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James Li
James Li
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Revisiting the GuruFocus Predictability Rank: 2010-2019 Backtest Study

GuruFocus’ business predictability rank still has high correlation with average total return

As the stock market attempts to rebound from a coronavirus-driven first quarter of 2020, GuruFocus conducted a backtest study of the Predictability Rank for the period between January 2009 to December 2019.

Berkshire Hathaway Inc. (NYSE:BRK.A)(NYSE:BRK.B) CEO Warren Buffett (Trades, Portfolio) said that the percentage of total market cap to gross domestic product is “probably the best single measure of where valuations stand at any given moment." As Figure 1 illustrates, the Buffett indicator tumbled from a record high of 152.5% in January close to a three-year low of 120.3% in March, highlighting the stock market decline driven by shelter-in-place orders around the globe. Despite this, Buffett’s market indicator rebounded above 144% in June on the heels of economies reopening worldwide during April and May.

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Figure 1

Predictability rank overview

The following video discusses a brief overview of the GuruFocus Business Predictability Rank, which measures the strength and consistency of a company’s revenue and earnings over the past 10 years. The video also discusses how to make the “Predictability Chart” using GuruFocus’ Interactive Chart feature.

Backtesting study assumptions and biases

As we discussed in the 2008 research article, the predictability rank backtesting study is subject to a few assumptions and biases. For example, although dividends are a key portion of investment returns, we are excluding dividend returns in our study as predictable companies are more likely to pay dividends than do nonpredictable companies. The bias could favor the average of returns for one-star and two-star companies. On the flip side, excluding dividend returns might underestimate by approximately 2%, the dividend yield of the Standard & Poor’s 500 index, the true average return for the companies with a four-star predictability rank or higher.

The predictability rank calculation requires at least 11 years of historical financial data so that we can consider the year-over-year growth for 10 years: 2009 is Year 0 of this study, while 2019 is Year 10. Also, the study is subject to survivorship bias. As Table 1 illustrates, the study is based on just 1,721 U.S.-based stocks: While there are certainly more than 1,721 stocks trading in the U.S. around 2009, just 1,721 stocks survived to the end of 2019. Several stocks that might have evolved from the end of the 2008-09 financial crises might have been merged, acquired or delisted. One-star companies are most subject to survivorship bias as such companies might not have the strength and profitability to withstand 10 years of market movements.

Predictability Rank

Total Stocks

1

1,281

2

39

2.5

66

3

78

3.5

71

4

69

4.5

60

5

57

Total

1,721

Table 1

The study also ignores price adjustments due to spinoffs over the past 10 years.

Study finds that predictable companies overall still generate higher returns

Our study shows the following key trends:

  1. Stocks with higher business predictability have the potential to generate higher 10-year annualized total returns.
  2. Stocks with higher business predictability are less likely to have a negative 10-year total return, reducing the possibility of loss.
  3. Stocks with higher business predictability are more likely to have 10 years of probability over the past 10 years, i.e., generate a profit every year during the 10-year period.

As Figure 2.1 illustrates, the average 10-year annualized total return ranges from just approximately 4.38% for one-star companies to nearly 11.90% for five-star companies. Likewise, one-star companies average just approximately 6.9 years of profitability over the past 10 years, while five-star companies average over 9.5 years of profitability.

Figure 2.1

Figure 2.2 offers an alternative perspective: One-star companies have approximately a 28% chance of loss over the 10-year period, a probability that declines to just around 3% for five-star companies. On the other hand, five-star companies have close to a 72% chance of having 10 years of profitability over the 10-year period, while one-star companies have just around a 32% chance of making a profit in 10 years out of 10.

Figure 2.2

Five-star companies

The most prestigious predictability rank, five stars gives the company a 10-year annualized total return of 11.904% and 9.56 years of profitability over the past 10 years on average. The probability of loss for five-star companies is approximately 3.51%, while the probability of having 10 years of profitability is approximately 71.93%. Figure 3.1 shows the distribution of profitability years among five-star companies.

Figure 3.1

Figure 3.2 illustrates the predictability chart for a five-star company like Group 1 Automotive Inc. (NYSE:GPI), one of the top stocks on the Buffet-Munger Screener.

a12e6ae310aa2bc9351f45315161d20b.png

Figure 3.2

4.5-star companies

Companies with a 4.5-star predictability rank had an average return of 11.553% per year and 9.433 years of profitability over the past 10 years. Among these companies, 5% reported losses, while 71.67% reported 10 years of profitability during the 10-year period. Figure 4.1 shows the distribution of profitability years among 4.5-star companies.

Figure 4.1

Figure 4.2 illustrates the predictability chart for a 4.5-star company like Apple Inc. (NASDAQ:AAPL), a major holding of Buffett’s Berkshire.

8d6da6aa1a6b725ce21a0fbb650d2f82.png

Figure 4.2

Four-star companies

Companies with a four-star predictability rank had an average return of 11.72% per year and 9.043 years of profitability over the past 10 years. Among these companies, 11.59% reported losses, while 68.12% reported 10 years of profitability during the 10-year period. Figure 5.1 shows the distribution of profitability years among four-star companies.

Figure 5.1

Figure 5.2 illustrates the predictability chart for a four-star company like Google parent Alphabet Inc. (NASDAQ:GOOGL)(NASDAQ:GOOG).

06add5014dc6f1a9137d94f3c2096f64.png

Figure 5.2

3.5-star companies

Companies with a 3.5-star predictability rank had an average return of 8.385% per year and 8.831 years of profitability over the past 10 years. Among these companies, 18.31% reported losses, while 59.15% reported 10 years of profitability during the 10-year period. Figure 6.1 shows the distribution of profitability years among 3.5-star companies.

Figure 6.1

Figure 6.2 illustrates the predictability chart for a 3.5-star company like Booking Holdings Inc. (NASDAQ:BKNG).

8ecb713c2896156b32a2ddfcac0d926d.png

Figure 6.2

Three-star companies

Companies with a three-star predictability rank had an average return of 10.629% per year and 8.872 years of profitability over the past 10 years. Among these companies, 11.54% reported losses, while 64.10% reported 10 years of profitability during the 10-year period. Figure 7.1 shows the distribution of profitability years among three-star companies.

Figure 7.1

Figure 7.2 illustrates the predictability chart for a three-star company like Target Corp. (NYSE:TGT).

bbbfd718e20dde296016cd096177005f.png

Figure 7.2

2.5-star companies

Companies with a 2.5-star predictability rank had an average return of 9.297% per year and 8.803 years of profitability over the past 10 years. Among these companies, 15.15% reported losses, while 56.06% reported 10 years of profitability during the 10-year period. Figure 8.1 shows the distribution of profitability years among 2.5-star companies.

Figure 8.1

Figure 8.2 illustrates the predictability chart for a 2.5-star company like McDonald’s Corp. (NYSE:MCD).

f9430d28a55a93eb81ed518e188fa248.png

Figure 8.2

Two-star companies

Companies with a two-star predictability rank had an average return of 9.539% per year and 8.897 years of profitability over the past 10 years. Among these companies, 12.82% reported losses, while 64.10% reported 10 years of profitability during the 10-year period. Figure 9.1 shows the distribution of profitability years among two-star companies.

Figure 9.1

Figure 9.2 illustrates the predictability chart for a two-star company like International Business Machines Corp. (NYSE:IBM).

749688511e843d38cf0248ae6dd44fff.png

Figure 9.2

The unpredictable, one-star companies

We reserve the one-star predictability rank for companies that have inconsistent revenue and earnings growth over the past 10 years. Companies that have shown declining revenue for consecutive years are likely to get hit with a one-star predictability rank. Figure 10.1 illustrates the predictability chart for a one-star company like Hertz Global Holdings Inc. (HTZ), a company that filed for Chapter 11 bankruptcy in May 2020.

f0a46d6f481fa5337ff4ccbe9b2395f3.png

Figure 10.1

Our study shows that one-star companies had an average return of just 4.384% per year and 6.874 years of profitability over the past 10 years. Among these companies, 28.81% reported losses, while just 32.24% reported 10 years of profitability during the 10-year period. Figure 10.2 shows the distribution of profitability years among one-star companies.

Figure 10.2

See also

Buffett and Berkshire co-manager Charlie Munger (Trades, Portfolio) seek companies using a four-criterion approach to investing: understandable business, favorable long-term prospects, competent management and attractive valuations. The business predictability rank measures how favorable a company’s long-term prospects are.

GuruFocus Premium members have access to a wide range of value screens utilizing our predictability rank, which include the Undervalued-Predictable Screen, the Buffett-Munger Screen and the Historical Low Price-Sales Screen.

Disclosure: The author is long Apple.

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About the author:

James Li
I am an editorial researcher at GuruFocus. I have a Master's in Finance from SMU, and I enjoy writing reports on financial trends and investor portfolios. Follow me on Twitter at @JamesLiGuru!

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