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Liang Chen
Liang Chen
Articles (4)  | Author's Website |

Under-Coverage Alpha: A Simple Index Strategy That Is Proven to Have Outperformed

The implication of under-coverage alpha is that investors would most likely be better off picking stocks that nobody 'cares about' on the Street

May 14, 2019 | About:

Overview

By now, investors should have recognized the poor value-add from Wall Street analysts. But what about the opposite? Namely, would stocks that sell-side analysts care about (cheer) less do better than the average? The answer should be a "yes," mainly due to the following:

  1. Under-covered stocks are less prone to price bubbles and volatility.
  2. These businesses deal less with the Street, leaving them more time to spend on business operations.
  3. Thanks to little (or no) analyst coverage, which is usually shortsighted, the management can focus on longer-term strategies.

"If we think long term, we can accomplish things that we couldn't otherwise accomplish."

- Jeff Bezos

Warren Buffett (Trades, Portfolio) is well known for spending almost zero time talking to analysts, while he estimates that 20% of the typical public CEO’s time is "wasted" on talking to Wall Street.

Of course, all the above three are conceptual, without any quantitative evidence yet. Therefore, it would be beneficial to run a backtest to find out whether under-coverage alpha exists among those under-covered stocks.

The strategy

As the first step, a ranking model is run against each stock in the S&P 500 universe to be assigned a "Urbem Under-Coverage Score" based on the following factors:

  • The total number of analysts that give price targets.
  • The total number of analysts that give the revenue estimate for the current and next years.
  • The total number of analysts that give earnings-per-share estimates for the current and next years and quarters.
  • The total number of analysts that forecast long-term earnings-per-share growth rates.

The "Urbem Under-Coverage Index" then incorporates, with equal weights, the top 50 stocks that are most neglected (highest ender-coverage scores) by Wall Street. The index rebalances itself every 52 weeks. The current holdings (as of May 10) in the index are listed below:

Ticker Weight Return Rank Shares Days Held
AES 1.89% 34.05% 85.6 556 1970
AIZ 1.90% 4.95% 86.6 94 150
ALLE 2.05% 54.70% 88.7 97 1242
AMG 1.67% -39.60% 91 84 514
ARE 2.02% 8.12% 92.7 68 514
ARNC 1.99% 9.19% 87.5 426 150
BR 2.15% 18.66% 91.7 87 150
BRK.B 1.85% 26.67% 98.4 42 878
CBRE 2.15% 116.76% 90.3 209 2334
CDNS 2.92% 57.24% 90.5 201 514
CINF 2.15% 115.95% 95.7 107 4881
CPRT 2.56% 40.90% 85.7 183 150
DVA 1.61% -10.96% 87.3 146 150
EXR 1.91% 5.02% 86.8 87 150
FLIR 2.15% 19.00% 93.2 197 150
GPC 1.79% -0.71% 89.4 86 1606
GRMN 2.21% 21.35% 89.9 133 150
GT 1.41% -22.13% 92.2 390 150
HII 1.84% 3.17% 86 42 150
HRB 1.80% 30.01% 92 318 2334
HRL 1.61% 6.14% 88.6 193 1242
IDXX 2.34% 53.41% 93.5 45 514
IPGP 2.24% 24.63% 85.5 69 150
IRM 1.65% 12.99% 90.9 252 1242
JKHY 1.81% 0.05% 88.2 64 150
KEYS 2.68% 47.29% 92.9 147 150
LEG 1.80% -9.60% 95.7 224 1606
LM 2.28% -2.00% 87.6 319 1242
LW 1.70% -6.80% 96.1 117 150
MSCI 2.67% 48.71% 90.1 57 150
NRG 1.65% 132.55% 86.5 213 2334
NWSA 1.68% -7.52% 94.1 697 150
PBCT 1.91% -12.58% 91.6 532 878
PBI 1.40% -54.20% 96.6 1231 2698
PSA 1.88% 4.03% 86.2 40 150
PWR 2.21% 21.67% 86.9 279 150
RE 1.92% 15.88% 89.5 37 514
RHI 1.78% -1.74% 85.2 147 150
RJF 2.10% -0.87% 92.5 114 514
RMD 1.85% 1.62% 93.4 78 150
ROL 1.73% -4.42% 96.5 225 150
RSG 2.01% 10.33% 85.7 115 150
SNA 2.02% 58.41% 93.9 57 2334
SNPS 2.46% 31.50% 90.8 98 514
TMK 1.97% 18.13% 92.6 107 878
TUP 1.17% -44.15% 96.4 247 5606
VAR 2.05% 47.86% 88.1 72 878
VRSN 2.25% 206.69% 85.6 55 1970
WHR 2.01% -17.51% 89.6 71 1606
WY 1.84% -17.50% 88.3 340 878

Source: Portfolio123; data as of May 10, 2019.

From the list, it is not hard to spot some stocks that have stellar track records of generating tremendous values for shareholders (the most prominent one should be Berkshire Hathaway). There are also wonderful businesses earning high Urbem Quality Scores with superior return on invested capital and strong cash flow, such as Rollins, VeriSign, Jack Henry & Associates, and IDEXX Laboratories.

To break down in terms of sectors, the index currently overweights financial and industrial and underweights consumer staples and communication service (see below).

Source: Portfolio123; data as of May 10, 2019.

Backtest

How would this under-coverage index have performed? I used Portfolio123 to calculate its historical returns compared to the S&P 500 (SPY) as the benchmark for the past 15 years.

Source: Portfolio123; data as of May 10, 2019.

Source: Portfolio123; data as of May 10, 2019.

Source: Portfolio123; data as of May 10, 2019.

As demonstrated above, the index has been delivering alpha, beating the benchmark by a wide margin so far. Please note that trading costs and management fees are not included in the performance calculation for the under-coverage Index.

Source: Portfolio123; data as of May 10, 2019.

To break down by years (see above), only in the five out of the total 15 years did the under-coverage index fail to beat the market. However, the Index has been underperforming for the most recent two years. One explanation for this could be that in a soaring market, everything goes up in price, including "junk."

Limitation

Like all other quantitative methodologies, backtesting has its limitations. The main one, in our case (to test the alpha resulting from under-coverage), is due to it being backward-looking. A backtest purely considers the evidence from the past, but market dynamics could change in the future. For example, it could be the case that Wall Street analysts in aggregate could improve their analysis in the future or the case that corporates America on average would spend less effort on "co-promotion" on the Street for the short run and focus more on the long-term value creation for shareholders.

Summary

No one can predict the future, but the under-coverage alpha for the past 15 years did exist with regards to S&P 500, implying that large-cap equity investors could be better off picking stocks under-covered by Wall Street than chasing "hot" ones.

Read more here:

A Backtest Approach: Do Wall Street Analysts Add Value?

Secular Growth: The Ultimate Reinvestment Opportunity

The True Competitive Advantages of Berkshire Hathaway

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About the author:

Liang Chen
Liang Chen (Steven) is a quality-focused investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur in tech, computer scientist and free-market capitalist. He contributes to well-known financial media sites, such as GuruFocus, SeekingAlpha, TalkMarkets, and Investing.com. Steven is also the founder of Urbem Media (HK) Ltd. and Urbem Partnership (www.urbem.cn).

Visit Liang Chen's Website


Rating: 3.7/5 (3 votes)

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yuehao.lu.mba2016
Yuehao.lu.mba2016 - 1 week ago    Report SPAM

A good read!

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