This Fund Looks Beyond Accounting Earnings to Find Value
November 27, 2018
•6 min read
We’ve long argued (and proven empirically) that there is a strong correlation between improving ROIC and increasing shareholder value. Nevertheless, the majority of mutual fund managers continue to pick stocks based on flawed metrics such as price-to-earnings ratios, return on equity, or accounting book value.
We recommend avoiding funds with managers who consider accounting earnings as representative of “fundamentals”. Instead, look for managers that not only talk about cash flows and return on invested capital (ROIC)[1], but use them in their investment process
We analyze[2] these metrics for all the holdings of over 7,500 U.S. ETFs and mutual funds daily to identify which fund managers put their analytical money where their mouth is. Occasionally, we come across a fund whose managers diligently leverage ROIC in their investment strategy. This week we are featuring one such fund, the MainStay Epoch U.S. Small Cap Fund (MOPRX), as this week’s Long Idea.
Backwards Looking Research Underrates this Fund
MOPRX has underperformed its benchmark, the iShares Russell 2000 ETF (
As the fund has allocated more to higher rated stocks, the fund has grown more attractive. However, backward looking fund research cannot identify such a change, as evidenced by the disconnect in ratings in Figure 1. In late September, MOPRX was upgraded to an Attractive rating, and then upgraded again to a Very Attractive rating on October 5, 2018. Higher quality holdings and below average costs mean MOPRX is more likely to outperform moving forward, something traditional fund research can’t tell you.
Figure 1: MainStay Epoch U.S. Small Cap Fund Ratings
Image Source: New Constructs, LLC
Sources: New Constructs, LLC and company filings
Holdings Research Reveals Stock Methodology Based on ROIC
MOPRX’s subadvisor, Epoch Investment Partners, uses an investment philosophy that recognizes the flawed nature of accounting earnings, noting:
“The key to understanding a company requires a focus on the cash generation drivers of the business, not a focus on accounting terms like earnings or book value.
Furthermore, the company believes that ROIC is correlated with increasing value:
“If a company can invest, either internally or in an acquisition, and generate a marginal return on invested capital that is greater than its marginal cost of capital, then making that investment will increase the value of the business.”
This investment philosophy, along with a process that assesses the quality of earnings, helps Epoch, and MOPRX, pick higher quality stocks and avoid riskier stocks compared to its peers. Figure 2 shows that MOPRX allocates a higher percentage of its assets to Attractive-or-better rated stocks and a lower percentage to Unattractive-or-worse rated stocks than its benchmark, the iShares Russell 2000 ETF (IWM).
Figure 2: MOPRX Asset Allocation Compared to IWM
Image Source: New Constructs, LLC
Sources: New Constructs, LLC and company filings
Per Figure 2, MOPRX allocates 16% of its assets to Attractive-or-better rated stocks compared to just 9% for IWM. On the flip side, MOPRX allocates 31% of its assets to Unattractive-or-worse rated stocks compared to 44% for IWM.
Given this favorable allocation relative to the benchmark, MainStay Epoch U.S. Small Cap Fund appears well positioned to capture more upside with lower risk. Compared to the average mutual fund, MOPRX has a much better chance of generating the outperformance required to justify its fees.
Superior Stock Selection Drives Superior Risk/Reward
With a focus on ROIC and cash generation, one would expect MOPRX’s managers to excel at finding higher-quality companies (as measured by ROIC) with lower-risk valuation. Per Figure 3, they do just that.
Figure 3 contains our detailed rating for MOPRX, which includes each of the criteria we use to rate all funds under coverage. These criteria are the same for our Stock Rating Methodology, because the performance of a fund’s holdings equals the performance of a fund after fees.
Figure 3: MainStay Epoch U.S. Small Cap Fund Rating Breakdown
Image Source: New Constructs, LLC
Sources: New Constructs, LLC and company filings
As Figure 3 shows, MOPRX’s holdings are superior to IWM in three out of the five criteria (and equal in one) that make up our holdings analysis:
- The return on invested capital (ROIC) for MOPRX’s holdings is 16%, more than three times higher than the 5% ROIC earned by companies held by IWM.
- The price to economic book value (PEBV) ratio for MOPRX is 2.1, while the PEBV ratio for IWM is 3.2.
- Our discounted cash flow analysis reveals an average market implied growth appreciation period (GAP) of 28 years for MOPRX holdings compared to 37 years for IWM.
Ultimately, the stocks held by MOPRX generate superior cash flows compared to IWM, yet the market projects IWM stocks to grow profits by a larger amount and for a longer period of time.
Deep Dive on a Quality Holding
We can see how MOPRX’s methodology leads it to pick high-quality stocks by looking at one of its holdings, PetMed Express (
PETS meets many of the criteria that drive MOPRX’s investment decisions. Its 78% ROIC (up from 39% in 2014) puts it in the top quintile of all 2,800+ companies under our coverage. Over the past five years, it has generated $105 million (17% of market cap) in free cash flow and currently earns a 6% FCF yield.
At its current price of $30/share, PETS has a price-to-economic book value (PEBV) ratio of 0.9. This ratio means the market expects PETS’ NOPAT to permanently decline by 10%. This expectation seems overly pessimistic for a firm that has grown NOPAT by 15% compounded annually over the past five years and 7% compounded annually over the last decade.
If PETS can maintain TTM NOPAT margins of 13% and grow NOPAT by just 6% compounded annually for the next decade, the stock is worth $49/share today – a 65% upside. See the math behind this dynamic DCF scenario here.
Given the stock’s strong fundamentals and cheap valuation, it makes sense for MOPRX to overweight PETS compared to its benchmark. We featured the excellent risk/reward of this stock in our Long Idea report “Ahead of the Curve.”
By utilizing ROIC as part of its methodology and focusing on cash generation, not accounting earnings, MOPRX is able to identify highly profitable companies trading at large discounts to their fair value, such as PETS.
Below Average Costs Benefit Investors
Not only does MOPRX offer high-quality stock selection, it does so at a reasonable price. The fund’s total annual costs of 1.51% make it cheaper than 54% of the 844 Small Cap Blend mutual funds that we cover. Its costs are also below the Small Cap Blend mutual fund average of 1.74% but above the asset-weighted average of 0.95%.
The Importance of Holdings Based Fund Analysis
While it is easy to pick a 5-Star rated fund from Morningstar, research shows such a strategy has risks and does not necessarily lead to outperformance. Smart fund investing means analyzing the holdings of each fund. Unfortunately, most investors do not realize they can get high-quality research on fund holdings and are content with investing based on past performance.
Our Robo-Analyst technology analyzes the holdings of all 892 ETFs and mutual funds in the Small Cap Blend style. The number of holdings in these ETFs and mutual funds varies from just 23 stocks to 3,266 stocks in a given fund. Our diligence on fund holdings allows us to find mutual funds, like MOPRX, with a portfolio that suggests future performance will be strong.
This article originally published on October 12, 2018.
Disclosure: David Trainer, Kyle Guske II, and Sam McBride receive no compensation to write about any specific stock, style, or theme.
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[1] Ernst & Young’s recent white paper “Getting ROIC Right” proves the superiority of our holdings research and analytics.
[2] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.
David Trainer
New Constructs leverages reliable fundamental data (https://bit.ly/381hKF1) to provide unconflicted insights into the fundamentals and valuation of private and public businesses. Combining human expertise with cutting-edge machine learning (ML) technologies (featured by Harvard Business School: https://hbs.me/308BaTX), the firm shines a light in the dark corners (e.g. footnotes) of hundreds of thousands of corporate financial filings to reveal critical details that drive uniquely comprehensive and independent credit and equity investment ratings, valuation models and research tools.
The Journal of Financial Economics (https://bit.ly/3q6G8LI) reveals:
1. Legacy fundamental datasets suffer from significant inaccuracies, omissions and biases.
2. Only our “novel database” enables investors to overcome those flaws and apply reliable (https://bit.ly/303iuoQ) fundamental data in their research.
3. Our proprietary measures of Core Earnings (https://bit.ly/3bQVrD9) and Earnings Distortion (https://bit.ly/3uJkrF3) materially improve stock picking and forecasting of profits.
Harvard Business School and MIT Sloan are not the only institutions to write papers on the superiority of our data and research. Find more papers here (https://bit.ly/3uGW0Ih).
Now, all investors, not just Wall Street insiders, can access trustworthy research on the earnings and valuation of stocks, bonds, ETFs, and mutual funds. Elite money managers, advisors and institutions have relied (https://bit.ly/3sCT2mj) on us to lower risk and improve performance since 2004. See our client testimonials (https://bit.ly/3dZaa1G) and media coverage (https://bit.ly/3sxYDu2).
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