At A. Stotz Investment Research we look at investing through our FVMR framework: Fundamentals, Valuation, Momentum, and Risk. To come up with investment strategies for portfolios that should generate above-benchmark return we do a lot of backtesting. Below you can see a few factors that we consider when we look at the Risk of an investment.
We previously tested a Fundamentals factor, return on assets, in Investing Is Not Just Buying Highly Profitable Companies, a Valuation factor, price-to-book, in Dirt Cheap Stocks Are Too Risky, and Momentum in Momentum Is a Good Start to Beat the Market. In this post, we will test a Risk factor: gearing.
Investing in stocks with low gearing (net debt-to-equity) generates outperformance.
When backtesting, you should use original statements (and not re-stated) to avoid hindsight bias. When you backtest you also need to know and adjust for when a company closes its books. A company may close its books in December but that data is only available some months after on the announcement date. Focus on the announcement date when you backtest.
By looking at the chart below it doesn’t look like investing in low-gearing companies is a winning strategy. Gearing and return seem to be unrelated.
Adjusting for risk does not make any difference if anything it makes the outcomes look even less related.
We can’t find any support for our hypothesis that low-gearing companies would generate higher return. Investing based only on low gearing doesn’t work.
It’s not uncommon when backtesting that you find that a factor doesn’t work. If you want to see a single factor that actually works quite well, check out: Momentum Is a Good Start to Beat the Market.
What do you think about these findings on gearing? Did you expect another outcome?
Share your ideas and experience in a comment below.