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Quality Companies

Long/Short Strategy
Nick Ireland
au.linkedin.com/in/ nickirelandau

This paper outlines a quantitative strategy for selecting excellent companies at less than intrinsic value with resulting performance simulated over 15 years. Running a portfolio of 25 stocks selected from the Russell 3000 universe delivered an annual return of 19.8% p.a. from March 1999 to July 2013. During this tumultuous period which included the Tech Wreck and GFC, the S&P500 returned only 4.0% p.a. including dividends and the Russell 3000 Index delivered 2.78% (ex dividends). Results for the strategy are shown in the chart below.

Quantitative selection criteria were chosen to find companies matching our investment objectivesa focus on returns through quality businesses at attractive valuations. This selection process was kept as straight forward and intuitive as possible. The strategy was validated across a number of investable universes and time periods to ensure robustness through time and across different market characteristics such as size and liquidity. In all cases pre-trade liquidity filters were applied.

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In terms of transaction costs, trading commissions of 0.07% and slippage of 0.10% per trade were assumed. Performance outcomes were not particularly sensitive to transaction costs as the portfolio turnover is not high. This study focuses on US markets due to ready access to data for this region. Similar studies can be made in Europe and Asia with provision made for the required data sets.

Quality Companies at Fair Prices


Our Investment thesis is that good returns can be generated through investing in excellent companies if they can be bought for less than intrinsic value. In addition, it is recognised that while market risk is always present, there are times when risks increase, in particular: 1. During periods of deteriorating economic conditions 2. During periods when the relative value provided by the stock market fails to compensate investors adequately when compared to conventional risk free alternatives such as fixed income investments. Selection Strategy Companies within the chosen universe were scored according to quality, growth and value factors. In terms of quality, businesses were sought with high and relatively stable margins, and ones that are showing strong returns on investment. Quality balance sheets were also preferred, such as low levels of debt and good debt serviceability. In terms of growth, consistent sales growth is considered most important for two reasons. Firstly a business with growing sales and high returns on investment is more likely to enjoy growing profitability in the future, provided it continues to enjoy competitive advantage. Secondly, the further down the income statement one goes, the more growth metrics can be confounded by idiosyncratic circumstances. In terms of earnings growth for instance, decisions such as increased marketing following a new product launch or varying tax rates can reduce earnings temporarily, masking excellent longer term prospects. In terms of value, intrinsic value was considered to exclude companies which fail simple valuation criteria. When measuring intrinsic value across a universe of many thousands of companies through time, some simplifying assumptions are required. This measure provides a sanity check, to ensure only firms below the value threshold are purchased, and that they are sold once they rally significantly above intrinsic value.

Hedging Strategy
Hedging considerations in a market neutral or long/short strategy are critical and not as a simple as they may first seem. Hedging with short stock positions can be rewarding, but a number of considerations need to be taken into account when hedging with stock:

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A short position is more risky than a long position. A long stock position has limited risk because the price can never fall below zero. However a short stock position has unlimited risk as there is no theoretical limit to the price a stock can rise. Short positions are subject to additional costs, regulations and restrictions. These include: o Limited availability. Not all stocks can be borrowed, and even once borrowed, the loan may be recalled. o Stock borrowing fees o Prohibitions on short selling by regulators during times of financial turmoil may make the strategy unavailable. Where the investor employs periodic rebalancing of long/short exposures, different returns will be realised depending on the volatility of the hedge portfolio. High or uncorrelated volatility is detrimental to returns, as illustrated by the following example: Consider stock A over 4 periods with a starting and ending price of $1 and starting capital of $100. In the long case, the capital balance tracks the portfolio returns so that the ending capital equals the starting capital of $100.
Figure 1 - Long Portfolio Returns

Now, consider the same return series for the short portfolio. Rebalancing is done each period to ensure the value invested equals the available capital, ie leverage is set at 1x.
Figure 2- Short Portfolio Returns

Although the investment has the same beginning and ending value, the return achieved in the short portfolio is eroded by the volatility of returns over time. A combined long / short portfolio with perfect correlation, removes this volatility, however there is no such thing as perfect

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correlation, especially as the growth, value and size characteristics of desired long/short portfolios typically differ significantly. In formulating a hedging strategy we recognise that market risks are always present. In addition, we recognise the additional risks to equity holders, during periods of deteriorating economic conditions and where equity market valuations become stretched. To address these objectives, a hedging strategy employing equity index futures was chosen 1. To reduce drawdowns and volatility, 50% of long exposure was hedged at all times. To address additional risks, hedging was increased to 100% in either of the following scenarios: 1. Earnings estimates are declining for the market as a whole 2. The market risk premium is less than 2%, indicating limited additional returns for stock market investors as compared with fixed income alternatives. Equity index futures addresses a number of the issues with shorting stocks outlined above, as well as offering significant transaction cost and liquidity advantages in implementing the timing component of the hedge strategy. The following table shows the impact of hedging on overall portfolio returns and risk measures.
Figure 3 - Performance Mar-99 to Jul13

While the hedging strategy did not improve overall returns over the 14.5 years considered, it did significantly improve risk metricsreducing the maximum drawdown from 42% for long only to 18% for long/short, and improving the Sharpe ratio from 0.88 to 1.19.

Diversification and Rebalancing


Diversification and rebalancing are important components of a risk management strategy. To reduce exposures to specific industries or sectors within the economy, tight constraints were placed on the number of stocks that can be held within any given industry or sector. In addition, monthly rebalancing was employed to control stock specific exposures. Rebalancing was only performed where the stocks weight varied by more than 25% of its initial portfolio weighting, or where its suitability based on selection criteria diminished.

The S&P 500 was selected for its diversity and liquidity. Returns were simulated with an S&P ETF (including dividends) adjusted for carrying costs using the 3 month T-Bill rate.

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Transaction Costs and Market Impact


Transaction cost and market impact assumptions can render historical simulations worthless in high turnover portfolios or illiquid markets. These considerations cannot be properly addressed independently of the size of funds under management, which in turn determines a suitable approach to trading and rebalancing. The strategy was not particularly sensitive to market impact assumptions with an increase from 0.1% to 0.25% resulting in a performance deterioration of around 0.55% per annum. Moreover while the bests performance was indicated within a small cap universe of stocks (Cap: $50M $500M), outperformance of relevant benchmarks was seen across all size categories, including the S&P500.

Conclusion
This paper outlines a purely quantitative strategy for selecting quality businesses at attractive valuations. This approach significantly outperformed benchmarks over the nearly 15 years considered in both hedged and unhedged versions of the strategy. In the hedged version, the strategy returned 19.8% p.a. with an inter-month drawdown of only 18%.

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