Capital Discipline – There Is A Fourth Great Stock Market Anomaly by Andrew Hunt, Better Value Investing: A simple guide to improving your results as a value investor
Pretty much every investor is aware of the big three stock market anomalies. They are Value, Quality and Momentum. These three strategies have outperformed over the long term across most markets. Indeed, most investors define their styles by one of these approaches or a mixture of them.
Yet there is a fourth great anomaly that is at least as powerful as the big three. It also has sound, long-term empirical backing and real world explanations. This fourth anomaly is Capital Discipline. I also call it the “Parsimony ‘n’ Payouts” anomaly, because strong Capital Discipline manifests itself in two broad ways: low spending and high payouts. In the table below I define the attributes of Capital Discipline versus its opposite, profligacy.
|Capital Discipline – good signs||Profligacy – bad signs|
Low or negative growth in operating expenditures
|Rapidly rising costs|
No or low M&A activity
|High M&A activity. Especially big deals, deals paid in stock or diversifying deals|
|Low or falling capital expenditures||High or rapidly growing capital expenditures|
|? 3 years since peak capex||Near peak capex|
|Low or negative total asset growth||Rapid total asset growth|
|Low or negative working capital growth||Ballooning working capital|
|Consistently negative cash from financing||Consistently positive cash from financing|
|A growing or initiated dividend||Little or no shareholder returns|
Flat or falling share count
Rising share count
|Issuance of exotic securities (convertible bonds, PIK notes etc.)|
|Falling debt, debt buybacks||Rising debt. New debt issuance|
Like the big three, Capital Discipline is measurable in various ways, and also overlaps with the other anomalies – especially Quality and Value. However, it tends to get significantly overlooked.
For example, when we think of quality investing, we normally define it in terms of stability (such as low earnings volatility or low beta), high profitability due to some form of sustainable competitive advantage, a strong financial position and reasonable growth prospects. Capital Discipline rarely tops that list.
No-one has done more to prove up the big three than Cliff Asness of the hedge fund AQR. Asness has run hundreds of back-tests across different markets, countries, sectors and time periods. His research is pretty rigorous, and as a result he has found that many recorded anomalies are nothing more than statistical quirks. Nevertheless, Asness has found robust evidence of consistent outperformance for basic Value, Quality and Momentum strategies.
Two of Asness’ recent big studies have been on quality investing[i] – an increasingly popular area. In these papers, Asness sought to define quality and then test for it. Sure enough, quality factors outperformed. But now look at his findings:
The most powerful Alpha factor here is Payout (which Asness defines as the aggregate of dividends, buybacks and debt pay-down less issuance and debt raising). Not only does Payout deliver greater alpha than any of the other quality factors, it delivers more alpha than all the factors combined (QMJ in the table above)! Strip out the Payout bit and the other factors behind the quality anomaly offer pretty slim pickings.
It’s not only Cliff Asness who has stumbled on the Capital Discipline Anomaly. Every Capital Discipline factor in the table above has been found to deliver positive alpha in a wide range of back-tests covering different time periods, different countries and different sectors. The Capital Discipline (aka The Parsimony ‘n’ Payouts) Anomaly appears to be universal.
Some examples of research supporting the findings include:
- The outperformance of parents and spin-offs after a spin-off (Rüdisüli, 2005).
- The accruals anomaly. Companies with low or negative accruals have outperformed those with high accruals (Richardson, Sloan, Soliman & Tuna, 2005). Accruals are the difference between reported earnings and reported free cash flows. Hence negative accrual companies have low capex and low working capital.
- Companies with the lowest growth in operating costs have been found to subsequently outperform (Huang, Jiang, Tu & Zhou, 2014).
- The value destruction of M&A and subsequent underperformance of acquirers has been widely reported, while those selling or divesting tend to do much better (e.g. Sirower, 1997; Loughran & Vijh, 1997)
- Out-performance of stocks with the lowest capex growth (Anderson & Garcia-Feijoo, 2007) and lowest total asset growth (Cooper, Gulen & Schill, 2006; Li & Sullivan 2015), and underperformance of those growing fastest.
- The widely recorded success of dividend strategies, such as the Dogs of the Dow (see this Tweedy, Browne paper for a helpful summary: http://www.tweedy.com/research/papers_speeches.php ). In particular, two studies have made the counter-intuitive finding that stocks with high dividend payouts actually experience faster future earnings growth than stocks with low dividend payouts! (Arnott & Asness, 2002; Zhou & Ruland 2006).
- A similar body of research exists on the outperformance of companies buying back shares, especially when they’re cheap (e.g. Bali, Demirtas & Hovakimian, 2010)
- More recently, research has emerged finding that yield or buyback strategies can be enhanced by using a total shareholder yield measure – the aggregate of buybacks, dividends and debt paydown less equity and debt issuance (Gray & Vogel, 2012; Bradshaw, Richardson & Sloan, 2006; Meb Faber, 2013).
From Meb Faber research: http://mebfaber.com/2012/10/09/a-50-tax-rate-on-dividends/
- However, by far the most comprehensive body of research on Capital Discipline has been compiled by Empirical Research Partners. They’ve written dozens of papers looking at all different aspects of Capital Discipline (changes in share count, dividend policies, asset growth, capex, M&A etc.) as far back as 1952.[ii] They’ve back-tested in the US and internationally, across different sectors, and over holding periods from one month to three years; yet their findings have been remarkably consistent. The most disciplined companies tend to outperform the most spendthrift by about ten percent a year. Further, a Capital Discipline filter is complimentary to value strategies, typically adding about 5% of outperformance a year.
Why is Capital Discipline so powerful?
I recently attended a wedding. The bride had a beautiful new dress, we had a picnic followed by a house-party with live music, and there were flowers and cake – everything that a great wedding needed. As the couple were trying to save, they did the whole thing on less than $500. By contrast, last week newspapers reported a Russian oligarch spent a cool billion dollars on his daughter’s wedding. In the end, both couples had a fabulous and memorable day surrounded by friends and family.
The point is, just as there is no limit to how much you could spend on a house, a meal, an outfit or a wedding, there is no limit to what companies can spend. You can get an office chair for $10 or $10,000, a headquarters can cost over a billion, and there really is no ceiling to how much you can pay staff, throw at M&A, or fritter away on management pet projects, private jets and even stationery. The whole