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Differentiation is back!

15 November 2018

With capital markets seemingly dominated by geopolitical noise in 2018, GAM Investments’ Gianmarco Mondani highlights the potential of a low-volatility approach to equity investing to extract alpha against this testing backdrop.

Dedicated investors pursuing active security selection often refer to the need for dispersion to be evident in market prices for their approach to prove effective. This is also true of our investment discipline which requires the market to show fundamental differentiation in stock prices by rewarding companies who positively surprise in earnings statements, while punishing those that disappoint. This approach is steeped in historical academic research and may potentially provide a sustainable and repeatable stream of investment returns, but there can be occasional periods of exception where macro or geopolitical triggers lead to a period of herd mentality. So how has the strategy fared in 2018 when markets have endured President Trump’s trade aggression, Italian political upheaval and a string of emerging market crises?

It is almost 50 years since the first known reference to the tendency of shares to drift in the direction of recent earnings surprises appeared in academic research1. Further studies over time have reinforced this assertion and have served to demonstrate the sustainability of the opportunity to harness alpha through a long / short approach based on earnings revisions. Relying purely on alpha as the driver of returns, such strategies are capable of generating relatively solid annualised returns with muted volatility and no significant correlation to underlying equity markets.

Steeped in fundamental research

In our view, the key to identifying stocks which are likely to surprise positively is to continuously direct fundamental analysis and dialogue toward the reason for changes in fundamental trends affecting the company’s environment and profitability. For example, despite an almost overwhelming level of geopolitical tension during 2018 so far, which has largely dictated the directionality of most equity markets, it has still been possible, although sometimes challenging, to uncover winners and losers in such an environment. Ultimately, this is what, in our view, makes the opportunity set so sustainable. For example, the technology sector has still provided a fertile ground to harness alpha because innovation has been the key driver. This is particularly noticeable in companies which are at the forefront of change. For example, a German fintech business has recently been promoted to the DAX index by virtue of its rising share price and, hence, market capitalisation.

In addition, technological developments can cause disruption in sectors like retailing and this has highlighted some short selling opportunities. For example, a number of quality fashion retailers have hit the headlines after struggling to meet earnings targets, as have select gaming retailers. Online sales of the product lines of these businesses are almost inevitably eating into both sales and profit margins.

Over time, we have discovered that the earnings’ revision approach is enhanced when supported by valuation and price momentum – this provides us with a higher degree of confidence to build meaningful positions during volatile trading conditions, such as we have seen virtually throughout 2018. Furthermore, since long positions are offset by short positions, we are typically able to navigate through high periods of volatility at the total market level.

Subject to occasional setbacks…

We can define two distinct periods - 2008-9 and 2016 - when the approach endured difficulty in extracting alpha and, interestingly, we can identify characteristics that were common to both periods. The second-half of 2008 coincided with the height of the financial crisis and this was a ‘correlation one’ event in which the vast majority of financial assets tanked simultaneously. However, while low directional exposure proved very effective in limiting losses in 2008, beta made a staggering comeback the following March, when we witnessed a sudden shift in investor sentiment from despair to euphoria. This triggered a completely non-discriminate, v-shaped recovery which totally ignored earnings announcements. Even shares in companies that issued dire profit warnings spiked as the asset class was effectively commoditised in the race to buy risk assets. There was no correlation between revisions and share price movements, meaning that the strategy failed to generate positive alpha during the initial phase of the market rebound.

Similarly, in 2016, we saw a wide embracement of the reflation trade which prompted a sharp rotation into cyclicals, catalysing a sharp upward re-rating of stocks that had been suffering from deeply negative earnings revisions. The ‘reflation trade’ lifted every segment of the market considered risky and cyclical, while investors shunned everything seen as defensive, even though this was the very area of the market where positive revisions were widespread. Consequently, in both periods, the earnings revision approach was substantially undermined.

…but capable of producing sustainable and stable returns

Interestingly, these rare reversals in fortunes for this strategic approach typically provide opportunities for recovery. First, it is worth pointing out that it is highly unusual for momentum to fail for a long period, because major turning points in equity markets do not tend to arise on an annual basis. Second, periods of indiscriminate buying and selling inevitably create valuation dislocations that can be unlocked by managers pursuing the earnings’ revision approach.

Indeed, the price of a substantially oversold stock will inevitably become the subject of strong and enduring momentum as sentiment shifts and analyst ratings are revised in accordance with positive earnings surprises. Conversely, and equally saliently, when a company’s share price outperforms dramatically due to a rapid improvement in sentiment, expectations can become very exaggerated and earnings prone to disappoint. This provides the potential to benefit from a subsequent mean reversion in share price through short positioning.

Price momentum has proved persistent

Psychological and behavioural influences on market participants can also help ensure the enduring nature of opportunities for those pursuing this investment approach. Earnings revisions are deeply correlated to share-price momentum and the concept of ‘buying momentum’ is completely contrary to the penchant of the human psyche for buying into weakness and selling into strength. This means that we are often able to initiate new positions at undemanding valuation levels. Another behavioural bias – anchoring – can also partly explain the reason why prices continue to drift in the direction of earnings surprises long after the actual announcement. Since sell-side analysts can be reluctant to distance themselves too much from the average due to reputational risk, they are typically slow in revising their figures higher or lower. As such, their tardy revisions create continuing momentum.

Consequently, we believe that a fundamental, earnings revision-based strategy, incorporating both valuation and momentum metrics, can potentially deliver favourable outcomes in the majority of time frames. The past performance of a price-momentum basket, which serves as a good proxy, adds credibility to this view, given that it has generated positive returns in 11 of the last 13 calendar years2.

Furthermore, since the philosophy is based on momentum, which is not trading at expensive levels, technical and fundamentals appear to have conspired to provide an attractive entry point. This is consistent with the signals being generated by our proprietary risk management framework.


1.An empirical valuation of accounting income numbers’ Ball and Brown (1968).
2.Source: Morgan Stanley European Momentum basket as at 29 December 2017.

Past performance is not indicative of future performance.

Important Legal Information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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