Thursday, January 27, 2022

Equity investing - It is all about the timing of cash flows

 


Equity investing is all about cash flows - how large will they be, and when will they be coming.  If you can get the guess on cash flow right, you will be a good investor. Yet, forming future cash flows is not easy. Extrapolation usually does not work because there will be fluctuations with the business cycle. Some industries will react quickly to a macroeconomic shock while others will see slow reaction. There will be industry leaders based on cash flow reaction and laggards. Given this differential timing, laggard industries can learn from leading industries, which is the view of researchers who have written the paper, "The Leading Premium". 

The researchers find that those industries that are leaders receive a meaningful premium relative to lagging industries. This empirical result makes sense on two levels. One, industries that will reach strongly and immediately to macro growth shocks will price in a premium for the added risk. Two, leading industries tell us something about future risks for lagging industries. Leaders resolve uncertainty for laggards. 




The authors do some heavy lifting to show the lead-lag relationships between growth and industries, but the story makes sense on an intuitive level. The difference in earnings (dividends) and thus pricing between leading and lagging industries is a forward equity premium. Industries that will have a strong and immediate reaction to a macro shock will have more risk than those that lag a macro shock. Sensitive industries will generate a premium and provide insight on the less sensitive industries. 

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