Today’s post will cover the second half of the Combined Consumer Staples/Utilities Strategy presented in the book What Works On Wall Street. The first part was covered in my last post. This strategy has one of the best risk adjusted returns of all the strategies tested and also has the lowest downside risk. The utilities portion of this strategy offers compound returns of 16%, a sharpe ratio of 0.76, and a drawdown of 33%. With strong compound returns, lower risk, and reasonably high base rates this strategy should be at the top for more conservative investors interested in adding quant strategies to their portfolio. Lets jump right in.
The Utilities Strategy takes a little more work to implement than the consumer staples strategy. It is a pure value strategy like the consumer staples strategy with the difference being that it uses a composite of value factors as its screening criteria. One of the biggest insights from What Works On Wall Street and other quant researchers is that choosing stocks based on a composite of value factors outperforms portfolios based on solely one factor over time. For example, in the previous edition of What Works On Wall Street Price to Sales was the top performing value factor. In the latest edition EV/EBITDA was the top performing value factor. Just like strategies different value factors outperform in different time periods. Also, it is not optimal to rank companies with different capital structures based on the same value metric. For example, P/E ratios do not work well for REITs and insurance companies. The Utilities Strategy uses a combination of value factors called Value Composite 2. It sums up the ranking of companies based on P/E, P/B, P/FCF (free cash flow), EV/EBITDA, and SHY (shareholder yield). It then chooses the top 25 companies and invests in an equal weighted portfolio for one year and then re-balances. Its important to learn how to calculate these composite rankings so lets look at that in some more detail.
To calculate the composite value factor you start by ranking the companies based on each individual factor. Normally, you need fancy financial software to do this but excel works well enough. You just need a screener that allows excel downloads. Both screeners I have discussed, FINVIZ and Stock Investor Pro, have this feature. For each factor you can use the PERCENTRANK function in excel. Starting with P/E ratio you apply the PERCENTRANK function which ranks the stocks by P/E from 0 to 100. Low numbers are better in this case. You do the same for P/B, P/FCF, and EV/EBITDA. For SHY you need to do 1-PERCENTRANK since high numbers are better. After you have all the ranks you sum them up into a total rank and sort from lowest to highest. Done. Now, there is some devil in the details. Not all stocks have data in all fields. For missing data, you assign it a neutral rank of 50 so as not to unfairly bias the results against the stock. If you are using FINVIZ there are no fields for SHY or EV/EBITDA. You would ignore EV/EBITDA and substitute dividend yield for SHY. I don’t know how much this would change the return results but the underlying principle is the same. You’re sorting for the cheapest stocks based on a combination of traditional value factors. Below are the results of the Utilities screen I ran using Stock Investor Pro with data as of June 10.
Note the the 25th stock on the list NVE received a buyout offer from Berkshire Hathaway and is trading within 90% of the buyout price so we exclude it and add the next stock on the list VVC. Also, in the table I listed each value factor used in the screen, the total rank for each stock, and the dividend yield. Besides being conservative strategies with great returns the consumer staples and utilities sectors also offer investors nice yields which makes sticking with these strategies even easier. The utilities portfolio here has a dividend yield of 3.7% and the consumer staples portfolio I discussed last time has a yield of 2.6% (3.9% if dividend yield vs shareholder yield is used). A combined portfolio would offer the investor a yield of 3.8%. The combined strategy is a powerful combination. The table below summarizes the stats. Note that the benchmark used, All Stocks, is pretty darned good and has outpeformed the S&P500 (which is a large cap strategy).
There you have it. After an initial learning curve you can now implement a quantitative value strategy that has been show to crush the market over time with superior risk adjusted returns, high base rates, and reasonable drawdowns for literally a few hours work per year.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.