Are fundamentals being rewarded in stock selection in the post-COVID period?

Based on the results of our MAER stock selection model, the answer has been “yes” since the end of the “COVID year” of 2020.

There has long been a debate about the degree to which stock prices reflect trends in underlying fundamentals (corporate earnings) or are driven by non-fundamental drivers like speculative trading, index fund flows, corporate buybacks, etc. And of course, the answer is always “a mix of all of that”, but these various factors vary in their influence at different points in time.

The fact that it is all but impossible to definitively attribute stock returns to any single driver most of the time (an unexpected tender offer for a company might be an exception) has not stopped many researchers from trying, or stopped investors from making their own assumptions.

One possible way to try to answer this question of “are stocks behaving as they ‘should’?” is to have a model of how stocks “should” behave based on prior research into the drivers of stock prices over time, and then see if stock returns do in fact behave in line with that model or not. If we conclude that stock prices are following long-established company-specific fundamentals like earnings trends, valuations, and price trend, then that would describe what I would call a “normal bottom-up driven market”.

The alternative might be an environment in which company fundamentals and valuations do not appear to be the drivers of returns, but instead either “speculative” forces that are unrelated to fundamentals (e.g. “meme stocks”, or movements caused by leveraged trading or margin calls) are the driver, or “top-down” macro influences (e.g. “risk on/risk off” and/or big monetary or fiscal policy changes) are the driver. The top-down influence can even include direct buying by central banks or other official, price-insensitive activity (this is not normally done in the US but is in other countries at times, including Japan and Switzerland).

Using our MAER model as a proxy for “rewarding fundamentals”

So while this is clearly a complex topic that cannot be covered in depth here, one way to address it is to use Mill Street’s long-standing MAER stock selection model as one proxy for whether stocks are following company-specific fundamental trends (which drive the MAER rankings) or are instead being more influenced by “top-down” or non-fundamental forces.

The “MAER” moniker is acronym of the tool’s original name, the Monitor of Analysts’ Earnings Revisions, and thus reflects the primary driver of the model: revisions (updates) to the company earnings estimates published by equity analysts at brokerage firms worldwide. A brief summary of MAER is available here.

That is, the model’s biggest driver is a company’s “fundamental momentum”, or the direction and magnitude of revisions to earnings forecasts. Any unexpected “good news” about a company’s fundamental earnings outlook will be reflected in changes to analyst earnings forecasts, and the same is true for unexpected “bad news”. And the research shows that such changes to future earnings forecasts tend to move in persistent trends that last for months at a time (once analysts start raising estimates, they often keep doing so for months, and vice versa).

So a key underlying assumption of our model is that investors respond to changes in earnings estimates (increased EPS estimates cause a rise in a stock’s price, and vice versa), which we find is indeed true most of the time.

But earnings estimate changes are not the only driver of returns, and the MAER model includes two other well-established factors: valuations and price trends. If all else is held equal (a big assumption!), then cheaper stocks should tend to outperform more expensive stocks, as the expensive ones essentially have more of the potential future good news already priced in. So the MAER model looks for stocks with lower estimated price/earnings ratios, based on both the absolute P/E and the P/E relative to its own historical range (relative P/E).

Price trend and momentum is the third well-known driver of returns, and one which captures investor behavior, i.e., the tendency for investors to over-react and under-react to news, causing intermediate-term trends (persistence in returns) and short-term mean-reversion (counter-trend behavior). These tendencies have been well studied for many years and we have our own proprietary implementations in the MAER model that look for positive risk-adjusted six-month returns and negative short-term (one-month) performance to capture the mean-reversion tendency.

So MAER look for these key factors to rank stocks highly: strong earnings estimate revisions, strong intermediate-term price trend and a short-term pullback, and low absolute and relative valuations. The reverse would identify unattractive stocks in MAER. The key point is that all of these drivers are specific to each individual company, and do not include any top-down macro influences like interest rates, economic data, commodity prices, etc.

If highly-ranked stocks in MAER outperform low-ranked stocks, then that implies that company-specific fundamentals and price activity are indeed driving returns. If the MAER rankings are unrelated to future returns, or are inversely correlated (low-ranked stocks outperforming), then it is likely an environment where company fundamentals are not being rewarded, or at least are not reflected in earnings estimates and valuations.

So . . . what do the results show??

Our studies use a simple test of the MAER rankings for the constituents of the US Russell 1000 index (large and mid-caps) based on their actual historical constituents and rankings, rebalanced at the start of each month to hold the top 40 ranked stocks (“Buy Ideas”) or the bottom 40 ranked stocks (“Avoid Ideas”). The 40 stock hypothetical portfolio size was chosen because we feature 40 stocks in each month’s report to clients, but we get similar results for other portfolio sizes.

The chart below shows the cumulative hypothetical returns to the top-ranked and bottom-ranked stocks in the period since the start of 2019. This captures the pre-COVID year of 2019, the 2020 “COVID year”, and the 3+ years since then.

Source: Mill Street Research, Factset

The basic result is that MAER has worked well outside of the COVID year of 2020, but did poorly in that year. The main driver of the poor relative return performance in 2020 was not the Buy Ideas doing badly, but the Avoid Ideas (low-ranked stocks) doing extremely well, and outperforming the Buy Ideas for a while. Note that while stocks did fall sharply in March/April of 2020, much of the unusual relative performance trends occurred in the rest of the year when stock prices were volatile but mostly going up. That is, disruptions to the usual drivers of stock returns are not restricted to bear markets, but can also often occur in the immediate aftermath of market declines.

This is in fact consistent with our earlier studies, which showed that investors may not “follow the fundamentals” in extremely volatile market periods, especially those where “macro” influences like the Fed, fiscal policy, or other extreme external events are dominant. The year 2020 certainly fit that bill, with the combination of COVID arriving and causing stocks to plunge, then a dramatic rally when monetary and fiscal stimulus was implemented, led by “stay at home” stocks and other perceived COVID beneficiaries. Then in November the COVID vaccine results from Pfizer were announced and surprised everyone with both their speed and efficacy, causing a dramatic reversal in the relative returns: all the stocks that had been pummeled by COVID restrictions (travel and leisure, restaurants, etc.) all suddenly soared while the “stay at home” stocks lagged.

Those dramatic shifts in market direction and relative leadership within the stock market are exactly the type of reasons that investors will temporarily not respond to traditional company fundamentals or maintain persistent price trends. So 2020 was clearly a year when traditional fundamentals were not the driver of relative stock returns, and everything was driven by macro views and headlines about COVID and the policy responses to it.

But starting in 2021, the influence of COVID and policy on markets started to ease, and investors returned to focusing on the fundamentals captured by our MAER model. Since the start of 2021, highly-ranked stocks have dramatically outperformed low-ranked stocks: top-ranked stocks rose at a 23.7% annualized rate compared to a -1.5% annualized return for bottom-ranked stocks*. This implies that individual company fundamentals and price trends were important drivers again starting in 2021. This has continued into 2024, and we might expect it to continue as long as no new major global or US policy shocks appear (though the November election is a possibility).

While this result does not mean that the stock market has been easy to beat in recent years, due in part to the difficulty that large fund managers have in beating a cap-weighted benchmark index like the S&P 500 when a small number of mega-caps (some of which could be described as “magnificent”) have driven much of the performance. But highly ranked stocks have beaten the index since the start of 2021, and low-ranked stocks have lagged, and thus we can argue that investors have indeed rewarded companies with improving fundamentals, supportive price trends, and reasonable valuations on average in recent years. And because our hypothetical portfolio results are equal-weighted (not cap-weighted), the influence of a few mega-caps is drastically reduced.

Conclusion

The bottom line is that investors do tend to reward stocks with good or improving fundamentals and price trends most of the time, but in certain extraordinary times like COVID (2020) or the Great Financial Crisis (late 2008/early 2009), investors do not follow fundamentals and instead focus only on “risk on/risk off” or whatever top-down forces are dominating the headlines. This pattern shows up clearly in our studies of the performance of our MAER ranking model (and likely for other similar types of stock selection models as well): a general trend of outperformance by high-ranked stocks interrupted by occasional sharp reversals when low-ranked stocks suddenly outperform for a little while, before returning to lagging again.

We have other tools like our Global Equity Risk Model to help gauge the risk of such volatile, macro-driven conditions, but extreme market volatility with dramatic reversals are generally the signs to watch out for. Outside of such times, our work tells us that it (still!) pays to follow the fundamental and behavioral trends that investors focus on.

Sam Burns, CFA

Chief Strategist

* Note: returns cited are backtested and purely hypothetical. Mill Street Research does not manage money and thus nothing here reflects any actual trading results: these are purely hypothetical results for informational purposes only, are not meant as complete portfolios, and do not include important considerations such as transactions costs, taxes, liquidity and other factors. Past performance is no guarantee of future results.