- We created a quantitative ranking system to help portfolio managers sell short or sell existing long positions that are likely to underperform.
- The worst 5% ranked stocks of the Russell 3000 and Russell 1000 universe generated -17.3% and -9.5% of annualized return respectively.
- We did a performance attribution of these 5% worst ranked stocks on phases of the business cycle using the Leading Economic Indicator (LEI).
With markets making new all time highs on minimal volatility, investors have an opportunity to replace skeletons in their closet with better prospects. This month we discuss a ranking system to help portfolio managers avoid stocks that are most likely to underperform. This exercise is even more important now as the late-stage economic cycle may shift in the next couple of months.
Russell 3000 Bombs
You will find the ranking system result below. As you can see, it is highly effective at sorting the bombs out of the Russell 3000 universe. For the 1999-2017 period, which corresponds to two business cycles, the worst 5% ranked stocks generated -17.3% of annualized return! Investors can take advantage of this awful performance by selling short or selling existing longs.
Ranking System Details
In this ranking system, the factors chosen are not typical of long only models but geared to identify the worst publicly traded companies. 25 factors are selected for this purpose and we classify them in twelve distinct categories. We provide the rationale behind each category and disclose the factor 1) sorting direction, 2) short definition and 3) cross sectional relationship.
Business Cycle Performance Attribution
Now let’s proceed with a performance attribution by phases of the business cycle as shown on the chart below. Whenever the Leading Economic Indicator (LEI) is falling, the 5% worst ranked stocks produce a negative alpha of -35% or worse. As we are writing this report, the LEI just increased to 4.4% YoY in August from 3.9% YoY in July with no imminent reversal in sight yet.
However, these 5% worst ranked stocks are outperforming when the LEI is rising & below 0. This means an investor shorting these 5% worst ranked stocks might lose money in the early innings of a new business cycle. As the expansion becomes more mature when the LEI is rising & above 0, these 5% worst ranked stocks more or less market perform vs. the benchmark.
Russell 1000 Bombs
The Russell 3000 universe is a good benchmark of the entire U.S. stock market but does the ranking system work even with large companies? For the 1999-2017 period, the worst 5% ranked stocks in the Russell 1000 made -9.5% of annualized return. The losses are not as huge because large caps have higher odds of refinancing, restructuring, surviving a legal battle, etc.
In conclusion, our ranking system is successful at highlighting companies that are most likely to erode alpha in the long run. The list below are companies you may want to avoid in a long only portfolio right now. You will find below a link to the Excel file containing the full list of companies in the Russell 1000 and Russell 3000 universe classified by this ranking system.