The further out that companies had a large amount of expected cash flow, the less their stocks tended to get hit during the Covid-19-prompted crash, University of Southern California researchers have found.
It’s a logical relationship, based on adapting the bond duration to equities, as a measure of their sensitivity to shocks.
But by slicing the universe of stocks in this way, the study indicates, investors can build a hedge for events like the ongoing pandemic. Alternatively, portfolios heavy on companies with substantial short-term cash flows are at additional risk of grave drops in value.
“The coronavirus pandemic that broke out in early 2020 provides a natural setting to evaluate the ability of implied equity duration to capture this particular type of macroeconomic risk,” wrote authors Patricia Dechow, Ryan Erhard, Richard Sloan, and Mark Soliman in the paper, released this month before peer review.
Over the first three months of the year — when U.S. stocks crashed dramatically — a model hedge portfolio of highest-duration stocks (those with cash flows furthest in the future) outperformed a basket of the lowest duration by 36 percent, or 144 percent annualized.
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The duration metric also sheds light on value stocks’ significant underperformance during the onset of the pandemic shutdown, the USC authors wrote. “Investors expect their longer-term future earnings and book values to be low relative to their current levels. As such, these stocks are low duration stocks that should lose more of their value during a sharp and short-term decline in macroeconomic activity. Thus, the larger relative declines in value stocks can be viewed as a rational response to the onset of the pandemic shutdown.”
