Disciplined Stock Selection

Disciplined Stock Selection Nicholas Clark March 4 th, 2010 04 March 2010 Designator author 1

4 th March 2010 2 Overview 1. Introduction 2. Using Valuation Dispersion to Determine Expected Stock Returns 3. Interaction Between Value and Momentum 4. Market Outlook for European Large Caps 5. Conclusion

Introduction 04 March 2010 Designator author 3

4 th March 2010 4 Quantitative Alpha Modelling What is it and how can it help? A consistent application of investment rules of thumb subjected to empirical testing. Goal is to capture main cross-sectional determinants of stock returns. Works because standard economic theory doesn t offer an accurate description of how people process information and evaluate risk. People make systematic errors. Likelihood of random stock outperforming in top quintile never above 60% on average. Rely on law of large numbers to increase cumulative performance. Investment time horizon of 1-12 months. Is not technical analysis. Determines market risks/reward for market and compliments top-down views.

4 th March 2010 5 Characteristics of Different Investment Approaches Fundamental Source:. Breadth Depth Replicability Approach Low. Only minor subset of universe High. Low. Subjectivity is built into Absolute or relative. can be considered concurrently. investment approach. Not always possible to determine basis of investment decision. Quantitative High. Variable. Model construction is a creative process. Data limited by types of information available in quantifiable format ( quality of management ). High. Quant process ensures transparency in terms of what drives ranking of each stock. Relative. Technical Analysis Low.? Low. Largely subjective. Absolute.

4 th March 2010 6 Selected Documented Anomalies Anomaly Description Source Size Low market cap stocks tend to outperform. Banz (1981) and Reinganum (1981) January Effect Higher market returns in Jan. Keim (1983) Value (low P/E) Low valuation stocks tend to outperform. Basu (1977) Value (low P/Book) Low valuation stocks tend to outperform. Rosenberg, Ried and Lanstein (1984) Value (low P/E Normalized) Low valuation stocks tend to outperform. Graham & Dodd (1951), Shiller (2000) Value (low P/Cash Flow) Low valuation stocks tend to outperform. Chan, Hamao and Lakonishok (1991) Long-term Price Reversal Prev. losers outperform over next 3-5 years. DeBondt & Thaler (1985) Medium-term Price Momentum Prev. winners outperform over following 3-12 months. Jegadeesh & Titman (1993) Short-term Price Reversal Prev. winners underperform following month. Jegadeesh & Titman (1993) Post-Earnings Announcement Drift Stocks with positive earnings surprise outperform. Bernard & Thomas (1989) Analyst Earnings Revisions Stocks with relative upgrades outperform. Givoly & Lakonishok (1979) Analyst Recommendations Buy-rated stock recommendations outperform sells. Womack (1996) Accruals Stocks with low-quality earnings underperform. Sloan (1996) Ideosyncratic Volatility Stocks with high volatility underperform. Ang et al. (2006) Source:.

4 th March 2010 7 Market Dynamics Limits Upside for Complex Modelling 1 Estimation Uncertainty Reduces Reliability of Highly Complex Models. Some relationships can t be forecast. Beware of Optimization. Use risk models with caution and avoid model complexity. 50 Day MA Correlation Between Performance of Value and Price Momentum 0.8 0.6 0.4 0.2 0-0.2-0.4-0.6-0.8 What Happened To The Quants In August 2007? Average -1 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Source: FactSet,.

4 th March 2010 8 Potential for Simple Quant Models Remains 1000 900 800 700 600 500 400 300 200 Bottom Quintile Market Top Quintile Long/Short 100 0 Apr-94 Oct-94 Apr-95 Oct-95 Apr-96 Oct-96 Apr-97 Oct-97 Apr-98 Oct-98 Apr-99 Oct-99 Apr-00 Oct-00 Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Model is equal-weighted valuation, quality and momentum. Valuation is book-to-price and earningsto-price. Quality is Return on Assets and Growth in Total Assets (y/y). Momentum is average monthly number of analyst EPS estimate upgrades minus number of analyst EPS estimate downgrades divided by total number of changed EPS estimates for rolling past three months. Universe is MSCI Europe. Performance calculated as total return, net of tax. Test period is Apr 1994 Jan 2010. Source: MSCI, FactSet,.

4 th March 2010 9 What has the last few decades taught us about equity investments? 1. Markets can be fairly valued, but deviations from fair value can take years. 2. Bubbles can be spotted in advance, but bursting can not be timed. 3. No relation between CAPM beta and realized returns. 4. Stocks can be described in terms of fundamental characteristics relating to accounting, valuation and price related variables, some of which have cyclical properties. 5. The cross-sectional dispersion to valuation factors represents a risk/reward proxy for investing in risky assets.

Using Valuation Dispersion to Determine Expected Stock Returns 04 March 2010 Designator author 10

4 th March 2010 11 Valuation Matters over the Long Term (S&P 500) 25% 0 Annualized Total Return for Following Ten Years (inflation adjusted) 20% 15% 10% 5% 0% -5% Ann. Returns CAPE 1920 1929 1949 1982 1964 1999 5 10 15 20 25 30 35 40 45 Cyclically Adjusted P/E (Earnings Calculated as Average over Past 10 Years, Scale Inverted) -10% 1881 1885 1888 1891 1894 1898 1901 1904 1907 1911 1914 1917 1920 1924 1927 1930 1933 1937 1940 1943 1946 1950 1953 1956 1959 1963 1966 1969 1972 1976 1979 1982 1985 1989 1992 1995 1998 2002 2005 2008 50 Source: Robert Shiller s website,.

4 th March 2010 12 Valuation Matters over the Long Term (S&P 500) 20% Valuation only drives return over the long run. 15% 18 20 19 17 48 49 4651 4750 53 87 88 90 89 The greater the imbalance, the stronger the effect of mean reversion. Returns were negative for ten year period from Dec 1999, both in nominal and real terms. Current valuations imply annualized returns of ~4% real. Annualized Total Return for Following Ten Years (Inflation Adjusted) 10% 5% 0% -5% 21 Implied Return 81 82 7942 44 52 45 85 86 91 84 83 54 41 23 2657 *96 *95 78 80 43 55 94 25 *90 *94 77 58 93 24 *88 56 *91 *99 74 76 *84 *82 *93 *81 *92 92 32 75 34 40 62 *98 22 35 31 16 *83 *87*89 60 59 *00 *03 *02 *85 *97 *01 14 33 15 37 39 30 *86 61 73 *0627 *05 38 *04 29 *07 13 63 12 70 66 36 *08 *09 11 10 71 69 72 67 65 68 64 95 28 96 97 98 99 Latest Observation -10% 0 5 10 15 20 25 30 35 40 45 50 Cyclically Adjusted P/E Source: Robert Shiller s website,.

4 th March 2010 13 Valuation Not Catalyst for One Year Returns (S&P 500) 60% 50% 32 53 To tal Return Followin g Year 40% 30% 20% 10% 0% -10% -20% -30% -40% 20 21 1817 19 34 *07 26 27 14 44 57 54 35 94 74 *90 60 84 *84 23 24 88 08 42 85 37 *03 *99 49 82 62 *97 48 02 7543 50 90 *85 *04 71 66 81 79 51 *96 25 63 87 *88 *00 58 91 70 67 64 10 *93 *08 41 92 78 47 *82 *81 *91 55 22 83 38 77 52 11 *87 *95 *94 *09 *05 31 93 86 69 59 13 463315 *83 *01 *98 89 80 39 *92 *86 *02 76 12 *89 56 61 65 40 45 16 73 30 72 *06 36 29 68 96 95 05 03 04 06 28 07 01 97 00 98 99-50% 0 5 10 15 20 25 30 35 40 45 50 Cyclically Adjusted P/E Source: Robert Shiller s website,

4 th March 2010 14 Europe Composite Valuation Dispersion Valuation dispersion expresses a standardized measure of difference between cheap and expensive. Level of valuation dispersion is a risk/reward proxy for investing in risky assets. Not a forecasting tool. Risky assets outperform when valuation dispersion spreads narrow. Valuation dispersion is driven by mean reversion, strength of which is proportional to deviation from averages. Valuation dispersion gives incremental information beyond that implied by valuation multiples. Valuation dispersion measured as equal-weighted z-score of Book-to-Price, Sales-to-Price, Operating Cash Flow-to-Price and Dividend Yield, based on normalized median inter-decile spread. Universe is MSCI Europe. Source: Sanford C. Bernstein, Fortis investments.

4 th March 2010 15 Risky Assets Outperform when Valuation Dispersion Spreads Narrow (MSCI Europe) Current valuation dispersion spreads remain relatively wide, implying 1) further market upside, 2) favour value stocks over growth, 3) favour small caps over large caps. Works because 1) concept not well known, 2) most investors can t or won t take a sufficiently long investment time horizon. Relevant to all strategists and asset allocators. Performance measured as total return in EUR. Source: MSCI, FactSet,.

4 th March 2010 16 Valuation Matters Factor Level (Russell 1000) 250% 2.5 200% Main drivers of expected returns are the same for the market and at the stock level. When capital is scarce, spreads are wide, increasing expected return to valuation factors. 150% 100% 50% 0% -50% -100% Dec-82 Dec-83 Dec-84 Dec-85 Dec-86 Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Return to value strategy over the next 36 months (%) 2.0 1.5 1.0 Dispersion of earnings yield 0.5 0.0 Return over the next 36 months Dispersion Source: UBS.

Interaction Between Value and Momentum 04 March 2010 Designator author 17

4 th March 2010 18 Performance of equal-weighted combination of value and momentum (MSCI Europe) 300 Carhart (1997) combined Market Beta with Size, Value and Momentum as a replacement factor model for CAPM. 250 200 Combining Value and Momentum worked like a charm until March 2009. 150 Value PriceMom 50/50 Combo 100 50 May-94 May-95 May-96 May-97 May-98 May-99 May-00 May-01 May-02 May-03 May-04 May-05 May-06 May-07 May-08 May-09 Performance is total return, net of tax measured in local currency. Source: FactSet, MSCI,.

4 th March 2010 19 Long/Short Quintile Return to Value (MSCI Europe) Flight to Safety Resulted in Perverse Value Factor Efficacy. Record spreads in March created historic opportunities for Value Value is calculated as equal-weighted combination of book-to-price and earnings-to-price, based on reported data. Performance is total return, net of tax measured in EUR. Source: FactSet, MSCI,.

4 th March 2010 20 Long/Short Quintile Return to 9 Month Price Momentum (MSCI Europe) Flight to Safety meant disregarding price and bidding up high quality, favouring what was already going up. Price Momentum typically works through first year of bear markets. This gives clear warning as to when to reduce exposure. Price Momentum is calculated price change on a total return basis for the past nine months, less the latest month. Performance is total return, net of tax measured in EUR. Source: FactSet, MSCI,.

4 th March 2010 21 High Risk Environments Torpedoes Price Momentum (MSCI Europe) Expected return to Price Momentum depends on market risk appetite. Exemplifies that factor efficacy is related to level of valuation dispersion. Suggests approach to dynamically weight factors over time. Source: FactSet, MSCI,.

4 th March 2010 22 Performance of combinations of value and momentum (MSCI Europe) Switching off price mom when volatility is high improves performance. Having a qualified view on future factor efficacy can add value. Generally, adjusting factor weights based on valuation dispersion works. Source: FactSet,.

Market Outlook 04 March 2010 Designator author 23

4 th March 2010 24 Development of Net Profit Margins (MSCI Europe) Market cap-weighted data. Net profit margins calculated based on rolling last 12 months reported data. Source: FactSet, MSCI,.

4 th March 2010 25 Share of Stocks with Improving Net Profit Margins (MSCI Europe) Net profit margins calculated based on rolling last 12 months reported data. Source: FactSet, MSCI,.

4 th March 2010 26 GICS Sector Net Profit Margins (MSCI Europe) % 20 15 10 5 0 Average Current -5 Consumer Discretionary Consumer S taples Energy F inanci als Health Care Industrials Information Technology Material s Telecommunication Services * Utilities Market capitalization-weighted data, covering Jan 1994 Feb 2010. Net profit margins calculated based on rolling last 12 months reported data. *) Telecommunication Services excluding Apr 2003 Dec 2005. Source: FactSet, MSCI,.

4 th March 2010 27 Current Intra-Sector Valuation Spreads (MSCI Europe) % 100 Large spreads indicate higher level of dispute Utilities and Financials appears most undervalued Consumer Staples and Industrials look priciest Frequency Percentile Rel ative to History (share of periods with narrower sector spreads than current) 90 80 70 60 50 40 30 20 10 89.1 Cheap 80.2 70.3 68.9 65.6 58.3 54.7 47.4 43.2 26.0 0 Utilities Financials Telecommunication Services Health Care Materials Consumer Discretionary Energy Information Technology Industrials Co nsumer Staples Expensive Equal-weighted data, covering Jan 1994 Feb 2010. Note: Value of 50 represents average valuation spread. Spread calculation based on median inter-decile spread for Book-to-Price, Sales-to-Price, Operating Cash Flow-to-Price and Dividend Yield (payers only). Source: FactSet, MSCI,.

4 th March 2010 28 Recommendations European Large Cap Equities Sector Recommendations are relative. Overweight Utilities and Telecoms (wide valuation spreads, in-line net profit margins). Underweight Industrials (narrow valuation spreads, sub-par net profit margins). Intra-Sector Recommendations. Prefer high quality names in sectors with narrow valuation spreads (small difference between cheap and expensive).

4 th March 2010 29 Conclusions - Conceptual Valuation dispersion can be used as value measure at the market and sector level. This gives important information about locating best investment opportunities. Market returns driven by mean reversion at multi year time horizons by valuation. Same force drives valuation dispersion at shorter time horizons. Efficacy of most investment factor returns move with valuation spreads over shorter investment time horizons. Narrowing valuation dispersion imply outperformance of risky assets (low quality, small caps, value stocks). Potential of systematic quantitative strategies intact, due to behavioural and institutional factors.

4 th March 2010 30 Appendix Stocks ranked in top Quintile (1/2) Please note that the information below is shown for illustrative purposes only and reflects the workings of a proprietary stock selection model* *) The information in these slides does not constitute a recommendation to buy or sell any securities.

4 th March 2010 31 Appendix Stocks ranked in top Quintile (2/2) Please note that the information below is shown for illustrative purposes only and reflects the workings of a proprietary stock selection model* *) The information in these slides does not constitute a recommendation to buy or sell any securities.

4 th March 2010 32 DISCLAIMER Nothing in this material should be construed as investment or any other advice; it is provided for information purposes only. We have taken all reasonable care to ensure that the information contained herein is reliable, however it is unaudited and is subject to amendment. This document does not constitute an offer to buy or sell investments. Nor does it express any views as to the suitability of investment to the individual circumstances of any recipient. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Changes in the rates of foreign exchange may cause the value of investments to fluctuate. Past performance or achievements are not indicative of current or future performance. Please note that this material is provided for information purposes and may represent the opinion of the author. Any information contained within this document is subject to change and is based on data which is unaudited. Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purpose of illustration only. is the trade name for all entities within the Fortis Investment Management Group. This document has been issued by Fortis Investment Management UK Limited, authorised and regulated by the Financial Services Authority ( the FSA ) and part of the Fortis Investment Management Group (address: 82 Bishopsgate, London, EC2N 4BN).