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Replicating Private Equity Returns With Leveraged Small Value Stocks

I recently came across a new paper by Dan Rasmussen and Brian Chingono (by way of Wesley Gray's blog post on Alpha Architect ) on the viability of private equity style investing in public markets. Private equity firms buy small to mid-sized distressed companies with hopes of fixing and reselling them for a profit. Rasmussen and Chingono conclude that by investing in small, cheap, and moderately-to-highly leveraged publicly traded companies, one can replicate the returns of private equity firms while avoiding the illiquidity normally associated with PE deals.

The authors regressed several fundamental and technical features over quarterly returns on small-to-mid cap stocks, finding statistical significance for a premium on value (cheap) companies with moderate to high leverage ratios ( Long-Term Debt/Enterprise Value), falling debt (LT Debt (t) < LT Debt (t-1)) and growing asset turnover (% Revenue Growth > % Asset Growth).

The proposed explanation for this premium is centered around deleveraging via free cash flow yield. Free cash flow yield is the cash a company has left over after all its operational expenses and capital investments (buying new machines, paying salaries, keeping the lights on in the factory, etc.) divided by the company's enterprise value (market cap - debt). Debt has opposing impacts on free cash flow yield, lowering its denominator through decreased enterprise value and lowering its numerator by increasing the burden of interest payments. A higher ratio of debt to purchase price will amplify the impact purchase price (market cap) has on free cash flow yield. In other words, when you pay very little for a company relative to the debt on its books, you are maximizing free cash flow yield by lowering enterprise value more than the negative impact of interest payments on free cash flow.

As time goes on, the more free cash flow a company has, the greater their ability to pay down debt, raising enterprise value and lowering their future interest payments. The authors use the year over year changes in long term debt and asset turnover as proxies for the change in free cash flow yield.

I used the following filters on data from a call to get_fundamentals( ) to build a quarterly rebalancing strategy based on the paper's findings :

Start with companies in the 25th to 75th percentiles of market cap.
From that group, take the cheapest 25% of stocks (as defined by ln(EV)/ln(EBITDA)).
From that group, take the stocks with above median leverage ratio (LT Debt/EV).
From there, only take companies with positive debt paydown (LT Debt (t) < LT Debt (t-1)).
And finally, take only companies with growing asset turnover (% Revenue Growth > % Asset Growth).

This first pass is generally profitable but with a sizable max-drawdown ('08 was not a good time to be long leverage!) and high beta. Ten points to anyone who can develop a hedged version of this strategy!

Clone Algorithm
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# Backtest ID: 55d1ea554224390c67367a44
There was a runtime error.
Disclaimer

The material on this website is provided for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation or endorsement for any security or strategy, nor does it constitute an offer to provide investment advisory services by Quantopian. In addition, the material offers no opinion with respect to the suitability of any security or specific investment. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as none of Quantopian nor any of its affiliates is undertaking to provide investment advice, act as an adviser to any plan or entity subject to the Employee Retirement Income Security Act of 1974, as amended, individual retirement account or individual retirement annuity, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement or other investor, contact your financial advisor or other fiduciary unrelated to Quantopian about whether any given investment idea, strategy, product or service described herein may be appropriate for your circumstances. All investments involve risk, including loss of principal. Quantopian makes no guarantees as to the accuracy or completeness of the views expressed in the website. The views are subject to change, and may have become unreliable for various reasons, including changes in market conditions or economic circumstances.

4 responses

Here is a quick and dirty beta hedged version of this really cool strategy.

Clone Algorithm
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Backtest from to with initial capital
Total Returns
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Alpha
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Beta
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Sharpe
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Sortino
--
Max Drawdown
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Benchmark Returns
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Volatility
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Returns 1 Month 3 Month 6 Month 12 Month
Alpha 1 Month 3 Month 6 Month 12 Month
Beta 1 Month 3 Month 6 Month 12 Month
Sharpe 1 Month 3 Month 6 Month 12 Month
Sortino 1 Month 3 Month 6 Month 12 Month
Volatility 1 Month 3 Month 6 Month 12 Month
Max Drawdown 1 Month 3 Month 6 Month 12 Month
# Backtest ID: 55ef547d86ac2a0dded46fe7
There was a runtime error.
Disclaimer

The material on this website is provided for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation or endorsement for any security or strategy, nor does it constitute an offer to provide investment advisory services by Quantopian. In addition, the material offers no opinion with respect to the suitability of any security or specific investment. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as none of Quantopian nor any of its affiliates is undertaking to provide investment advice, act as an adviser to any plan or entity subject to the Employee Retirement Income Security Act of 1974, as amended, individual retirement account or individual retirement annuity, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement or other investor, contact your financial advisor or other fiduciary unrelated to Quantopian about whether any given investment idea, strategy, product or service described herein may be appropriate for your circumstances. All investments involve risk, including loss of principal. Quantopian makes no guarantees as to the accuracy or completeness of the views expressed in the website. The views are subject to change, and may have become unreliable for various reasons, including changes in market conditions or economic circumstances.

perhaps converting to cash when markets are bearish would really help this strategy....really cool idea...but even with a 51% drawdown, your gains would be wiped out big time, and leverage would hurt you big.

I took James's hedged version and added a MACD signal that will send the algorithm it 100% bonds in a bear market. Seems to have reduced the max drawdown significantly.

Clone Algorithm
118
Loading...
Backtest from to with initial capital
Total Returns
--
Alpha
--
Beta
--
Sharpe
--
Sortino
--
Max Drawdown
--
Benchmark Returns
--
Volatility
--
Returns 1 Month 3 Month 6 Month 12 Month
Alpha 1 Month 3 Month 6 Month 12 Month
Beta 1 Month 3 Month 6 Month 12 Month
Sharpe 1 Month 3 Month 6 Month 12 Month
Sortino 1 Month 3 Month 6 Month 12 Month
Volatility 1 Month 3 Month 6 Month 12 Month
Max Drawdown 1 Month 3 Month 6 Month 12 Month
# Backtest ID: 55f037907db7590dda156c80
There was a runtime error.

Nice gains Andrew but there could be look ahead bias since you are choosing the cheaper stocks.(Split adjusted prices)

https://www.quantopian.com/posts/split-adjusted-prices-introduce-a-look-ahead-bias