/1988 to 9/30/2015. Source for paragraph: Record Currency Management, with data from 12/31/1988 to 9/30/2015. No WisdomTree Fund is sponsored, endorsed, sold or promoted by Record Currency Management (“Record”). Record has licensed certain rights to WisdomTree Investments, Inc., as the index provider to the applicable WisdomTree Funds, and Record is providing no investment advice to any WisdomTree Fund or its advisors. Record makes no representation or warranty, expressed or implied, to the owners of any WisdomTree Fund regarding any associated risks or the advisability of investing in any WisdomTree Fund. Important Risks Related to this Article Hedging can help returns when a foreign currency depreciates against the U.S. dollar, but it can hurt when the foreign currency appreciates against the U.S. dollar. Investments focused in Japan or Europe increase the impact of events and developments associated with the regions, which can adversely affect performance. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”