Identify High-Risk Stocks That Are More Likely to Get Re-Rated, and for that, Focus on Core Fundamentals.
“In the short run, the market is a voting machine. In the long run, it is a weighing machine.”
Benjamin Graham
“Beating the Market”: earning an investment return greater than the return of benchmark indices such as Sensex, and Nifty.
Everyone aspires to beat the market but only a very few achieve it, which means it is not an easy task – and many are doing it the wrong way. The long-held adage in finance is that ‘to achieve more return you have to take more risk’: risk and return are positively correlated. So, to beat the market our portfolio risk must be greater than the market risk.
But by assuming more risk, we are exposing our portfolio to the possibility of not just above-average returns, but also to the possibility of below-average returns, which could include investment losses too. This might be a reason why many fail to beat the market – they take risks when the odds are against them.
When the odds are against us, we are more likely to arrive at a below-average return than an above-average return. To succeed at investing, we need to take more risks with odds in our favour: then, above-average returns are more likely to happen than below-average returns. But how do we do that?
As investors are generally risk-averse, to take on more risk they should be compensated with higher expected returns. This is why risky (high-risk) stocks trade at low valuations – and thus have high expected returns, while stable (low-risk) stocks trade at a high valuation – and thus have low expected returns.
But how does the market decide whether a stock is high-risk or low-risk? Financial risk is generally measured based on volatility: how much a stock moves up or down from a central value, and the ubiquitous measure of risk is standard deviation. Stocks that move too much from their central measure (mean) during a particular period are considered high risk, and those that fluctuate very less from their central measure are considered low risk.
But what causes the prices of high-risk stocks to fluctuate so widely? Maybe the earnings and growth prospects of high-risk stocks are volatile and fragile, and the volatility in their stock prices is a reflection of those factors. The earnings prospect of a stock with no notable competitive strength in a commoditised industry with intense competition is subject to high uncertainty. Similarly, poor fundamentals such as leveraged balance sheets, poor working capital management, weak cash flow, and poor capital allocation could also increase uncertainty and risk around a stock’s earnings prospect. The market reflects such uncertainties and risks through increased volatility and low valuation.
High-risk stocks might look promising due to occasional positive developments like a sudden earnings spike, but their prospects and earnings are still under thick clouds of uncertainty. It is very stressful to maintain a position in such stocks. So, the natural inclination is to avoid such stocks.
However, what is astonishing is that the secret to beating the market also lies amidst this risk and uncertainty. As we have seen, a stock with serious shortcomings such as poor industry economics or poor fundamentals, is perceived as high risk by the market, and usually trades at a low valuation. However, if such a stock could make improvements on its shortcomings (it can’t do much about industry economics), the risk perception of the stock will decline.
If risk perception declines, the stock gets re-rated upwards. In other words, the stock’s valuation improves, causing its price to increase even without any earnings growth. Hence the formula to beat the market is identifying risky stocks that are likely to get re-rated.
How do we determine a stock’s likelihood of getting re-rated? The answer lies in the stock’s core fundamentals. I classify a stock’s fundamentals into two types: core fundamentals and peripheral fundamentals.
Core Vs Peripheral
Core fundamentals (CF) are more entrenched and real, and thus not much impacted by outside factors. It is the principal source of a stock’s true value but is paid less attention by market participants during decision-making. Competitive position, capital allocation, and operating profitability are my three principal core fundamentals.
Meanwhile, the peripheral fundamentals (PF) are every fundamental factor outside of CF. They are superficial and ephemeral, hence more sensitive to changing economic conditions. Generally, PF receives more attention from market participants than CF during the investment decision-making process due to their immediate visibility and sensitivity. Hence, stock price movements in the short term mostly follow PF. I consider earnings growth, profitability, and financial position as peripheral fundamentals.
Despite possessing favourable CF, a stock might be considered risky and hence trade at a low valuation because of unfavourable PF. But over the long term, only CF matters, as they are the primary source of value of a stock. Therefore, stocks that have favourable CF but unfavourable PF – which is only temporary – are those that are more likely to get re-rated.
Among the core fundamentals, I have discussed competitive position and operating profitability several times in my earlier writings. In the remainder of this writing, I share my thoughts on the third of the principal core fundamentals – capital allocation.
Capital Allocation
Capital allocation means how a firm utilises capital at its disposal: good capital allocation adds value to the firm, while bad capital allocation destroys value. I classify a firm’s capital allocation under four classes: financial assets, capital expenditure, deleverage, and dividends. Each adds or is supposed to add value to the firm. But they do so in different ways because of different degrees of uncertainty associated with each.
While calculating the capital allocation score – a measure of a firm’s efficiency in capital allocation – each class are assigned different weights based on their level of uncertainty. The one with the lowest uncertainty receives the highest weightage in the score; likewise, the one with high uncertainty receives the lowest weightage.
Capital allocation – financial assets
Consider financial assets. It doesn’t add much value through return on capital. The returns are generally lower than the return from the firm’s operating business and, sometimes, lower than its cost of capital. The main value provided by financial assets is that it makes a firm’s financial position robust. It makes a firm more resilient by providing a corpus of liquid assets to tap into during difficult times.
Moreover, during a capital expansion phase, the firm can meet its increased capital needs internally at zero cost, instead of relying on debt or equity, as is the general case, but comes with cost and risk. Debt comes with interest and needs to be repaid, while equity issue dilutes the firm’s equity base and reduces its per-share value.
Capital allocation towards financial assets has its pluses and minuses: the soothing benefits during capital expansion, a sense of robustness, and a corpus to tap into during difficult times are the pluses, while the minus is the poor return on capital. After due consideration, I assign financial assets the lowest weightage in the capital allocation score.
Capital allocation – Capex
Capital expenditure (capex) is a firm’s spending on new factories, plants, and equipment. The benefits from such expenditures are expected to accrue over long periods. However, there are chances that it (the expected benefits) may never accrue too. Whether increased capital expenditure is a better allocation of capital that causes a re-rating for the stock is a contentious issue. Capital expenditure, supposedly, increases a firm’s production capacity, or, in other words, it improves a firm’s capacity to serve its clients. However, there is ambiguity about whether the increased capacity will lead to better earnings growth and profitability or be a drag on the firm’s profitability.
Capital expenditure has a long gestation period, and such expenditures are made based on the management’s long-term forecast of demand in their industry. If the expected demand doesn’t materialise, the firm’s profitability will suffer significantly due to an increase in fixed costs, depreciation, and finance costs associated with capital expenditure. As a result, the firm’s stock price will decline, which would have done better without the capital expenditure, and the management gets criticised for their poor capital allocation decision. However, if the expected demand materialises, then the capital expenditure enables the firm to capitalise on the opportunity, and the management will be applauded for their foresight.
Regarding capital expenditure, I have observed wide-ranging scenarios. In one kind of scenario, a firm that undergoes major capex sees an escalation in cost, its profitability declines, and its stock price underperforms. But as the expected demand ensues after the capex is over, earnings and profitability rise and its stock price outperforms.
In some other cases, the increase in earnings and profitability happens alongside the capex, so the stock outperforms both during and after the capex cycle. In certain worse cases, even after the capex cycle is over, the expected demand never materializes, significantly impacting both profitability and stock price – both suffer during and after the capex cycle.
Hence, as we saw, there is some uncertainty around the impact capex can have on a stock’s prospect. This uncertainty could be reduced to some extent if the firm has a better competitive position and favourable industry economics.
An industry with high entry barriers, better pricing power, high switching costs, and less intense competition could markedly reduce uncertainty. However, the uncertainty is higher if the capex is towards an unrelated business segment, or an unknown, new market. So, I assign capex a weightage higher than financial assets, but lower than dividends and deleverage (which is discussed below), on the capital allocation score.
Capital allocation – Deleveraging
The third class of capital allocation is deleveraging – here, a firm uses its capital to repay debt or buy back shares. The benefits are more certain and immediate here. When a firm repays its debt, its interest cost declines, boosting its profit immediately. Similarly, if a firm buys back its shares, then its per-share earnings improve immediately. Or, said another way, its net worth declines, providing an immediate boost to its profitability (return on equity).
When capital is allocated towards financial assets, a firm’s capital base increases, but its profitability suffers. However, deleveraging reduces a firm’s capital base, giving its profitability a boost. I assign deleverage a weightage higher than capital expenditure, but lower than dividends.
Capital allocation – Dividends
Dividend payment is the final class of capital allocation, but also the one with the highest weightage on the capital allocation score. It receives the highest weightage because, relatively, the cash paid out to shareholders out of the firm’s current or retained earnings is the most certain, real, present, and liberal way a shareholder could be rewarded.
The value of a firm is the sum of the cash flows the firm is expected to generate over its useful lifetime. But everything about this statement – the expected cash flow, the useful lifetime – is uncertain. It promises to reward us in the near or distant future. But the only concrete, certain reward is dividends – and, thankfully, it is not a promise expected to be delivered in the future; it happens now – in the present.
For an investor, it is his money now: the most tangible reward for assuming a stock’s risk. He can use it as he wishes. He can meet his expenses or re-invest the money in the same or different stock. Therefore, I believe that dividends deserve the highest weightage in the capital allocation score.
Conclusion
We started this discussion as a contemplation on how to beat the market. We learned that stocks with high risks generally command a low valuation in the market. But such stocks are more likely to get re-rated if they possess robust core fundamentals; that is, experience an expansion in their valuation.
Capital allocation is one of those core fundamentals – the others being competitive position and operating profitability. Better capital allocation means efficiently utilising the capital at a firm’s disposal in a value-accretive way. It could cause a marked improvement in a firm’s business fundamentals, growth prospects, or how shareholders are rewarded.
Having robust core fundamentals increases a stock’s chances of getting re-rated by making it more probable that its fundamentals, earnings, and profitability improve going forward. If earnings growth improves alongside expanding valuation, then that is a reliable combination for a return that beats the market.
AMN CAPITAL 