The Anomaly That Can Beat the Market

What our 1% know... Most 'market' returns come from just a few stocks... Quality with a capital 'Q'... Using the F-score... The big surprise... Low volatility wins in the long run...

Editor's note: Before we get into today's main essay, I (Corey McLaughlin) want to highlight this morning's latest inflation read...

Uncle Sam reported the July consumer price index ("CPI") results, which showed 0.2% growth last month and a rate 2.9% higher than a year ago. That's the lowest headline number since March 2021, and the numbers align with the Federal Reserve's supposed inflation goal in the 2% range.

This data follows yesterday's producer price index ("PPI") reading for July, which showed 0.1% growth from the previous month, lower than Wall Street expectations. The headline PPI was 2.2% year over year.

These numbers only strengthen recent market expectations that the Fed will cut its benchmark bank-lending rate at its next policy meeting in September as "disinflation" continues and signs of the labor market weakening grow.

The outstanding question now, after last week's mini panic in the market, is how much the central bank will "cut" the cost of borrowing: 25 or 50 basis points? As of today, market odds are on the former... We'll continue to monitor the rate question and keep you updated.

Now, as we mark our 25th anniversary at Stansberry Research this week, we continue with our series of essays highlighting some of the principles that have sustained our business as the leading independent publisher of financial research in the world.

Today, we're sharing an excerpt from an exclusive Stansberry Alliance-only benefit we first shared back during the bear market of 2022. It was the last of our seven-module Stansberry's Financial Survival Program, designed to guide folks through the bear market. (The essay's discussions of economic uncertainty were written back then... but still apply as unemployment continues to rise.)

Written by our Director of Research Matt Weinschenk and senior analyst Alan Gula, this module explains an "anomaly" that folks can use to seek market-beating returns – including amid tough economic conditions.

This research is also an example of the "secret" we've been talking about recently that a select number of our subscribers understand... You can hear more about that here.

It's a cataclysmic event that's still without precedent...

The Great Recession of 2008... the COVID-19 shutdown of 2020... even the bear market and recession looming today...

None of it compares to the economic destruction of the Great Depression.

The U.S. stock market lost more than 80% of its value following the crash in 1929. The unemployment rate peaked around 25%. Roughly 9,000 banks failed across the country. Many people lost their homes and farms, and some even starved.

Companies operating in the wake of the October 1929 crash had no choice but to tighten their belts and try to eke out a conservative profit.

That's precisely what cereal-maker Post did, cutting back on advertising spending to conserve cash. On paper, it sounds like the most practical way to navigate such a catastrophic event. And the board of directors for the other big cereal maker, Kellogg, planned to do the same.

But company founder W.K. Kellogg had other plans.

When he found out that the board was planning to slash advertisement spending, Kellogg was not pleased. He admonished them and called for a new vote.

Instead, the company doubled its ad budget, moved into radio advertising, and heavily promoted its new cereal, Rice Krispies.

It turned out to be the right call.

As the economy tanked and consumers had less to spend on cereal, Kellogg's profits rose 30%. It even took some market share from Post.

That's the ideal investment, isn't it? An appealing product, robust financials, and a management team that knows how to seize an opportunity.

But few companies operate that way...

Up close, most businesses are held together with duct tape. They are flying blind, hoping to make the next quarter's numbers, scrambling to stay one step ahead of the competition.

A study by finance professor Hendrik Bessembinder found that most businesses – even public ones – just don't work. In fact, the vast majority of all of the stock market's returns come from just a few good stocks. According to Bessembinder...

Since 1926, most stock market returns in America have come from a tiny fraction of shares. Just five stocks (Apple, ExxonMobil, Microsoft, GE, and IBM) accounted for a 10th of all the wealth created for shareholders between 1926 and 2016. The top 50 stocks account for two-fifths of the total. More than half the 25,000 or so stocks listed in America in the past 90 years proved to be worse investments than Treasury bills.

But you can't just take shots at a dartboard trying to find the five stocks that generate actual returns. That's no way to survive a bear market. Heck, it's no way to survive a bull market.

You find these ideal stocks by diving deep into their businesses and understanding who's going to keep advertising going through the recessions, undertaking projects with positive returns, and sending capital back to shareholders via dividends and share buybacks.

But before you dig in, you need to know where to point your shovel.

With that in mind, in this module, we're going to take a broad approach to finding two kinds of companies: those of high quality and those of low volatility.

We find that these two types of companies tend to offer better rewards during all kinds of markets.

What's more, owning high-quality and low-volatility businesses in a period of market turmoil will help you feel more confident and sleep better at night.

Understanding the appeal of quality...

We know which direction the economy is headed (down), but we don't know by how much... We know the moves that the Federal Reserve and Congress are taking, but we don't know how effective they will be... And we know the market has rallied lately, but significant risks are still out there...

In short, we should own high-quality businesses with low volatility amid market uncertainty.

If you roll your eyes at this "deep" insight, we don't blame you... Of course we don't want to own bad businesses. And the need for quality has been pounded into your head repeatedly by everyone from Warren Buffett to the talking heads on CNBC.

But this is where the idea of using limited information to make a simple choice leads us today... "Buying quality" is a plan that's perfect for this moment.

But it's not always the obvious choice.

For instance, if you knew for a fact that the stock market had already seen its bottom, you might be tempted to buy the most speculative, low-quality things you can find. When the market panics, risky assets get sold indiscriminately. The riskier the asset (say small-cap stocks compared with large caps), the more it sells off.

But when the fear subsides, those risky assets rally the fastest. If you could pick the bottom, you'd want to buy small caps, junk bonds, or highly levered companies.

But that sort of strategy is dangerous.

We can't predict when any collapse or bear market will end. We can venture a guess. We don't think we've seen the bottom of this one yet... but we don't know for sure.

In the meantime, quality stocks will earn us fair returns if the market rises. And they'll hold their value better than other risky assets if the decline worsens.

Quality with a capital 'Q'...

"Quality" can seem like a thoughtless concept. Who doesn't want quality businesses?

But a lot of people don't think about why we want quality...

For one, junky assets perform well out of market bottoms. But plenty of people make serious money as deep-value investors or by buying distressed assets. They find things that are priced for death and earn profits while they limp along.

However, if you define quality very specifically – not as a soft, undefined description like "good businesses with strong profits," but an actual number you can look up – we can prove that the strategy of buying quality does indeed work.

And rather than argue about the merits of one business over another, you'll know quality immediately by looking at the numbers.

Quality works. In many ways, "value investing" is the opposite of quality investing, but the most famous value investor in the world understands that quality works. As Warren Buffett wrote in his 2012 annual letter to Berkshire Hathaway shareholders...

More than 50 years ago, Charlie [Munger – Buffett's longtime partner] told me it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible.

This quote also reveals why investing in quality isn't such an obvious choice.

However, you must remember that you get what you pay for. Quality businesses trade for higher prices. Markets are not perfectly efficient, but you generally pay more for a highly profitable business than you do for a mediocre competitor that ekes out a profit.

Which wins out? Over the long term, does quality justify its higher price? Or has the market figured out quality, meaning you need to find another edge?

Quality wins out. And you can see the proof...

By defining quality, you can test potential candidates. This sort of research is known as "factor investing," and it allows you to investigate stocks for the different factors that drive them.

Measurements of quality differ, so we'll start with a simple one...

University of Rochester business professor Robert Novy-Marx proposes "gross profitability" as a quality measure. It's simply gross profits (revenue minus cost of goods) divided by the value of a firm's assets. His research finds that a portfolio that buys the highest gross profitability stocks and shorts the lowest (the typical test for a factor) will earn an annual return 2.7% above the market. (That's a very significant number in financial markets.)

Gross profits is an easy, simple-to-find number. It normally appears as the third entry on a company's income statement. And it includes very few assumptions or accounting manipulations.

You can check it in a few seconds, making it a great number for everyday investors to rely on.

You can also look up (or calculate) a company's "F-Score," a measurement proposed by Stanford accounting professor Joseph Piotroski.

The F-Score includes nine tests. The company gets a point for every test it passes. The score is the total points earned. Companies with a score of nine have perfect quality. You can find the F-Score test formulas online, but in plain English, these are what they determine:

1. Is return on assets positive?

2. Is operating cash flow positive?

3. Did return on assets improve in the last year?

4. Is cash flow production better than earnings?

5. Did leverage decrease in the past year?

6. Did the current ratio improve in the past year (i.e., is there more cash on hand)?

7. Did the company refrain from issuing shares?

8. Did gross margin rise in the past year?

9. Did asset turnover rise in the last year?

Asking these questions can help you beat the market. From 1974 through 2014, an F-Score portfolio returned 12.6% compared with 11.2% for the S&P 500 Index. Even better, it had lower volatility.

Digging deeper, billionaire quantitative investor Cliff Asness tested the same concept in a paper called "Quality Minus Junk." The paper uses a more complicated measure of quality, making it hard to replicate, but the thought is the same.

Perhaps more valuable, Asness' firm, AQR Capital Management, publishes ongoing returns for the Quality-Minus-Junk factor. From that, we can see the difference in performance between quality and the S&P 500.

A portfolio of good stocks beat the market for decades... until "junk" stocks made a comeback in the raging bull we've seen since the bottom of the pandemic.

Of course, after that, the quality index has come roaring back again, protecting investors during the developing bear market.

But quality isn't the only measure you can use. You may suspect that the riskiest stocks are supposed to deliver the highest returns. But it turns out they don't...

The anomaly that can beat the market...

Finance textbooks are dreadfully boring.

They're filled with formulas, diagrams, and jargon. Even worse, much of the material isn't useful. The problem is that most finance principles and theories rely on unrealistic "in a perfect world" assumptions.

For example, the Capital Asset Pricing Model ("CAPM") is the backbone of pricing theory for securities. One of its creators, William Sharpe, even won the Nobel Memorial Prize in Economic Sciences in 1990 for his work on it.

The CAPM assumes that the financial markets are dominated by rational, risk-averse investors. Of course, there are irrational traders and investors out there. But the CAPM assumes that rational investors counteract the irrationality and eliminate mispricings.

The key insight of the CAPM is that the expected return of a stock is directly proportional to its systematic risk (or "beta"). The higher the risk, the higher the reward. This makes intuitive sense.

However, analysis of securities prices shows a surprising result: Lower risk can still translate into higher long-term returns. This puzzling phenomenon is called the low-volatility anomaly.

To illustrate the counterintuitive relationship between risk and reward, we ran a "backtest"...

Let's say you invested in an S&P 500 Index fund at the beginning of 1995. (We'll assume the fund had zero tracking errors and no fees or transaction costs.) Through the end of September 2022, your total return (including dividends) would have been around 1,200%. That's nearly a 10% annualized return. To achieve that solid return, you had to withstand some steep losses. October 2008 – near the apex of the credit crisis – was the worst month, with a nearly 17% decline.

We can use William Sharpe's metric, the Sharpe ratio, to measure return per unit of risk. The higher the Sharpe ratio, the better the risk-adjusted returns. And unlike the CAPM, the Sharpe ratio is rooted in statistics rather than theory.

Since 1995, the S&P 500's Sharpe ratio has been about 0.5.

Now, let's say you invested in the most volatile stocks. Suppose you ranked the stocks in the S&P 500 by volatility and divided them into five equal buckets (or "quintiles") of 100 stocks. You picked the most volatile quintile each month and held those 100 stocks in equal weights.

The beta of your portfolio would have averaged about 1.5, which means it had a systematic risk about 50% higher than that of the market. (The S&P 500 has a beta of 1.) And as is typical when investing in volatile stocks, the drawdowns were severe. Your worst monthly return would have been a 29% decline in March 2020 during the COVID-19 crash. In fact, you'd have suffered through five 20%-plus monthly declines.

However, you wouldn't have been compensated for the increased volatility. In the end, you'd have had a total return of just 880%. That's more than 300% less than the return for the S&P 500. And the Sharpe ratio would have been an abysmal 0.38.

Now, let's say you had invested in the least volatile stocks...

Suppose you picked the 100 least volatile stocks (bottom quintile) in the S&P 500 each month and held them in equal weights. The volatility of this portfolio would have been much lower than that of the market, with a beta of just 0.65.

The big surprise is that this low-volatility portfolio had a nearly 1,800% total return, outperforming the market by more than 500%. And its Sharpe ratio was a superior 0.7.

Lower risk with higher returns. These results fly in the face of the economic theory in textbooks.

Researchers have analyzed the low-volatility anomaly using decades of data. One study found that the market mispricing was likely due to a behavioral bias rather than the compensation for some hidden risk.

It's possible that collective risk-seeking behavior in the market creates these mispricings. Basically, people are overpaying for lottery-type stocks. The highest-volatility stocks – perceived to have the best chance of multiplying – are too expensive. And low-volatility stocks – perceived to be too boring – are too cheap.

Basically, the CAPM's assumptions about market efficiency are dubious. The rational investors who are supposed to dominate the market seem to be unwilling or unable to exploit the mispricings of good companies. If enough investors shunned high-volatility stocks and bought low-volatility stocks, the anomaly would disappear.

Of course, low-volatility stocks don't always outperform. They tend to underperform during powerful bull markets. And that may be one of the reasons why the anomaly persists. Few money managers are willing to underperform during bull markets.

We're not concerned about the causes of the low-volatility anomaly or why it persists. But we can, and do, take advantage of it.

By starting our search for quality stocks with low volatility, we believe we can earn better returns.

That means better returns in bull markets, in bear markets, and in flat markets.

You don't have to be a quantitative investor to benefit from this information. And you don't need to follow specific rules to "only buy stocks with a quality score higher than 80."

Rather, use the knowledge that these investment strategies just work as the basis for building your portfolio.

Editor's note: As I mentioned, our Stansberry Alliance members had first and exclusive access to this research as part of our Stansberry's Financial Survival Program in 2022... And there was much more to it, including a seven-module course packed with general insights and actionable advice...

For example, in the essay we excerpted today, Alliance members received a five-stock "recession- and crash-resistant" portfolio that our team called "virtually indestructible."

We've been referring to instant access to this type of research as the secret that only 1% of our subscribers understand. There are plenty of more examples – from our Quant Portfolio to new special reports that our editors and analysts consistently put together – that Alliance members get to see first.

If you want to hear all the details, you can do so here in a special no-cost broadcast featuring our publisher Brett Aitken, Retirement Millionaire editor Dr. David "Doc" Eifrig, and Stansberry's Investment Advisory lead editor Whitney Tilson.

In short, if you like our work at all and don't know what we're referring to with this "secret," you should check out this presentation.

But don't hesitate. This broadcast goes offline soon, and the last time our company's leaders publicly discussed it was three years ago. In other words, you don't get to hear the details frequently. Watch now.

New 52-week highs (as of 8/13/24): AbbVie (ABBV), Agnico Eagle Mines (AEM), Alamos Gold (AGI), Fair Isaac (FICO), Fidelity National Financial (FNF), Intercontinental Exchange (ICE), Intuitive Surgical (ISRG), Lockheed Martin (LMT), London Stock Exchange Group (LNSTY), Altria (MO), Northrop Grumman (NOC), Planet Fitness (PLNT), Regeneron Pharmaceuticals (REGN), Skeena Resources (SKE), Veralto (VLTO), Vanguard Short-Term Inflation-Protected Securities (VTIP), and Health Care Select Sector SPDR Fund (XLV).

Before we get to today's mailbag, a small housekeeping note... Due to a production error, our Monday Digest was missing a table showing the long-term performance of Berkshire Hathaway's top stock holdings. We've updated our Monday issue online with the table included, and you can find it right here. To the subscriber who let us know about the oversight, thank you.

In today's mailbag, some more feedback on our Saturday Masters Series essay from Stansberry Research founder Porter Stansberry on how "you can beat the market"... Do you have a comment or question? As always, e-mail us feedback@stansberryresearch.com.

"I find your rules of thumb and general instructions to be fairly correct... An opinion from my end would be the inefficiencies of the human mind and emotions which are what often lead to mispricings in the market.

"As an auction-driven setup, I would actually like to believe that this was a clever conspiracy set up by the brokers so as to squeeze out some commissions, whilst the superinvestors from Graham & Doddsville gleefully (and ever so quietly) agreed to it as that would open up the floodgates to what we now know as 'Value Investing'.

"A part of me wonders whether if the markets were to be closed or the auction-driven nature to be closed off, whether it would actually help reduce volatility, hike up the long-term average returns rate and also perhaps sound the death-knell of the type of derivatives that made kitties roar a few years ago..." – Subscriber Sanket K.

Good investing,

Matt Weinschenk and Alan Gula
Baltimore, Maryland
August 14, 2024