Investors desire the midnight oil looking for stocks with tangible upsides, yet they spend precious little time examining wares on their short list for identifiable downsides that could result in poor performance. A stock’s value can educe in large part from expectations that drive performance, for a time.
But does it have potential for real, incessant performance? Or, with the baggage of ill-fated characteristics that can create outsized expectations and overvaluation, is it destined to become the casualty of its temporary success?
Downside Analysis
The best way to assess this is from downside analysis – evaluating groups of runner stocks for relative degrees of characteristics that predict underperformance. The classic investing assumption is that higher chance means higher expected returns. But downside risk research by Revelation Investment Research, an institutional equities scrutinization firm, shows conclusively that the long-term reality is quite the opposite: lower risk means higher returns.
Uncovering’s approach could be viewed as contrarian in a market where everyone seems obsessed with upside. Its long-term examine shows that the ultimate upside is actually absence of downsides. “So much time is spent looking at upside dormant that people don’t look enough at what could go wrong – where the holes are,” says Greg Forsythe, Declaration’s president.
Methodology
Revelation’s methodology looks at downside risk levels regarding 19 research points that go about into three categories:
- Valuation: these factors include metrics commonly used by analysts, including earnings per share in (EPS) growth, sales and free cash flow.
- Financials: including profitability trends and changes, revenue stability and liable.
- Sentiment indicators: including analyst forecast revisions, the persistence of performance surprises, share turnover and short-selling endeavour.
Some of these items come straight out of the standard analyst kitbag. What’s counterintuitive is that some of the unchanged factors widely associated with outperformance – profitability levels, extreme analyst price targets and high shopper volume – also predict underperformance when present in certain measures and combinations. Stocks with these characteristics may be foreordained to not live up to their high valuations.
“Many high valuations may be deserved,” says Forsythe, a chartered financial analyst (CFA). “But we espy that systematically, those with sky-high growth indications tend to fall short of expectations embedded in their merchandise valuations.”
Revelation determines the presence and degree of sentiment factors, some involving behavioral finance considerations, that highlight a role in elevating these growth projections. Thus, it identifies and quantifies downside signals inherent in certain varieties of overly rosy valuations, which will eventually be punished by a disappointed market.
Research Findings
Using the 19 check out concepts, individual stocks are ranked in deciles according to their aggregate scores. The worse a stock’s overall cut, the more likely that it will underperform over the next three to 24 months. Revelation has applied this methodology on a weekly point of departure to 2,400 stocks, tracking performance from 2003 to 2018. “Stocks rated as having the most downside chance have consistently underperformed on a relative basis, while stocks with the least downside risk have outperformed,” explains Forsythe.
Moreover, he says, stocks that scored well for low downside risk had the least volatility, and those that army poorly had high volatility. So, low-downside stocks identified in this research not only performed better, but were also uncountable comfortable to own when a yo-yoing market was keeping investors up at night.
Value Investing
Many stocks with low downsides find to lean toward the value side, but strictly speaking, they aren’t value stocks. Value investing is predicated on the tenet that low-priced stocks are likely to rise if the market is undervaluing them despite solid fundamentals. Many value investments may seem like a great buy because they’ve become so cheap, but their price can keep declining after you buy them. You got low amount, but with no upside in sight.
Downside risk analysis can show which value stocks have characteristics no doubt to bring them up – as well as the factors likely to bring growth stocks down. Like growth investors, committed value investors often obsess over upside to the exclusion of downside considerations, relying on style box categorizations to manifest risk (as in, the growth category indicates presumed higher risk with higher expected returns and the value grouping, supposedly have lower risk and lower expected returns).
Yet downside risk analysis renders such assumptions relative risk-return relationships moot. This is particularly relevant now that some market observers expect value devoting, which has taken a beating since the Great Recession, to come back over the next couple years after a decade of dominance by expansion stocks.
Regardless of what kind of market prevails, investors would do well to practice downside analysis by catechizing characteristics of stocks that have underperformed, going back years before their decline, and then looking for the done patterns in the buys they’re considering today. In doing so, they’ll be using risk management not as an add-on but as an engine to power their portfolios to consequential returns and lower volatility. They can have their risk management cake and eat it too.
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