Why is increasing volatility likely to benefit active managers in 2018?
Low volatility will not remain low for much longer
Index level volatility is low for two reasons: firstly, the weight of low volatility stocks in
the index has increased, and secondly, correlations have fallen. Stock level volatility,
however, has different components: a structural one that is driving volatility lower (this
trend remains intact), and a cyclical one (driven by the Fed tightening) that is likely to
drive volatility and hence dispersion of returns higher in 2018.
Higher volatility and dispersion is good news for active managers
Active managers outperform when return dispersion is high. We believe the outlook for
active management is positive as return dispersion is likely to increase, and correlations
are at all-time lows. Providing we don't have any major macro-economic shock (that is
likely to drive correlation higher) active managers are likely to perform well in 2018.
Quality is still King and Queen
A recent study by Russ Wermers points out that analysts add 2% per annum through
correctly forecasting cashflows, and then subtract 0.8% per annum through incorrect
discount rate assumptions. Quant models can overcome this challenge by using
analysts' cashflow forecasts and using financial statement quality metrics to select high
quality companies with high cashflow yields. Implicitly, the correct discount rate is
captured in the financial statement quality score. We take this one step further and
look for companies with improving fundamentals, as this forecasts improvement in the
cost of capital. Our analysis show that markets are already pricing a premium for high
quality companies, however the high delta quality subgroup (i.e., companies with
strong growth in quality factors) is not an expensive cluster right now. The combination
of a potential positive dispersion outlook for active managers and the fact high delta
quality cluster could be the first to be acted upon, can create an interesting trade
window for investors seeking alpha in the medium term.
We list high delta quality businesses with improving fundamentals
Focusing on high quality businesses with improving fundamentals provides us with a
low risk approach as if we're wrong and volatility and dispersion remains low, these
stocks are likely to outperform slightly. If volatility and dispersion increase, these stocks
are likely to outperform significantly. Right now our screen is highlighting: NetApp,
Bristol-Myers Squibb, Costco, Lowe's, Berkeley Group, Aena, Covestro, Telenor, United
Arrows, ANTA Sports, Haier Electronics, Tsingtao Brewery, CSPC Pharmaceutical,
Harvey Norman, Rio Tinto. See page 22 for a full list of stocks.