According to some new research, the periods just before, during and just after recessions are actually the best times for stock pickers to beat the market.iStockphoto/Getty Images/iStockphoto
John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Weak economic data in North America, continuing sluggishness in China, beaten-down commodity prices, the spectre of interest rate hikes, stumbling corporate profits – all of these factors (and others) have sparked fears among investors at one point or another this year. Throw in a bull market that is now more than seven years old and that, in the United States, has made stocks fairly pricey, and you can see why Google searches for "recession" and "bear market" have hit their highest levels in several years in 2016.
In the United States, investors have responded by doing what they always do when they fear a recession or bear market is coming: take money out of stocks. But according to some new research, the periods just before, during and just after recessions are actually the best times for stock pickers to beat the market.
The research comes from O'Shaughnessy Asset Management (OSAM), which is headed by quantitative investing guru James O'Shaughnessy. (Mr. O'Shaughnessy runs a number of funds for RBC). The group invests using a number of "factors" – that is, fundamental criteria that measure valuation, momentum, financial strength and other stock qualities. It has found that investing in stocks that score highly using these metrics (individually and in conjunction) tends to be a good way to beat the market over the long haul.
In a new paper, OSAM looked at stocks scoring highly on each of these factors – including how they fared during different parts of the economic cycle going back to the mid-1960s. While there was some variation from factor to factor, the general conclusion was this: Focusing on fundamentals has historically given investors the biggest advantage over the broader market during "prerecession" periods (the 12 months prior to a recession). During these periods, stocks in the top 10 per cent of the market using a given factor have outperformed stocks in the lowest 10 per cent of the market using that factor by an average of 11.5 percentage points. Not far behind were postrecessionary periods (the 12 months after a recession ends), when the average spread was nine percentage points, and recessionary periods, when the average spread was 8.2 points. The period in which this sort of fundamental-focused investing has provided the smallest benefit during stretches of "pure expansion," when the spread has been 4.5 percentage points. In the prerecession, recessionary and postrecession periods (as well as the entire period studied), value was the factor that provided the biggest boost to returns, with cheap stocks far outperforming pricier stocks.
This indicates that fundamental-focused strategies do their best work relative to the broader market when you are feeling uneasy. (Usually, the market starts to turn down before a recession, which means that in prerecession and recessionary periods, stocks are falling; then, in postrecessionary periods, while stocks are usually rising, fears tend to linger.)
I know what you're thinking: Why not just avoid stocks altogether during pre-recession and recessionary periods?
For one thing, you never know for sure that you are in one of those periods, given the lag time involved in declaring recessions. Plus, if you try to guess where we stand, you are likely to miss the mark. Dalbar Inc., has found that the average mutual fund stock investor has underperformed the broader market by 3.52 percentage points per year, on average, over the past 20 years. The greatest factor in that underperformance, according to the group: "voluntary investor behaviour" – that is, bad timing decisions.
The message, then, is not "focus on fundamentals leading up to, during, and just after recessions"; you can't say for sure when any of those periods are occurring. Instead, it's that if you are using a fundamental-focused investment strategy, you need to stick with the strategy during good times and bad – because very often, the times when the market is volatile and you most want to ditch the strategy are the times when it will provide the most benefit.
Right now, my Guru Strategies – which are based on the approaches of several investing greats, including Mr. O'Shaughnessy – are finding a number of fundamentally strong stocks in North America. Here are a few that are high on the list:
United Therapeutics: This biotech company ($5.2-billion [U.S.] market capitalization) gets high marks from the model I base on mutual fund legend Peter Lynch's approach. It likes United's 38 per cent long-term earnings per share growth rate and 0.17 price-earnings-to-growth ratio, while the approach I model after star manager Joel Greenblatt likes its 25.2 per cent earnings yield and 60 per cent return on capital.
Power Corp. of Canada: This holding company ($14-billion [Canadian] market cap) has interests in the financial services and communications sectors. It gets approval from my O'Shaughnessy-based model, which likes its strong cash flow ($12.16 per share, about eight times the market average) and 4.2 per cent dividend yield.
Cognizant Technology Solutions: This IT firm, with a market cap of $38-billion (U.S.), is a favourite of my Warren Buffett-based model. The approach likes that its earnings per share have risen in every year of the past decade; its long-term debt ($858-million) is only about half of its annual earnings ($1.7-billion); and its 10-year average return on equity is an impressive 20.4 per cent.
Disclosure: I'm long Cognizant and United Therapeutics.