Value And Momentum: A New Exercise in Industry Rotation

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Value And Momentum: A New Exercise in Industry Rotation

A New Exercise in Industry Rotation

At Abnormal Returns, over the weekend, Tadas Viskanta featured a free article from Credit Suisse called the Credit Suisse Global Investment Returns Yearbook 2015. It featured articles on whether the returns on industries as a whole mean-revert or have momentum, whether there is a valuation effect on industry returns, “social responsibility” in investing, and the existence of equity discount rate for the market as a whole.

Industry Rotation
Industry Rotation

 

There are no surprises in the articles — it is all “dog bites man.” They find that:

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  • Industry returns exhibit momentum
  • There is a valuation component in industry returns
  • Socially responsible investing doesn’t necessarily produce or miss excess returns
  • There is an overall equity discount rate, which is levered about 20-25 times, i.e., a 1% increase in the rate lowers valuations by 20-25%.

The first two are well-known for individual stocks, so it isn’t surprising that it happens at the industry level. The third one has been written about ad nauseam, with many conflicting opinions, so that there is little effect is no big surprise. The last one resembles research I saw in the mid-90s, where the effect of changes in real interest rates has about that impact on stocks. Again, nothing new — which is as it should be.

But now some more on industry returns. They found that industry return momentum was significant. Industries that did well one year were likely to do well in the next year. The second finding was that industries with cheap valuations also tended to do well, but it was a smaller effect.

So, using one-year price returns as my momentum variable and book-to-market as a valuation variable (both suggested in the article), I divided industries for companies trading in the US into quintiles (also suggested in the article) for momentum and valuation. (Each quintile has roughly 20% of the total market cap.) Here is the result:

IMVC

Low valuations are at the right, high at the left. Low momentum at the top, high momentum at the bottom. Ideally by this method, you would look for industries in the southeast corner.

To me, Agriculture, Information Technology, Security, Waste, Some Retail, and Some Transportation look interesting. One in the far southeast that is not so interesting for me is P&C Insurance. Yes, it has done well, and compared to other industries, it is cheap. But industry surplus has grown significantly, leading to more competition, and sagging premium rates. Probably not a great time to make new commitments there.

Anyway, the above table should print out nicely on two sheets of letter-sized paper. Not that it would be a substitute for your own due diligence, but perhaps it could start a few ideas going. All for now.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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