Fundamentally Sound Stocks Win When Recessions Loom

Whether it’s interest rate hikes or China’s slump or US weakness, investors have found a myriad of economic reasons to worry in 2016 — and they’ve expressed their worries by pulling billions of dollars out of stocks. But in his latest for Canada’s Globe and Mail, Validea CEO John P. Reese highlights some new research showing that the best time to beat the market is when economic times are tough.

“The research comes from O’Shaughnessy Asset Management (OSAM), which is headed by quantitative investing guru James O’Shaughnessy,” Reese writes. “The group invests using a number of ‘factors’ — that is, fundamental criteria that measure valuation, momentum, financial strength and other stock qualities.” Investing based on these factors tends to lead to long-term success, and in a recent paper, the firm looked at how stocks scoring highly on each of these factors have fared during different parts of the economic cycle over the past 50 years or so. “While there was some variation from factor to factor, the general conclusion was this: Focusing on fundamentals has historically given investors the biggest advantage over the broader market during ‘prerecession’ periods (the 12 months prior to a recession),” Reese says. “During these periods, stocks in the top 10 per cent of the market using a given factor have outperformed stocks in the lowest 10 per cent of the market using that factor by an average of 11.5 percentage points. Not far behind were postrecessionary periods (the 12 months after a recession ends), when the average spread was nine percentage points, and recessionary periods, when the average spread was 8.2 points. The period in which this sort of fundamental-focused investing has provided the smallest benefit during stretches of ‘pure expansion,’ when the spread has been 4.5 percentage points.”

Reese says these findings indicate “that fundamental-focused strategies do their best work relative to the broader market when you are feeling uneasy.” It’s nearly impossible to predict when recessions will occur, so Reese says the underlying message is that “if you are using a fundamental-focused investment strategy, you need to stick with the strategy during good times and bad – because very often, the times when the market is volatile and you most want to ditch the strategy are the times when it will provide the most benefit.” He also looks at a trio of North American stocks that get high marks from his Guru Strategies – which are based on the approaches of several investing greats, including O’Shaughnessy. Among them: biotech company United Therapeutics.