Examining Downside Protection

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Examining Downside Protection

2019-11-15T13:33:38-05:00By |

My name is Josh Blechman and I own six pairs of jeans, two of which are far and away my favorites. Maybe you feel like that’s a lot (“college edition” of me certainly thinks it’s unfathomable), growing up I found jeans to be incredibly uncomfortable and therefor never bought them. In time, my wife convinced me that if I was willing to spend on the right type of jean, then I could have both comfort and style – side-note: she was right.

How does this anecdote have anything to do with investing or downside protection? And why should you care?

While modern society has stipulated that pants are a necessity, six pairs of the same type of pants are not. If I begin to feel financially insecure, I would not replace all six pairs; but to the extent that society tells me I still need pants, I know which brand I am buying from!

As the customer, I have valuable information on my future purchase habits (and how they differ in good/bad economic times) that the company itself and the analyst community at large, do not. I am just one person and changes in my purchase habits won’t affect the bottom line of any company. However, if we could take a representative sample of consumers in the United States and conduct a statistically significant national cross-industry measure of customer satisfaction – then the resulting tool would give us that same valuable information on future buying behavior, but on a scale that has impact on publicly traded companies.

As classical economic theory dictates, buyers use discretionary income (and debt) to maximize their utility (or satisfaction). Therefore, its reasonable to expect strong customer satisfaction companies to have better revenue growth relative to competition. Also, to the extent that satisfied customers, as repeat purchasers, are less costly compared to generating new customers, profits should be higher as well.

Customer Satisfaction as a Factor

The concept of customer satisfaction as a leading indicator of stock price has been well established in academic studies, through sources ranging from Claes Fornell (considered the father of customer satisfaction), to the management consultants at McKinsey. Moving the concept from academic theory to practice, Professor Fornell, who founded the American Customer Satisfaction Index at the University of Michigan in the 1990s, analyzed the data derived from about 150,000 annual customer surveys and created an investment thesis based on the phenomenon discussed above. In November 2016 Exponential ETFs launched its customer satisfaction ETF  (Ticker: ACSI), which tracks the American Customer Satisfaction Investable Index (ACSII).

The way in which satisfaction driven future buying behavior (an intangible asset that analysts don’t generally price into their estimates) is disseminated to the market at large, is through Revenue and Earnings Surprises. As shown in the tables and graph below, strong customer satisfaction companies have a higher frequency of positive revenue and earnings surprises than the S&P 500 at large.

Over the twelve-year period (2006-2017), the strongest satisfaction companies (as defined by companies that have an above average allocation in the American Customer Satisfaction Investable Index) had positive revenue surprises 5.5% more often than the S&P 500 (59.7% vs 54.2%), while posting positive EPS surprises 7.6% more often than the benchmark (70.5% vs 62.9%). The disparity, as shown in the above table, has been consistent over time with the top satisfaction firms posting a higher percentage of positive earnings surprises in every year and reporting a higher percentage of revenue surprises in 10 of the 12 years – 2010 and 2013 being the exceptions.

Downside Protection

Satisfied customers are sticky customers. They tend to have a higher degree of loyalty and are also less sensitive to price increases. These customers are the last to leave in economic downturns and the first to return when things improve. Tying back to my “jeans” example, while an industry in aggregate may suffer during a period of economic uncertainly; the firms that have higher satisfaction relative to their peers may receive a bigger slice of a smaller pie, as consumers concentrate their purchases in areas they know will yield satisfaction.

These effects manifest themselves in up-capture and down-capture ratios. The table below contains summary statistics, calculated by Morningstar, on how the customer satisfaction weighted ACSII fared in up- and down-markets.

Up-capture and down-capture ratios measure a portfolio’s relative performance in up- and down-markets. An up-capture ratio greater than 100 indicates returns superior to the S&P 500 TR benchmark during periods where the benchmark index is positive. A down-capture ratio of less than 100 indicates performance better than the benchmark during down-markets.

The ACSII’s up-capture ratio of 105.48 implies an expected return of 1.05% for each 1% increase in the S&P 500 TR and a down-capture ratio of 80.82 implies that for each 1% decrease in the S&P 500 TR, the ACSII would have an expected return of -0.81%. These ratios are not a result of market timing or repositioning, but the result of characteristics inherent to companies with strong customer satisfaction as they are expressed to the market in a way that transcends traditional “growth” and “value” designations. Those characteristics allow for a 100% long portfolio, that only rebalances at predefined time periods in a predefined manner, to produce alpha in both up-markets and down-markets. The fact that the ACSII has a monthly standard deviation of 14.29, which is only slightly above the S&P 500 TR monthly standard deviation of 14.15, underscores that this overperformance is not the result of strategy containing additional risk and volatility.

Factor Diversification in the Current Market Environment

Regardless of if last week’s S&P 500 pullback was a sign of a market top, or just an insignificant pause in a near decade long bull market poised to run further, the investing community’s reaction to a -3.8% decline on the heels of a near +7% month – underscores how resiliently and relentlessly stocks had risen in 2017. When the last meaningfully negative month for the S&P 500 was October 2016, it is easy to find your portfolio positioned to take advantage of grabbing those returns, at the expense of protecting from a possible pullback. Last week’s downturn doesn’t signal a further correction is imminent, but it should prompt the investing community to take a look at their portfolios and thoughtfully asses how they might fair if the market retraces. The addition of a non-traditional factor with exhibited downside protection characteristics may be a strong compliment to any existing Core US large cap exposure

P.s. To anyone who stuck around this long and is wondering what my preferred brand of jeans are, its “7 for all mankind”. Strange brand name, but boy are they comfortable!


The author, Josh Blechman is the Director of Capital Markets at Exponential ETFs, an SEC Registered Investment Advisor. Exponential ETFs is the issuer of the American Customer Satisfaction Core Alpha ETF (Ticker: ACSI)

The American Customer Satisfaction Investable Index (ACSII) is an index of large-cap US equity holdings selected and weighted using proprietary customer satisfaction data from ACSI, LLC. The index was launched on August 8, 2016 and is calculated by Solactive. Index performance prior to 8/26/2016 relates to a hypothetical model of past performance. Index methodology is available upon request. Index performance is presented for general information purposes only. It is not possible to invest directly in an index.

As relating to the ACSII and the S&P 500 TR: Please note that there may be material differences between the benchmark (index) and the investment strategies in terms of their composition, including, but not limited to level of diversification and exposure as well as amount of exposure to certain types of investments; and their level of risk, as measured by volatility and/or other methods.

Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities and should not be relied on in making any investment decision. All stock price and industry/company financial data was sourced from Factset unless otherwise noted.

Posted by: Josh Blechman 02/05/2018

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