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Summary In honor of the closure of Grantland, an application of sports analytics to portfolio management. In basketball, a long two-point shot is inefficient with a low average return and high variance of returns. This article looks at three similar investment classes in financial markets that similarly produce lower expected returns over time. The news late Friday of ESPN’s shuttering of sports and pop culture website Grantland was disheartening. I liked the mix of long-form journalism and irreverent pop culture topics from a diverse array of skilled young writers, but particularly I loved the articles on deep, and often arcane, sports analytics. As someone with post-graduate studies in analytic finance, the combination of Big Data and some of America’s pastimes spoke to me. Growing up in basketball-crazed Indiana, the articles from Grantland’s Kirk Goldsberry and Zach Lowe allowed me to watch a game I have had a life-long passion for in new and unique ways. One of the simplest and most frequent basketball-related discussion was the inefficiency of the “Long 2”, two-point field goal attempts from just inside the three-point line. A slightly above-average 3-point shooter making 40% of his shots could more than offset a skilled big man making 55% percent of his shots close to the basket. The 1.2 points-per-shot from the 3-point specialist outscored the 1.1 points-per-shot from the post player. The 3-point shooter will score more points on average over time, but of course, sample sizes are not unlimited in a came with a clock. Borrowing from finance, the three-point shooter has higher average returns, but more variable returns from the more difficult shots. If those long shots are not going in with enough frequency, a more steady point scorer can outperform over shorter stretches of time. Now imagine a jump shooter who typically takes long two-point shots, and makes 45% of the shots on average, more than the 3-pt shooter but less than the close range scorer. That shooter scores just 0.9 points per shot. Basketball coaches have realized these shots are inefficient. For investors, these long two point shots with lower expected returns per unit of risk can be said to be below the efficient frontier. In the spirit of Grantland and the inefficiency of the Long 2, I am going to cover three equivalencies in the world of finance, investments that do not offer requisite returns for their relative riskiness. Low Rated Junk Bonds When we learn the Capital Asset Pricing Model in school, we are taught that required returns are proportional to an asset’s (non-diversifiable) risk. The limits of this model can be seen on a basketball court. As you move further away from the basket, your shooting percentage is not going to fall linearly. If you hit 80% of your free throws from 15 feet away from the basket, you are less likely to hit 40% from 30 feet from the basket (8 feet behind the NBA 3-point line) and are even less likely to hit 20% from 60-feet from the basket, or two-thirds of length of a professional court. This analogy can be applied to the debt of corporations. Imagine you are getting paid 5% returns to lend to a company with leverage (Debt/EBITDA) of 3 times. Even if yields paid to investors did rise linearly per unit of leverage (they do not), if you expected to earn 15% returns lending to companies with nine times as much debt as their earnings, you are employing a strategy akin to shooting sixty-footers every time down the court. The only exception is in this example, you can actually see points reduced from your scoreboard in the likely scenario that the 9x levered company goes bankrupt, liquidates its assets, and pays a recovery to bondholders less than the price at which you purchased the securities. Over long-time intervals, it has been shown that buyers of BB-rated bonds (the highest quality junk bonds) outperform buyers of lower rated, higher yielding single-B and CCC-rated bonds. You just aren’t getting paid enough for those more risky shots. For additional evidence of this phenomenon, see: The Low Volatility Anomaly: A High Yield Bond Example or The Winning Trade in High Yield Corporate Bonds High Dividend Stocks Research has shown that stocks paying dividend yields between three to six percent produce higher absolute returns than stocks with yields above six percent. Dividend yields above this threshold are usually a function of lower stock prices and not necessarily higher payouts as the market begins to reflect concerns about the company’s business profile. Companies that are generating enough stable cash flow to support this dividend level could also be signaling to the market that they do not have sufficient internal investments to drive the value of the firm prospectively. S&P 500 companies that have dividend yields above this 6% threshold include businesses from the secularly declining wireline telecom industry – Frontier Communication (NASDAQ: FTR ) and CenturyLink (NYSE: CTL ). Seagate Technology (NASDAQ: STX ), a make of hard drives, would also fit into this declining business model archetype. To me these types of stocks are the Kobe Bryant’s of the investing world. CenturyLink delivered 30% annual returns from 1995-1999. Frontier put up an MVP-like 77% return in 1999. Seagate averaged 20% returns from 2003-2007. These are former all-stars, but their best days may well be behind them. Investors attracted to the flashy dividend yield may see a star, but not recognize that the future is not nearly as bright as the past. For additional evidence on the relative underperformance of high dividend yielding stocks: The Dividend Sweet Spot High Beta Stocks One of my most common themes on Seeking Alpha has been the Low Volatility Anomaly, or why lower risk investments have outperformed their higher risk cohorts. An example of this phenomenon was discussed in the junk bond/sixty-footer analogy. Across markets, geographies, sectors, and time, lower volatility investments have produced higher returns per unit of risk than higher beta investments. Similarly, there have been plenty examples of all-star laden teams that failed to have sustainable success where more disciplined teams have generated surprising outperformance. In 2014-2015, Gordon Hayward (formerly of those great overachieving Butler Bulldog teams) and DeMarre Carroll, the only member of the unexpectedly excellent Atlanta Hawks not named to the All-Star team, both averaged 1.35 points-per-shot. This figure just trailed the performance of LeBron James (1.36 points-per-shot), arguably the best player on the planet. If the NBA were a market exchange, LeBron would likely be the highest priced commodity, but two players who combined last year earned less than LeBron (who is likely vastly underpaid given the salary cap construct) produced similar levels of efficient play by one measure. Low volatility stocks are mis-priced because investors prefer the spectacular alley-oop to good ball movement and an efficient corner three. For more detailed information on why Low Volatility Stocks outperform: 5 Ways to Beat the Market: Part-3 Revisited Those closely guarded pull-up long 2s can be spectacular to watch, but as Grantland showed us, they do not lead to long-run winning performance. Hopefully, this illustration of the Long 2’s of finance can help Seeking Alpha readers build more efficient portfolios. Scalper1 News
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