Three Very Insightful Findings

My return to the finance-reading journey has been smooth so far. After finishing Buffett’s 30 years of letters, I went on to read all of Terry Smith’s, which I believe I’ll write about them again on next article, and then I read a book a friend of mine wrote, Geoff, called ‘Low Risk Rules’. Geoff is a writer on Substack and has a long experience as a portfolio manager, I’d suggest you give his articles a look:

Low Risk Rules

Anyway, in his book, Geoff goes over how to approach the market from a very initial standpoint. Particularly, the first half of the book consists in pragmatic advice for post-exit entrepreneurs and what things should they be careful with when being approached by money managers. The second half of the book, in which I’ll base this article, focuses on the importance of long term equity investing. In this latter part, I found extremely interesting studies and datapoints. We’ll go over a few of them in today’s article.

The Low Beta Anomaly

In an efficient market, it is expected that higher returns could only be obtained by exposing oneself to more risk, in the form of volatility, of course. More specifically, theory predicts a positive relationship between risk and return. However, what research has found is that the correlation between higher volatility and higher returns is quite difficult to prove.

The below-mentioned abstract is about a study made with the aim of illustrating how theory is incorrect. Authors test the real correlation between stocks’ beta and their respective return throughout decades. They did this for companies within the US, utilizing data from the Center for Research in Securities Prices, and for companies abroad, with data from the S&P Broad Market Index.

We’ll be only look at the US study, but results are similar in both of them. The following chart illustrates what a $1 investment in each portfolio would have generated throughout time. Portfolios are constructed upon the quintile each stock belongs to, on a risk scale. This means that the lower the quintile, the lower the stock’s beta.

Source: The Low Beta Anomaly: A Decomposition into Micro and Macro Effects

A dollar invested in the low risk quintile portfolio in 1968 compounded to $81.66 in 2012, while a dollar invested in the highest risk quintile portfolio only grew to $9.76. This is truly fascinating, I never came across something like this. It literally goes against all finance theory, which is why this anomaly makes no sense.

If you’d like to read further on the subject, I’ll leave here the report.

Report: “The Low Beta Anomaly: A Decomposition into Micro and Macro Effects”

The Small Firm Anomaly

The small firm effect states that, over long periods of time, smaller companies tend to outperform larger companies. Keep in mind all studies are subject to time-selecting bias, errors, misarrange of information and survivorship bias. This theory suggests that smaller firms have a greater opportunity for growth than larger companies, which makes sense. Nevertheless, it is worth reminding that these businesses are more subject to suffer from:

• A more volatile environment, due to larger exposure to individual shocks

• Liquidity might be an issue

Finding:

“We use S&P500 since 1995 to test if the size anomaly is true. Every day we split up the data into deciles (tenths of the data distribution) according to market capitalization of the stocks comprising the index. So, we create 10 portfolios that invest in each decile.”

Source: Quantdare

“Small-caps outperform large-caps, especially during market rises, but at the expense of increasing the portfolio risk.”

History shows that high earnings growth is unsustainable

Steven Romick is a Managing Partner of First Pacific Advisors, an LA based investment firm with 24bn in assets under management as of December 31, 2022. He has managed the 8.8bn FPA Crescent Fund since inception in 1993, which represents one of the strategies followed by FPA.

“FPA Crescent has provided the third best risk-adjusted returns of all domestic mutual funds that invest in equities and have been managed by the same party since its inception, and is number one compared with those with assets under management greater than $1 billion according to Morningstar”

Anyhow, in 2021, Steven published a research report (I don’t have access to it) in which he analyzed how plausible was for companies to sustain high earnings growth over time. In a more specific manner, he took the top 1000 US businesses with over 10% earnings growth in 1979 and observed what were the chances of them keeping that growth rate over time.

From all studies, I believe these results are the ones that surprised me the most:

Source: Acquirersmultiple

Out of the thousand analyzed businesses, 353 of them were able to maintain a higher than 10% earnings growth after one year. After three years, 74 of them were still growing at 10%+ rates. When 5 years passed, only 21 of them, or 2.1%, were able to sustain the selected earnings growth rate.

Personal Commentary

The book is not that long, I believe it’s around 250 pages, if you want to give it a read. I enjoyed it, mostly that second half, which has all the things I like reading about. Hope you enjoyed today’s article, I truly think the topics covered are fascinating!