The 2000s may have been a lost decade in the stock market, with the S&P 500 down 25%. The teens, however, have been terrific. The blue chips have returned about 85% since the start of 2010, and the index is now almost 45% above where it ended the 1990s. So it’s understandable to wonder if the tide will turn, especially since the next significant move in interest rates will likely be upward. If risk management isn’t top of mind, it should be.
Unfortunately, conventional risk measurement concepts (beta et al.) are just highfalutin statistical report cards derived from how stock prices behaved in the past. They don’t consider why the stocks moved as they did. Instead we should assess risk based on factors likely to influence future share-price performance.
Research published recently in the Journal of Portfolio Management, by Russell J. Fuller, Raife Giovinazzo and Yining Tung of Fuller & Thaler Asset Management, is a step in this direction. They start with the widespread recognition of return on equity (ROE) as the ultimate measure of company quality. This is common sense: A company that earns $20 of profit from $100 of capital is “better” than one that earns only $10. They also sought out consistent ROE generators.
The financial establishment has long cherished maximization of expected return and minimization of share-return volatility. Fuller, Giovinazzo and Tung found they could achieve market-beating risk-adjusted returns by starting with S&P 500 stocks with strong ROEs, then optimizing expected return and low ROE volatility.
I adapted this by screening on Portfolio123 for stocks ranked in the top 25% in terms of five-year average ROE and in the lowest 20% in terms of ROE volatility. From among those stocks, I selected the ten best values (based on enterprise value to sales). A back-test of this hypothetical portfolio over ten years (assuming rebalancing every four weeks and 0.25% per trade price slippage) produced an annual return of 15.6% versus 8.1% for the SPDR S&P 500 ETF (SPY, 208). It outperformed SPY by an average of 0.24% during up months but was 1.11% better during down months.
