Genus Factor Focus - July 2009

Factor Focus Vol. 1, No. 04 — July 2009

Risk continues to drive market surge A

fter another strong month, deep value remains the dominant investment strategy year-to-date. Deep value and risk attributes have consistently led the market since March. They paused briefly in May when value based strategies emphasizing earnings outperformed. We expect that deep value and risk will continue to dominate, with volatility persisting for the remainder of the year, although its magnitude will begin to moderate.

Overall, the performance of stock selection strategies continues to be characterized by extremely negative returns from momentum and extremely positive returns from value strategies emphasizing cheapness. Among the value factors we follow, the best performers so far in 2009 are Book to Price, EBITDA to Enterprise Value and Dividend Yield. These factors typically outperform by the widest margin in the early stages of an economic recovery. The excessive outperformance of deep value, risk and high leverage should begin to wane as the economy stabilizes and investors gain confidence in fundamentals and switch their focus to high-quality stocks, earningsdriven valuations and positive long-term price momentum. For the long-term, the most attractive valuation factors from a reward to risk perspective are Return on Equity, Price to Earnings, and Earnings Growth, which have also outperformed so far this year.

Exhibit 1: Stock Selection Factors (Canada) — Best and Worst Performers for July 2009 Valuation

Dividend Yield

Earnings growth Valuation

Quarterly Cash Flow

Earnings growth

2-Year EBITDA Growth

Book/Price Share Repurchase

Management signals Size

Size

Valuation

EBITDA/Enterprise Value Price/Earnings

Technicals

6-Month Price Momentum

Financial strength Street research Financial strength

Return on Equity Analyst Estimate Revision Interest Coverage

Earnings growth Technicals Financial strength

11-Month Price Momentum Low Leverage

Street research

Analyst Agreement

Quarterly Dividends

Earnings Surprise -5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

Exhibit 1 shows the performance of our broader set of common factors in Canada. Across all these factors, the shift from momentum to value outperformance that started mid-March continued through July. The best performers were deep value factors with a focus on cheapness rather than earnings and profitability. The month’s best performers were Dividend Yield, Quarterly Cash Flow and EBITDA to Enterprise Value. Momentum factors (Earnings Surprise, Analyst Agreement, 11M Price Momentum and Analyst Estimate Revision) continued to underperform in July. Factor Focus

1

Factor Focus

Rationale behind our factor performance research

O

ur research into factor performance in Canada is designed to determine which common factors (stock characteristics) drive returns in the market place. It does not focus on the overall movement in the S&P/TSX composite index, which is dominated by large cap names such as RIM, banks and oil companies. If we look at index movers at any time, large cap names often are in the top or bottom 10. This does not tell us much about what is actually driving returns; big cap names can make either list simply by virtue of their size, and their ability to move the market. Our approach to factor research starts with a multivariate regression analysis, with all stocks in the index weighted equally. We take into account stock returns, industry returns and individual risk factor exposures such as value, leverage, growth, etc. The resulting coefficients reveal the direction in which these factors drive “stock returns” in the market and their magnitude. For example, if we examine the S&P/TSX index’s top

10 stocks based on actual second quarter “returns”, we see a completely different list of names (Exhibit 2) compared to the index’s major points movers. These names are generally risky and low quality. Their 2008 relative performance to the market is testimony to this fact.

Exhibit 2:

Stock Returns

Teck B

163%

Thompson Creek

140%

Gerdau

111%

Trinidad Drilling

99%

Pacific Rubiales

96%

Addax

80%

FNX

78%

Sherritt

78%

Celestica

77%

Precision Drilling

76%

Since we remove the industry effect, if we consider Royal Bank’s 29% return in the second quarter, it underperformed the TSX Financials index, which returned 33%. In another words, from a factor perspective, lower quality names with higher risk performed better than Royal Bank in the second quarter.

Exhibit 3: Genus Canadian Value Combo Versus Momentum Combo (3M rate of change as at July 31, 2009) 80 60

5 Sigma

40 3 Sigma

20 0

Mean

-20 -40 -60 -80 Apr 93

Apr 94

Apr 95

Apr 96

Apr 97

Apr 98

Apr 99

Apr 00

Apr 01

Apr 02

Apr 03

Apr 04

Apr 05

Apr 06

Apr 07

Apr 08

Apr 09

Exhibit 3 shows the extreme outperformance of value factors versus momentum factors in the past three months as investor appetite for risk was marked by a massive and rapid change in preference toward deep value stocks that previously had been beaten down in price. That preference moderated dramatically in July. Source: Genus/BARRA 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