HOLT Growth Percentile Leveraging HOLT for Expected Growth

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1 cumulative excess return (log scale) HOLT Growth Percentile Leveraging HOLT for Expected Growth Contacts: Richard Curry, PhD HOLT Investment Strategy David Rones, CFA HOLT Investment Strategy Greg Williamson, CFA HOLT Investment Strategy Jordan Hassett HOLT Investment Strategy What is HOLT? HOLT is a value-based, return on capital framework proprietary to Credit Suisse. HOLT provides an objective view of over 2, companies in 65 countries using a methodology that examines accounting information, converts it to cash, and then values that cash, allowing investors to identify key drivers of value. HOLT uses this framework to help institutional investors across the investment process, from idea generation and company analysis to portfolio construction and risk management. For more information, see What is HOLT? 1 Introducing the HOLT Growth Percentile a multi-factor composite score that measures the degree to which a company is likely to have higher or lower future cash flow growth than its peers. Key insights: Benefits: The HOLT Growth Percentile is a forward-looking metric for comparing a company s growth profile relative to its peers. It focuses on identifying growth in cash flows, rather than accounting earnings or assets. Measurement: HOLT Growth Percentile provides a measure of relative growth, with a score of 1 representing the highest growth outlook, while a score of represents the lowest growth outlook relative to regional or global peers. Uses: Investors can use Growth Percentile to screen for growth and value ideas, to understand the profile of their portfolios, and to improve portfolio attribution. Descriptive, not Alpha: High growth companies do not necessarily outperform over time. As such, the Growth percentile does not contribute to the HOLT Overall Scorecard score and investors should not consider it a stand-alone alpha factor. Measuring Growth The growth percentile is a peer relative measure of the degree to which a company is likely to grow its cash flows. It is calculated using expected changes in the drivers of cash flow (CFROI and asset growth) in addition to historical cash flow growth and the sales of the firm. By focusing on cash flows, the factor differs from traditional style approaches, which tend to focus on historical growth and/or valuation metrics to distinguish stocks as growth or value. The HOLT measure leverages the CFROI framework to quantify a firm s ability to grow, likelihood of pursuing growth, and the market s expectations for future growth. Figure 1: Potential returns available with perfect foresight of 3-year forward gross cash flow growth Q1 = High Q2 Q3 Q4 Q5 = Low Source: Credit Suisse HOLT as of 1/31/216 Universe: Largest 1 North American companies by US$ market cap Return streams assume perfect foresight of a company s forward inflation-adjusted gross cash flow growth and are displayed relative to the universe return, equal weight, with a monthly rebalance (gross of transaction costs)

2 Challenges for growth investors Figure 1 shows the value of investing in high growth companies by highlighting the return an investor would receive if they were capable of knowing companies 3- year cash flow in advance. This chart demonstrates the utility of a growth indicator as a potential stock selection tool and illustrates why many investors seek to identify growth companies for their portfolios. While Figure 1 demonstrates the power of successfully identifying growth, successfully investing in growing companies can be difficult as their valuations often fully embed an above average growth outcome. Identifying future growth - and if that growth is mispriced represents the duel challenge for growth investors. Additionally, investors do not uniformly define growth. Does growth refer to asset growth, sales growth, EPS growth, cash flow growth, equity book value growth, etc.? These distinct understandings of growth make it difficult to identify growth companies that resonate across a range of investors. Finally, the correlation between historical growth and future growth is low, which requires that investors estimate the growth potential for stocks. While there are difficulties in defining, identifying, valuing, and profiting from growth; Figure 1 is a reminder that the rewards from doing so can be significant. Understanding growth Growth can refer to the rate of change in some aspect of a firm. From a financial statement standpoint, growth occurs in two contexts: building the stock of productive assets on the balance sheet and increasing the flow of cash through the business on the income statement. Ultimately, the size of the asset base and the flow of cash it generates represent the value of a firm. The HOLT CFROI Framework provides a unique perspective on both elements of growth by carefully identifying the current value of all productive assets of a firm, whether on or off the balance sheet, and the productivity of those assets via CFROI (Cash Flow Return on Investment); assessment of likely changes in both are key aspects of the HOLT Growth Percentile. Figure 2: The HOLT pricing puzzle Source: Credit Suisse HOLT 2

3 cumulative excess return (log scale) Measures of growth in sales, net income, EPS, book value, etc. can be helpful ways to quantify growth; however, cash flow growth is more explicitly linked to a firm s value and predictive of shareholder returns. Over time, the market recognizes the value of cash flows over net income. Similar to Figure 1, Figure 3 shows that knowing cash flows three years in the future would provide a return superior to knowing net income. Investors view achieved cash flows as more indicative of future cash flows than achieved profits are of future profits. Figure 3: Performance with perfect foresight of cash flow vs. net income 1 Top/bottom quintile of HOLT cash flow growth Top/bottom quintile of net income growth Source: Credit Suisse HOLT, November 1991 October 216 (last 25 years) Universe: Largest 1 North American stocks by market cap. Performance represents what an investor could have earned with perfect knowledge of future cash flows and net income 3 years ahead of time. To estimate the Growth Percentile, HOLT uses a multi-factor model consisting of both forecasts and historical data: Historical Change in Inflation Adjusted Gross Cash Flow 3% Forecasted CFROI Change 3% Normalized Asset Growth Rate 15% Market Implied Normalized Growth Rate 15% Sales (Size) 1% Appendix A provides a complete definition. Empirical findings Each factor in the HOLT Growth Percentile adds to the overall effectiveness of the metric. Figure 4 shows the rank correlation of the sub-components of the HOLT Growth Percentile to future 3-year cash flow growth as each incremental input is added to the model. The graph begins on the left with the rank correlation between historical cash flow change and future cash flow growth. Moving to the right, each individual subcomponent is added to the model. With each additional factor, the chart demonstrates that the correlation increases monotonically, with the HOLT Growth Percentile providing a ~4% rank correlation with achieved growth higher than any individual factor. 3

4 3Y Forward CF growth 3Y Forward CF growth rank correlation Figure 4: Rank correlation of HOLT factors and achieved growth 55% 5% 45% 4% 35% 3% 25% 2% 15% 1% 5% % Composite Factor Correlation Historical cash flow change Individual Factor Correlation Forecast Growth Market CFROI Used in implied change Valuation growth Sales Source: Credit Suisse HOLT as of 1/31/216 Date range: January 199 October 216 Universe: Largest 1 North American companies by US$ market cap Each bar represents the median rank correlation of forward-looking inflation-adjusted gross cash flow growth versus a composite growth percentile consisting of all factors that precede the bar (from left to right) between January 199 and. It is apparent in Figure 4 that historical cash flow growth alone is only a moderate predictor of future growth, as it has only a 15% correlation with growth over the following three years. As a comparison, another commonly used metric, price to book, has a correlation of around 28% over the same period. Figure 5 provides another view of efficacy of the HOLT Growth Percentile at predicting the relative growth and the effect meeting or missing growth expectations have on performance. The table shows the percentage of companies in each tercile of the Growth Percentile that achieve High, Average or Low growth over the subsequent three years. The percentage of companies with high Growth Percentiles that achieve high growth outcomes is much higher than would be expected by random chance, demonstrating the value of the Growth Percentile is an indicator of future cash flow growth. Firms with low Growth Percentiles exhibit similar behavior, indicating that the measure is useful for predicting both low and high growth outcomes. Figure 5: HOLT Growth Percentile versus forward gross cash flow growth Hit rates Growth score Annualized excess return Growth score Low Avg High Low Avg High High 16% 29% 57% High 12% 13% 9% Avg 34% 39% 26% Avg 5% 1% -8% Low 51% 31% 17% Low -5% -11% -2% 4 Source: Credit Suisse HOLT as of 1/31/216 Date range: January 199 October 216

5 Overall Valuation Momentum Quality Performance of the HOLT Scorecard factors within high & low growth universes High Growth Low Growth High 1.% -.1% Average 1.6% -.3% Low -2.8%.3% High - Low 3.9% -.4% High 2.6% -.2% Average.3%.4% Low -3.3% -.4% High - Low 5.9%.2% High 2.2% 2.6% Average.1%.2% Low -2.5% -3.% High - Low 4.7% 5.6% High 3.4% 1.4% Average.1%.4% Low -3.9% -1.8% High - Low 7.3% 3.2% Source: Credit Suisse HOLT as of 1/31/216 Date range: January 199 October 216 Universe: Largest 1 North American companies by US$ market cap HOLT scorecard percentiles are re-scored within the top/bottom half of the universe by Growth percentile High/Average/Low correspond to the respective terciles of each HOLT scorecard category Universe: Largest 1 North American companies by US$ market cap Hit rates represent the percentage of companies in a given tercile of the HOLT Growth Percentile that fall into a given tercile of 3Y forward-looking inflation-adjusted gross cash flow growth The right panel of figure 5 shows that companies with high Growth Percentiles that actually achieve high relative growth rates have outperformed the market. However, it also shows that companies that miss their high expectations have meaningfully underperformed. Likewise, firms that have low Growth Percentiles that surprise on the upside on growth show the highest returns while those that meet low expectations underperform. Investors should note that firms with low Growth Percentiles collectively tend to deliver better relative returns than those with high Growth Percentiles, highlighting that a strong growth assessment alone is an insufficient investment thesis. Companies with differing growth expectations have had different responses to the HOLT Scorecard Quality, Momentum, and Valuation factors. The side panel shows that companies with high growth expectations respond to all three factors, with the strongest signal coming from Momentum, indicating that these stocks are very sensitive to changes in market sentiment. Low growth companies, however, show a strong tilt towards relative value. Summary The HOLT Growth Percentile is a multi-factor composite score that measures the degree to which a company is likely to have higher or lower future cash flow growth than its peers. Unlike many other growth metrics, it is a forward-looking measure of company s growth profile relative to its peers. By focusing on cash flow growth, rather than accounting earnings or assets, HOLT can remove accounting distortions and focus on what matters most to investors. While companies with high growth expectations do not necessarily outperform, in the long run, the market typically rewards those that achieve superior growth rates. The HOLT Growth Percentile provides a measure of relative growth, with a score of 1 representing the highest growth outlook, while a score of represents the lowest growth outlook relative to regional or global peers. With the Growth Percentile, investors can screen for growth and value ideas, compare the profile of portfolios, and improve portfolio attribution. The HOLT Growth Percentile is available in HOLT Lens for Screening, see Appendix B for an example screen. 5

6 Asset growth CFROI Appendix A: Calculating the HOLT Growth Percentile The HOLT Growth Percentile is composed of five individual factors, which are all indicative of future cash flow growth. Four of these factors are visible on the HOLT relative wealth chart as shown in Figure A1. Figure A1: Growth Percentile on the HOLT Relative Wealth Chart [2] [1] x CFROI -1 Market implied CFROI [3] x [4] 5 3 Asset Growth 1 Market Implied Growth -1 Historical Change in Inflation Adjusted Gross Cash Flow 3% [1] (Inflation Adj. Gross Cash Flow LFY / 3Yr Avg. Inflation Adj. Gross Cash Flow) The historic growth trend in a firm s inflation adjusted Gross Cash Flow as measured by the change from the trailing three-year average Cash Flow and that of the past fiscal year. This component provides a check on the likelihood of a company to use its cash generation to grow based on recent trends. CFROI Change 3% (CFROI LFY / CFROI Used in Valuation) [2] The expected change from the last reported year s CFROI to the 12 month forward CFROI based on consensus EPS forecasts. This metric allows for an understanding of the forward looking profitability of a firm from the anticipated trend in profitability and is a gauge of a firm s ability to grow. Normalized Asset Growth Rate 15% (Growth Used in Valuation) [3] The forecast real rate of asset growth for the next 12 months derived via the HOLT CFROI framework. This measures likely growth in gross investment based on cash flows available to the firm and management's capital structure decisions. This measure is forward looking as it embeds analyst s expectations for cash flow growth (via CFROI estimates) and incorporates the likelihood that the firm will use cash flow to fund growth by considering managements decisions regarding dividend policy, share repurchases, debt repayment, and M&A. 6

7 Market Implied Normalized Growth Rate 15% [4] The real asset growth rate required within the default HOLT valuation model to justify the current market price of a firm. This value summarizes the market s expectation for the company s future asset growth. Size 1% The Size factor measures net sales in the last reported fiscal year. Companies with relatively larger Net Sales might have less ability to grow cash flow as a percentage of their current business in the future. The Base Rate Book (Mauboussin) and Terminal Success (Matthews) provide evidence that firms with larger current sales deliver lower future growth rates. Scoring HOLT calculates the HOLT Growth Percentile and its sub-factors relative to peer groups based on market cap, type of firm (REITs are group separately from other companies due to their unique business model) and either regional or global peers depending on the choice of the user. See scorecard primer for universe details (Lens Scorecard Primer). Appendix B: Using the Growth Percentile in Lens The HOLT Growth Percentile is available on the Screening Tab as well as on custom reports in HOLT Lens. When creating a screen or report, an investor can search for Growth Percentile or find the HOLT Growth Percentile under the HOLT Scorecard category. Figure B1: Growth Percentile in HOLT Lens As an example, the following screen finds companies with the high growth potential amongst US Mega Cap Stocks. Figure B2: Example Screen Using HOLT Growth Percentile 7

8 HOLT Growth Percentile Appendix C: The HOLT Growth Percentile for Apple Apple provides a good example of how the HOLT Growth Percentile changes through time. The following chart shows how Apple has gone from a declining computer company to an innovative maker of consumer goods and then to become the largest maker of mobile phones in an increasingly mature market. Figure C1: The HOLT Growth Percentile for Apple HOLT Growth Percentile 3-year forward cash flow growth Appendix D: The relationship between Growth and HOLT s alpha factors By identifying growth companies, the HOLT Growth Percentile allows for a more complete description of factor performance. The top panel of Figure D1 shows the signal strength of the HOLT Scorecard Percentiles without including Growth while the bottom panel shows the same including the HOLT Growth Percentile. Adding the HOLT Growth Percentile smooths out the returns of the other factors and more logically explains the performance during some of the more signification market events of the past 25 years. For example, in the analysis without growth, it appears that Quality and Value significantly outperformed the market between 2 and 22, an event which was ostensibly caused by a flight from momentum. However, adding growth shows that the underperformance attributed to momentum was more accurately a growth phenomenon, an explanation that fits the bursting of bursting of the dot-com bubble. During this drawdown, internet and telecommunications stocks with high growth expectations fell rapidly in value as few of them initially lived up to their promise. 8

9 basis points per scorecard point basis points per scorecard point What is signal strength? Signal strength measures how well the HOLT scorecard predicts returns of individual stocks over a one-month time horizon both with and without the HOLT Growth Percentile. For each month, signal strength for a factor is the corresponding beta of each factor in a multiple regression of the HOLT Lens scorecard with 1-month forward returns. The calculation is as follows: r = β I X + a Where: r = 1-month forward return β I = coefficient of best fit X = vector for scorecard percentiles Figure D1: HOLT factor signal strength with/without incorporating Growth Quality beta 12M Momentum beta 12M Valuation beta 12M Quality beta 12M Momentum beta 12M Valuation beta 12M Growth beta 12M Source: Credit Suisse HOLT as of 1/31/216 Universe: Largest 1 North American stocks by market cap Signal strength (or signal beta) measures how well the HOLT factors predict returns of individual stocks. For each month, the signal strength is measured as the corresponding beta for each scorecard factor in a 9

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