Market Factors: A simple, effective tool for stock picking from Goldman Sachs

REITs that might be able to compound cash flows and a simple way to use risk-adjusted returns for stock picking highlight this edition of Market Factors. We also report on new research uncovering a mass poisoning story worthy of a sci-fi novel, and we look ahead to important data reports.

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Equities

Sharpe stock picking

The Sharpe Ratio is a reasonably simplistic measure of stock-specific risk-adjusted return but, according to Goldman Sachs chief U.S. equity strategist David Kostin, it has been working well as a stock selection tool for U.S. equities.

The Sharp Ratio formula provides a measure of return per unit of risk. The numerator takes the average annual return for an asset and subtracts the return for a risk-free fixed income asset (the three-month T-bill often) for the same period (hopefully three years or longer to provide better statistical significance). This is designed to calculate excess return – how much an investor earned above what they would have earned by taking no risk.

The denominator of the Sharpe Ratio calculation is standard deviation – how volatile an asset is. (As an aside, I am ok with standard deviation here as a proxy for volatility because there aren’t many other good options. There are other cases, like the formerly vaunted “efficient frontier”, where similar normal distribution-based analysis is used but is entirely useless without manhandling with arbitrary constraints and biases added afterwards. The limitations of normal distributions in finance is one of the main points of Nassim Taleb’s The Black Swan).

Let’s assume we have a hypothetical investment that returned 11 per cent on average for the previous three years and had a standard deviation of 14. Assume an average annual return of 3.5 per cent for the risk-free short-term bond. The Sharpe ratio would be 11 minus 3.5 (that’s excess return) divided by 14. The Sharpe ratio is 0.54.

Mr. Kostin reports that a 50 stock portfolio of the best Sharpe Ratios generated a return of 29 per cent so far this year, equal to the market cap weighted S&P 500 but with far less volatility or risk. It should be emphasized that the best Sharpe Ratios are stocks with the best relationship between risk and return, not necessarily the top performers. Low volatility is as equally valuable as high returns in finding high Sharpe Ratio stocks.

Stocks in Mr. Kostin’s high Sharpe Ratio basket most likely to interest domestic investors includes Alphabet Inc. (a Sharpe Ratio of 0.9 using his more sophisticated version of the formula), MGM Resorts International (1.0), snack maker Mondelez International (1.3), Intercontinental Exchange (0.8), Berkshire Hathaway (0.6, I’m surprised it’s not higher), Biogen Inc. (1.5), Becton Dickinson and Co. (1.3), General Dynamics Corp. (1.0), Microchip Technology (1.1), Dow Inc. (1.2) and CDW Corp. (0.9)

For those of you wondering where the Canadian Sharpe Ratios are, and whether they work as indicators of performance, it was my plan to provide the answers to these questions but had data issues. Hopefully soon.

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Reits

Real estate compounders

Scotiabank analyst Himanshu Gupta believes he’s found three real estate companies capable of compounding cash flow growth – Colliers International Group Inc. (CIGI-T), Firstservice Corp. (FSV-T) and Storagevault Canada Inc. (SVI-T). Known smart person Albert Einstein once described compound interest as the eighth wonder of the world, which strongly suggests that companies capable of compounding cash flow are a good thing for investors.

All three companies are roll-up stories – they acquire properties in highly fragmented market sectors. Insiders own a significant amount of the shares in each case and all three companies have generated double-digit earnings growth over the past decade.

Colliers is Mr. Gupta’s favourite opportunity of the three. He recently raised his price target on the property and investment management company from US$167.50 to US$172.50. Firstservice, which manages residential communities and offers services through brands like California Closets, now has a price target of US$217.50 at Scotiabank, up from US$200.

The analyst’s price target on self-storage provider Storagevault is C$5.50, implying a 34 per cent return from current levels near C$4.10.

Diversions

Mass lead poisoning and violence

I previously mentioned the Marginal Revolution podcast that attempted to explain the rise in violent crime in the 1970s. One of their suggestions, that lead poisoning from gasoline and outdated water infrastructure negatively affected mental health, was supported by a recent academic paper.

The study by researchers at Duke University and Florida State University estimated that childhood lead exposure contributed to 151 million excess cases of psychiatric disorders over the past 75 years.

This story is dark, I get that, but the fact that gasoline was causing widespread insanity in western countries sounds like the premise of a science fiction novel. I originally found the report through Gizmodo

The essentials

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Globe Investor highlights

Canada’s benchmark stock index is about to welcome four new stocks. (And when it comes to the narrower S&P/TSX 60 index, there’s some good news for Algonquin Power shareholders.)

Tim Shufelt tells us why there’s no need to worry about whether we’re in a stock market bubble

David Berman argues that a potential cut to BCE Inc.’s dividend is no reason to sell the stock (and, John Heinzl writes on why he thinks that cut is coming)

David Rosenberg is backing off his long-held bearish view of the equity market. Here’s the lengthy note he sent to surprised clients last week

CIBC’s chief market technician reveals 10 stocks and 9 ETFs with uptrend forces this month

Robert Tattersall provides a helpful checklist on how to tell when a merger or acquisition will succeed

What’s up next

The most relevant event of the domestic schedule is the Bank of Canada decision on interest rates on Wednesday. Most economists expect another 50 basis point cut (Mark Rendell has a full preview). Manufacturing sales for October on Friday is the only other domestic economic report of note.

The Americans have the November CPI release on Wednesday. The headline month-over-month result is expected at 0.3 per cent and the ex-food and energy reading is predicted at the same level. Producer prices are out Thursday – excluding food and energy, a 0.2 per cent month-over-month increase is forecast.

For earnings, Oracle Corp. will announced profits late Monday with $1.481 expected. Adobe reports Wednesday – analysts expect $4.668.

See our full economic and earnings calendar here (You can bookmark the page – it gets updated weekly)