Sentiment Overlay to Avoid Value Traps

September, 2019 / Issue 2 - Editorial on nontraditional data for Israeli Investors


In this post we discuss how overlaying sentiment to a fundamental valuation model, which identifies undervalued U.S. large-caps, can improve overall returns (+1.6/2.4pp* per annum)

*pp - percentage points (absolute delta in %-returns)

Market

  • Country/Region: North America, USA

  • Asset Class: Equities

  • Investment Universe: Russell 1000


Research & Application Context

  • Alt. Data Factor: Trailing Sentiment

  • Method of Data Integration: Overlay

  • Underlying Inv. Strategy Type: Fundamental

  • Period of Analysis: 01/01/2002-01/07/2018

  • Investment Direction: Long

  • Avg. Holding Period: month(s)

  • Avg. Portfolio Size: 140

Investment Process


Underlying investment logic

The original strategy follows a fundamental valuation framework that tries to gauge when a stock is attractively valued, using fundamentals and price data. Cheapest 20% of U.S. large-caps are selected on a monthly basis.

Motivation for Sentiment Incorporation

The reason for a seeming undervaluation isn't known -> risk of "value traps".

Basic idea: if a stock is surrounded by bad sentiment in the media, then there is likely a reason for it being undervalued -> better to avoid such undervalued candidates.


Sentiment Overlay

  • Overall shorter-term trailing sentiment indicator, aggregated from various types of events and sources (news, social media), is used to rank and group stocks into quintiles

  • From the fundamentally "cheapest", undervalued stocks remove the low-sentiment ones (bottom 20%) and overweight instead the high sentiment stocks (top 20%)

Main Results

Sentiment - Avoiding Value Traps

Results - added value of sentiment

Evaluation has been performed for two time periods: the full period and the most recent one.


Reallocating undervalued low-sentiment stocks capital into undervalued high-sentimen stocks results in extra returns

  • 2002-2018 +1.62pp ann.

  • 2013-2018 +2.4pp ann.

>> this is the pure value added by the sentiment data to the underlying fundamental investment approach.


Overall performance (fundamental valuation + sentiment)

"Low valuation-High sentiment" stocks on average outperformed the market by

  • 2002-2018 +3.5pp ann.

  • 2013-2018 +0.5pp ann.

"Low valuation-Low sentiment" stocks on average underperformed the market by-1.9/-7.5 percentage points per year.

  • 2002-2018 -1.9pp ann.

  • 2013-2018 -7.5pp ann.

Remarks & Conclusion


Correlation to price momentum

Sentiment measured over shorter past periods (i.e. 1 to 3 months) records low correlation to price momentum returns. Longer "look-back" windows for trailing sentiment result in much higher correlation with the price momentum(!)


Conclusion

Avoiding low-sentiment stocks among the fundamentally undervalued companies, and increasing allocation to the high-sentiment ones, can provide uncorrelated (to value and price momentum factors) alpha source and improve overall portfolio returns.


Source: Empirical Research Partners, "Stock Selection: Research and Results", August 2018

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