I recently came across a useful research paper looking back 50 years at factors influencing stock prices, and I’ll attempt to simplify and summarize its findings with some practical stock-picking guidance. It emphasizes many concepts previously written about, but it’s worthy of repetition, with a few additional insights added in.
The most important positive factor was valuation – basically, how expensive a stock is compared to the money it earns. The study broke all the factors into 5-year periods, and interestingly, valuation was more important from 1975 to 2005 than from 2005 to today. I would suggest historically low interest rates for much of the past 20 years reduced the importance of valuation to investors, making high valuation/speculative stocks more enticing. As we enter an era with more realistic interest rates, valuation could again increase in importance.
Interestingly, the second most important factor was momentum. Stocks with a chart moving upwards and to the right do better than market averages. This is somewhat contradictory to the above, as better valuation often comes after a stock sells off.
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However, an investor must always be aware that a sell-off isn’t always temporary. It could also be a longer-term reduction in company performance from external events, technological obsolescence (buggy whips) or internal management issues.
Watching momentum can help avoid what are referred to as “value traps.” Stocks that look cheap but may be permanently impaired. My preference is to buy after a short-term market sell-off, such as occurred last spring, that doesn’t break a company’s upward momentum.
The third and fourth positive factors – quality and profitability – are closely linked. Quality was defined as gross profit over assets, and profitability as Return on Equity (ROE), Return on Assets (ROA), and Return on Invested Capital (ROIC). I prefer the cash flow/assets profitability metric for simplicity while also reviewing ROE and ROA. These factors measure how efficiently a company uses capital.
Valuation and profitability factors reinforce my overall view of looking for companies with high profitability (capital efficiency) and modest valuation. Adding upward momentum to the criteria is worth considering.
The negatives
The most negative factor was growth in assets, which supports the positive impact of capital efficiency. The stocks of companies that require high capital expenditures to purchase depreciable assets are more prone to underperformance.
The other negative factors were turnover, defined as heavy trading volume relative to number of shares, company size, and share price volatility. Interestingly, while valuation was less positive recently, company size and share price volatility have become more positive. Traditionally, these are negative factors, which raise the question of whether this is an anomaly or a longer-term trend.
Historically, size has been negative, because as a company grows, it becomes more difficult to maintain the same percentage of revenue and profit growth. However, technology is easily scaled, allowing mega tech companies to defy this general principle, increasing sales and profits faster than other large companies. That being said, it is worth reflecting on what are considered the four most dangerous words: This time is different.
No impact
Four factors that had no impact on total returns were leverage, earnings volatility, growth, and dividend yield. Some may be surprised that dividends have no impact on returns, but stock movement relates to company performance or anticipated company performance, not if and how returns are distributed to shareholders. Being relatively ambivalent to dividends, I simply place high dividend earners in tax-advantaged accounts and those with lower dividends in taxable accounts.
The surprise to me was that historical growth in sales and net income didn’t impact forward returns. The only explanation for that is that markets already price in expected growth — if those expectations aren’t met, the share price often declines. If the market thinks a stock will grow 10 per cent per year but it only grows five per cent, it is likely to decline.
How will this study impact my purchase decisions? It largely reinforces my past strategy of combining profitability with valuation criteria. I will try to pay more attention to upward momentum rather than dumpster dive for low valuations, but I suspect the bargain hunter in me will periodically prevail.
