SSR Skepticism Index – Don’t Be Skeptical

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 15th, 2014

SSR Skepticism Index – Don’t Be Skeptical

  • Our skepticism index works! Using it as a stock selection method and averaging returns across 126 companies shows compelling pattern in Exhibit 1. We have shown this analysis before on several occasions, but the caveat to the substantial average returns seen at the SI extremes has been an equally substantial volatility. We address this issue here.
  • The index is a measure of how forward earnings estimates compare to historical trends (based on return on capital) and compare with current valuation. The companies with the current highest SI are ACM, KBR, R, PWR and WOR. Those with the most negative index are ATR, SLGN, HON, LECO and SNA
  • Ranking the companies in our group by the extent to which current valuation is out of line with deviations from the return on capital trend has explained a large portion of the return volatility. Predictably, the companies with a high R2 (indicating valuation is largely explained by ROC) show a much greater level of outperformance at highly positive SI values (above 1.5) with roughly equivalent variability compared to the companies with a low R2 – Exhibits 5 and 6.
  • On a market cap basis, splitting the 126 companies into three groups of 42 shows the smallest capitalization stocks offer the best risk-reward at both high and low SI extremes – Exhibits 7 through 9. We would be looking for small cap stocks with an SI above 1.5 and a high R2– there are currently no stocks that meet these criteria (see Appendix) but we highlight a few prior instances where a high SI value has led to outperformance and examine the correcting mechanism that drove it.
  • High skepticism suggests that either returns on capital are unsustainably high (the market is discounting they will fall) or the stock is unsustainably undervalued. Low skepticism (i.e. a high degree of optimism) suggests that either returns on capital are unsustainably low and the market is pricing in an increase or the stock is unsustainably overvalued.

Exhibit 1

Source: Capital IQ, SSR Analysis

Note: History back to 1980 where company data exists and performance is relative to the S&P500

Skepticism Index Overview

Our skepticism index can be difficult to comprehend, but stated simply, it measures the extent to which valuation and returns are in line with one another and can be expressed as the sum of two components:

Divergence from Return-on-Capital Trend (forward earnings)

+

Divergence from Normal Value

If a stock is below its ROC trend by 1 standard deviation and is below its normal value by 1 standard deviation, these offset and equate the Skepticism Index to 0*– the stock is cheap but it is cheap because it is under-earning. Exhibits 2 and 3 depict the individual components of the SI (divergence from return on capital trend and discount/premium to normal value, respectively) and Exhibit 4 plots the components. The dotted line in Exhibit 4 represents all points where the SI is equalized – this stock currently has a skepticism value of close to 0, as its premium valuation is supported by above trend earnings. Also note the high R2.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

*note that we always show value as an inverse, such that a cheap company has a positive value measure – we measure discount to normal value

Exhibit 4

Source: Capital IQ, SSR Analysis

Where to Look and How to Use It

Typically we look for companies that are sitting in the top right quadrant of Exhibit 4, those that are over-earning and cheap – the SI will be maximized in this quadrant, as both components will be positive.

A highly positive value on the skepticism index indicates one of two scenarios, both supporting the same outcome of outperformance:

  • either the stock is undervalued relative to its returns (in which case valuation will presumably catch up), or;
  • the market is discounting a fall in returns (in which case the fall is already priced in, leaving room for marginal upside as returns move to equate with valuation).

This is the logic behind the large positive forward returns generated when the SI is at extreme highs (above 1.5), as shown in Exhibit 1. Over our universe of stocks, however, the variability is considerable, and in excess of the returns. To isolate this variability, we ranked the 126 companies in the return analysis by R2 (here measuring the extent to which divergences in valuation are explained by divergences the ROC trend) and then broke the group into three subsets of 42. At highly positive SI values (above 1.5) the high R2 group shows a significantly higher return than the low R2 group, with roughly equivalent volatility – Exhibit 5. The forward losses at low levels of skepticism (i.e. high levels of optimism, SI below -1.5) are slightly more pronounced in the high R2 group versus the low R2 group, with about the same standard deviation, but the difference is less notable than on the positive side.

To further test the conclusion that a higher R2 equates to better and less volatile performance, we took the 23 companies with an R2 over 50% and the 28 companies with an R2 below 10% and ran the return analysis again. The results here are even starker, for both the highly positive and negative SI ranges – Exhibit 6.

We similarly stratified the group of 126 into equal subsets based on market cap. The smallest cap group shows the best risk-reward profile at both high and low SI extremes – Exhibits 7 through 9. Taken together, we would be looking for small cap stocks with high degrees of skepticism and a high R2. No companies meet these screens at this time (see Appendix).

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

While no companies with a sufficiently high R2 currently screen at the skepticism extremes (see Appendix), we show a few examples of prior cases where high SI values led to outperformance and the mechanism that led to this alpha.

In these examples, the general dynamic is as follows:

  • The SI is initially close 0, with valuations and returns in phase
  • Valuation gets ahead of returns, creating a “skepticism bubble”
  • The change in returns plays out as the market anticipated, and valuation normalizes to equate with the new level of returns

In August 2008, FLS had an SI close to 0 and was nearly on the SI equalization line. The stock sold off with the rest of the world, but returns remained strong until the December 2008 SI peak. Eventually earnings did fall, but at each point along the way, the stock was cheap for the given level of returns and relatively outperformed. By July of 2009 returns and valuation were in line once again. Instead of the plotted points following the red arrow, the lag of returns versus valuation created the long opportunity, identified by the skepticism index.

Exhibit 10

Source: Capital IQ and SSR Analysis

ROK provides a similar example on the other end of the SI scale. In mid-2005, the SI value for the company was reasonable, then the market started to price in the expectation that returns would improve before the fact. This created a temporary opportunity where the stock was more expensive than its returns justified. Earnings did improve, but valuation got ahead of itself – instead of moving in the direction of the red arrow, where returns and valuation would have been in phase, the market’s overreaction created a short opportunity, and the stock trailed the S&P as it moved further above its ROC trend.

Exhibit 11

Source: Capital IQ and SSR Analysis

Appendix

Source: Capital IQ, SSR Analysis

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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