[12/24/20] 2020: Four Myths Busted

2020 was a calamitous year, but you know all about that. What you may not know is that four widely held beliefs among investors were empirically debunked in 2020. Here they are:

ESG Is Not An “Equity Vaccine.”

ESG (corporate environmental, social, and governance activities) is widely touted as “the best of all worlds.” Not only does it benefit the environment and society, it’s also good for shareholders. Thus, for example, Morningstar referred to ESG as an “equity vaccine” against the pandemic crash, claiming that 24 of 26 ESG-titled index funds outperformed their closest conventional counterpart funds. BlackRock (BLK) reported superior performance across sustainable investment products globally. And MSCI (MSCI) claimed that all four of their ESG-oriented indices outperformed the broad market.

Well, not so fast. With three capable colleagues, I examined the returns on all U.S. stocks in the height of the pandemic: January through March of 2020. (See “ESG Didn’t Immunize Stocks Against the Covid-19 Market Crash,” by Demers, Hendrickse, Joos, and Lev.) When we just correlated stocks’ returns (market performance) during the first three months of 2020 with the ESG ratings of the issuing companies, we found a positive, though not very high, correlation, seemingly supporting the claim that ESG was a “covid vaccine.” However, when we did a more serious research, adding ESG ratings to various corporate attributes, such as liquidity, profitability, debt, etc., ESG lost completely its statistical significance. In fact, relative to other factors, particularly investment in intangibles, ESG contributed a trifling 1% to stock performance during the height of covid. In the second quarter of 2020, ESG was negatively correlated with returns.

How can this be? Simple. Financially solid, intensely innovating, and profitable enterprises performed well in the covid peak months, but these same companies also tend to engage in ESG activities. So it’s the financial position, investment in intangibles, and performance of firms that determine their stock performance. ESG is just a byproduct; it’s not a casual factor.

Accounting (GAAP) Earnings Still Don’t Matter.

I have written in my blog several times about the irrelevance of the accounting system in the 21st century and devoted a whole book to empirically proving this claim. Nevertheless, some people are still skeptical, particularly about the irrelevance of GAAP earnings (net income). “How can this be?” some readers ask. “We know that ‘earnings move markets.'”

To prove the irrelevance of GAAP earnings, my coauthor Feng Gu and I resorted to the “ultimate proof.” If earnings, as accountants tell you, reflect enterprise performance and growth potential, then predicting companies with superior earnings and investing in them prior to the earnings release should be a winning investment strategy. Well, this can be empirically tested.

For all listed companies over the past 40 years we identified all the companies that exactly met or, better yet, exceeded the consensus quarterly earnings forecast – an indicator of great earnings. We then measured the performance of an investment strategy that invested in the stocks of these “winners” two months before quarter-end, and liquidated the investment a few days after the quarterly earnings release. That is, we measured the performance of a perfect-prediction (of companies’ forthcoming earnings) investment strategy. The following figure portrays the yearly average gains of this perfect-prediction investment, which essentially tests the ability of accounting earnings to truly reflect enterprise performance.Abnormal returns from perfect prediction of consensus meets or beats: 1986-2019

Source: Baruch Lev and Feng Gu

As you clearly see, the perfect-prediction investment strategy would have been highly successful in the 1980s, when accounting earnings were still meaningful measures of performance, but the strategy’s yield gradually collapses thereafter. For the reasons for this “earnings fall from grace,” you have got to read The End of Accounting over the holiday break. Today, as the figure indicates, even a perfect prediction of all the companies that will meet or beat consensus analysts’ earnings forecasts – an impossibility – will yield a trifling 1.3%. Accounting (GAAP) earnings are obviously irrelevant to investors.

Value Investing Is Still Moribund.

Anup Srivastava and I shocked last year’s proponents of “value investing” – buying low-valuation stocks and shorting high-value equities – by showing that this highly popular and widely touted investment strategy has lost its edge since the late 1980s, and not as generally believed only in the past 10 years. We provided an explanation for value investing’s fall from grace (see our paper “Explaining the Recent Failure of Value Investing”).

Some ardent believers (and vendors) of value investing have suggested that the strategy will work well during market crashes, particularly because shorting the declining high-value stocks will be rewarded during the crash. Reality, however, has turned out differently. Comparing the performance of three value indices (Russell 3000 Value Index, S&P 500 Value Index, and Vanguard Value ETF) with that of the Nasdaq Index – an indicator of growth stocks – over the first 10 months of 2020 indicates that investing in “value stocks” and shorting “growth stocks” would have yielded losses of between 24.5% to 43.0%, depending on the specific index.

Thus, despite fervent hopes of some, it appears that value investing is still moribund.

Nasdaq’s Recent Diversity Push Is Questionable.

Recently, Nasdaq’s management proposed strict board diversity rules for Nasdaq-listed companies. This is obviously not the place to comprehensively examine all the aspects and consequences of board diversity. But being an empiricist, I couldn’t resist examining the relationship between the extent of board diversity and stock performance during the first half of 2020 – the covid crash and subsequent recovery.

Measuring board diversity by a widely used indicator (Refinitive), and adding it to a financial model explaining stock performance, I find:

  1. Board diversity did not affect (was statistically insignificant) stock performance during the crash of the first three month of 2020, nor did it affect stock performance during the recovery period: April to June 2020.
  2. More broadly, over the 10-year period 2010-2019, board diversity did not significantly contribute to stocks’ alpha (abnormal returns).

Have a great 2021!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Note: This post was first published here at SeekingAlpha.com on Dec. 24, 2020.


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