Genus Factor Focus - August 2009

Factor Focus Vol. 1, No. 05 — August, 2009

Value has regressed to the mean T

he current environment still favours value, but with increasing focus on price-to-earnings. This was evident in August when deep value plays with accelerating cash flow were the best performers. This means investors are switching their focus from cheapness (the easy money has been made) to the future prospects of businesses that are priced at a significant discount to their intrinsic value. As is typical at the beginning of a cyclical recovery, the market rally since early March has seen a “worst to first” move with higher risk/lower rated stocks significantly outperforming higher-quality stocks. The performance

of stock selection strategies in August continued to be characterized by negative returns from large cap momentum and quality, and positive returns from deep value plays at the lower end of the quality spectrum. Factor performance for the month (Exhibit 1) confirms that investors are moving away from cheapness to focusing on the relatively attractive valuations presented by higher-quality stocks with solid fundamentals, positive cash flow and earnings momentum. This trend is illustrated by value’s rapid regression to the mean (Exhibit 2) over the past nine months. The longer-term reality of the marketplace has

Exhibit 1: Stock Selection Factors (Canada) — Best and Worst Performers for August 2009 Earnings growth

Quarterly Cash Flow Quarterly Dividends

Valuation Earnings growth

Book/Price 2-Year EBITDA Growth EBITDA/Enterprise Value

Valuation

Earnings Surprise

Street research Management signals Technicals Street research Valuation

Share Repurchase 6-Month Price Momentum Analyst Agreement Price/Earnings Low Leverage

Financial strength

Interest Coverage

Earnings growth

Analyst Estimate Revision

Technicals Financial strength

11-Month Price Momentum

Valuation

Dividend Yield

Size

Size

Return on Equity

-8%

-6%

-4%

-2%

0%

2%

4%

6%

Exhibit 1 shows the performance of our broader set of common factors in Canada. Across all these factors, the sharp shift from momentum to value outperformance that started mid-March continued through August. The best performers for the month were deep value factors with a focus on accelerating cash flow and profitability, such as Quarterly Cash Flow, Quarterly Dividends and Book to Price. Momentum and Quality factors (Analyst Agreement, 11M Price Momentum and Analyst Estimate Revision, Return on Equity, Size) continued to underperform in August. Factor Focus

1

Factor Focus reasserted itself. The extremely wide valuation spread which prevailed between the most attractively and least attractively valued stocks (Book-to-Price) on the S&P/TSX composite index in 2008 and into 2009 has narrowed to the long term mean. In the past nine months, the spread blew out to almost four standard deviations above the mean as beaten down stocks rallied. Our research shows that these valuation extremes typically coincide with periods of economic uncertainty and recession, and that spikes in valuation spreads also tend to coincide with market bottoms. It is also evident that valuation extremes tend to regress to their mean rather quickly.

Exhibit 2: S&P/TSX Valuation Spread -Top Book/Price minus Bottom Book/Price (As at August 31, 2009) 4.0

Valuation extremes coincide with periods of economic uncertainty and recession 3.5

Spikes in valuation spreads also tend to coincide with market bottoms Valuation extremes tend to correct rather quickly

3.0 2.5 2.0

1 Sigma 1.5

Mean

1.0 0.5

1 Sigma Jun-09

Jun-08

Dec-08

Jun-07

Dec-07

Dec-06

Jun-06

Dec-05

Jun-05

Jun-04

Dec-04

Jun-03

Dec-03

Jun-02

Dec-02

Dec-01

Jun-01

Dec-00

Jun-00

Jun-99

Dec-99

Jun-98

Dec-98

Jun-97

Dec-97

Dec-96

Jun-96

Dec-95

Jun-95

Jun-94

Dec-94

Jun-93

Dec-93

Dec-92

0.0

Source: Genus Institutional Equity

Exhibit 3: U.S. S&P 500 Versus Risk Index (As at August 31, 2009) 20%

20% 10% 10%

Risk Index

0%

0%

-1 0 % -10%

-2 0 % -20%

Risk Index Recovers

Exhibit 3 shows that the S&P 500 Risk Factor Index (Leverage, Volatility, Earnings Variation), which was oversold as a result of investor fear in the bear market, has --40% 40% bounced back. The Risk Factor Index is positively correlated with the performance of the market and shows that as the --50% 50% market recovers, risk-taking has bounced back. -30%

-3 0 %

S&P 500

-60%

-6 0 %

-70%

-7 0 %

Jan 07

Jun 07

Jan 08

Jun 08

Jan 09

Jun 09 Source: Genus Institutional Equity

Factor Focus is published monthly by Genus Institutional Equity, a division of Genus Capital Management 6th Floor ~ 900 West Hastings St., Vancouver, BC, Canada V6C 1E5 T 604 683 4554 [email protected] ie.genuscap.com