Sorting And Digging

December 15, 2010

Sorting And Digging

Most of traditional securities analysis falls into one of two areas—sorting or digging. Sorting consists of assigning stocks to classifications, groups or categories; digging involves delving into the financial, legal or operational details one company at a time.

Sorting begins when securities are divided into asset classes. Most investors believe that stocks are different from bonds, have different risks and returns, and usually behave differently. Any two stocks are likely to be more similar to one another than a stock is to a bond. This illustrates a key aspect of sorting: Two securities in the same category have less variation than two securities in different categories. While asset classes may be obvious, things become more interesting and useful when we divide stocks into style (growth and value); size (large, mid and small); or sectors. Most broad-based indexes sort stocks by style, size and sector. Further divisions are often included, such as more narrowly defined industries, style versus pure style or financial measures such as dividend yield.

Since the ultimate objective is to understand why some stocks perform better than others, a successful categorization should tell us something about past returns and risks at different periods of time. Unfortunately, a categorization of stocks—like all other securities analysis—cannot provide truly reliable predictions of future returns. Of course, that doesn’t stop analysts from trying. The three categorizations mentioned—style, size and sector—are the most oft-used sorts. These weren’t just the creation of index providers searching for more ways to slice and dice their indexes; rather, they are the result of an established and still-growing body of literature on comovement; that is, how some groups of stock tend to comove or move together.

The basic concept behind comovement is that fundamental factors such as earnings, capital structure or a company’s business model determine a stock’s underlying value. If one brings together a group of stocks with similar fundamentals, the stocks should have similar risks and returns. Dividing stocks into growth and value, usually done with various financial measures such as price-to-book value, dividend yield or others, is one example. Some fundamental factors such as earnings per share or dividends are easy to measure, others such as industry supply conditions or shifts in demand for a group of products are harder to identify and quantify.

One way to deal with hard-to-measure factors is to find an easy-to-measure proxy such as what industry a company is in. Grouping stocks by sector or industry works in the sense that stocks within a sector are more alike than stocks in different sectors. Another example of a proxy measure is size. Small-cap stocks often behave differently than large-cap stocks; one group may rise when the other falls. While there are lots of ideas about why small-caps don’t mimic large-caps, the key idea is that size can be a useful way to classify stocks.

All these sorts relate, more or less, to some fundamental factor affecting a stock’s returns. However, comovement can be a useful tool to examine situations where other, nonfinancial or noneconomic, factors are involved. One that should be familiar is home-country bias—despite globalization, many investors prefer stocks in their home market and therefore grouping stocks by nationality is common. Another might be whether the stock is listed on the NYSE or Nasdaq, even though the listing requirements can be quite similar. A more reasonable, and more studied, factor in stock performance is the extent of analyst coverage and the speed with which news about a company spreads through the markets. Widely followed stocks are heavily analyzed and discussed, while stocks with little analytical coverage are sometimes seen as either undiscovered gems or ignored for good reason. A lack of notoriety could be seen as a plus or a minus.

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