Investment ideas – an AI Automation ten stock basket, buyback ETFs and Warner as the streaming winner

Buyback ETFs have consistently outpaced their benchmark peers but they’re almost totally ignored by investors. Plus why Warner is winning the streaming wars

If you’re feeling bullish about markets do make sure to read my latest Citywire column HERE. I’m still cautiously bearish about valuations but I think the bull’s argument for a later 2023 rally is not to be ridiculed. And if you think it’s plausible then the massive discount on many listed funds looks slightly bizarre.

An AI and Automation Stock Basket

Last week I mentioned that I have started playing around with Citywire’s new tool, Fix the Future. This is a clever tool that scans through fund manager filings and tracks the companies backed by the top-performing 5% of the 10,000 equity fund managers in the system. Thus, you have a shortlist of the businesses owned by the most successful managers. But there’s also an additional sorting layer – the system then slots these companies into thematic baskets ranging from the Virtual Society through to Space Tech.

Now it’s important to say that this approach has its obvious potential challenges. The first is that it is unashamedly an alpha-focused, stock-picking data screen – which means if you have a view that passive works best, you should avoid this approach.

The next obvious point to make is that this approach is based on historical data and as we all know by now, the past is no guide to future returns.

One last worry I have is that the stocks are grouped together via a thematic lens i.e thematic baskets. This can be a haphazard exercise as the industrial classification system used by most index developers – the GICS classification system – is a bit hit-and-miss. Who for instance gets to decide if a business like Tesla really is a major bet on AI for instance? It has a major AI unit but it’s mainly in the business of selling luxury cars.

With these cautions in mind, I would argue that we can still use this tool to effectively screen through the universe of stocks, find stocks popular with successful managers, and then assemble a basket of say ten or a dozen stocks that might track a key theme.

Last week I looked at digital infrastructure whereas this week we’ll focus on AI and Automation.

Digging around inside the tool I’ve set up a series of rules for screening, with the aim of ending up with a basket of ten stocks – the rules are itemized in the first box below. I’ve done some weeding out, to give us a manageable stock basket, including ruling out chronic loss-makers and making sure we only have a max of two stocks per sector.

This gives us the next graphic – our ten stocks most likely to benefit from Ai and Automation trends. The good news is that you should be familiar with most of these stocks with popular names such as, yes, Tesla and Accenture, or even Union Pacific. I’ve also made sure to include a smattering of smaller cap names.

Finally, I’ve then dragged this shortlist of ten stocks and added them to the Sharepad system so I can give some color on the key growth metrics. The average forecast growth in turnover in the coming year is 10.35%, while normalized EBIT is forecast to grow by an average of 23% in the coming year – normalized EPS growth is running at 33%. The average PEG is 1.52 and the average return on capital employed is a healthy 15.88%.

I make no comment on the individual stocks in this portfolio but merely suggest it as a starting point for your own research – you can find out more about Citywire’s tool HERE. You can access Sharepad HERE (subscription needed, but recommended!)

Buyback strategies - ignored but effective

The idea of focusing on fundamental measures in order to construct an index – which can then be tracked by a cheap ETF – has been around for decades. Perhaps the most popular variant of this fundamental approach is an index built around stocks that pay a generous dividend. The idea with dividend strategies, especially those that focus on corporates that progressively increase their dividends over long periods of time and also screen for financial health, is that dividends and subsequent dividend reinvestment have been shown to be the major component of long-term returns. Within this dividend indexing space, I thoroughly recommend the tried and trusted Dividend Aristocrat indices pioneered by S&P Dow Jones. You can find out more about this gaggle of indices HERE. Here in the UK, State Street offers a range of cheap trackers.

One challenge with dividend strategies is that over time fewer and fewer businesses have chosen to pay a dividend, especially in the US where there are tax challenges. Many US corporates in particular have opted to focus their cash distributions on buyback policies instead – in fact, there’s far more money spent on buybacks in the US than dividends. From 1980 to 2018, the proportion of dividend-paying companies decreased from 78% to 43%, while the proportion of companies with share buybacks increased to 53% from 28%.

In reality, the decision to focus on either dividends or buybacks is driven by narrow, practical issues, and arguably in capital efficiency, it doesn’t really matter as an investor how you receive your cash from the corporate. But it’s also a highly politicized issue with the US Democrats’ very anti-buyback while dividends are seen as private investor friendly. I’ll leave it to the reader to decide which they prefer (I have some sympathy for anti-buyback policy school but I also think their negative impact is massively overstated). What is less up for debate is that a corporate that is producing bumper levels of cash which can then be distributed to shareholders (via dividends or buybacks) is worthy of closer inspection from a stock selection point of view.

This brings us nicely to the idea of an index – and an ETF – which screens not for dividend aristocrats but for stocks that pay out a disproportionate amount in share buybacks. Theoretically, we know that a dividend aristocrat approach (focus on progressive dividend payers with solid balance sheets) should outperform over the long term, so businesses with a similar buyback profile (increasing buybacks over time while boasting a solid balance sheet). But is there any evidence this is true in reality – especially after we include transaction costs?

S&P Global researchers have stepped up to the challenge and analysed whether buyback portfolios outperform benchmark indices (say the S&P 500) and the evidence seems fairly clear – they have “ historically generated positive excess returns over their parent indices in the U.S. market over a long time horizon. “. Here’s their exec summary in more detail:

• “All buyback portfolios generated higher average monthly excess returns over their benchmark indices in down markets than in up markets, regardless of weighting methods.

• Compared with dividend portfolios, buyback portfolios tended to have lower dividend yields and most of their outperformance was driven by capital gains rather than dividend income. Buyback portfolios achieved more balanced win ratios and excess returns in both up and down markets, which is a good complement to defensive portfolios that focus on strategies such as dividends and low volatility.

• The equal-weighting method employed in the construction of our buyback indices enhances win ratios and excess returns in up markets, making the outperformance of buyback indices more balanced in both up and down markets. The impact of equal weighting is more significant in the large-cap space than in the mid and small-cap spaces.

• Both equal-weighted and market-cap-weighted buyback portfolios were tilted toward high earning yield in the past 20 years that ended Dec. 31, 2019. The overlay of equal weighting gives the portfolios an extra small-cap bias, especially in the large-cap space.”

There are some important caveats to add at this point. The first is that S&P Dow Jones produces these indices so it can sell the methodology to ETF providers – thus you might have some questions surrounding their enthusiasm for this methodology (ie they are not a wholly disinterested party).

I’d also add that there’s less evidence that this approach works outside the US where buybacks are much less common – and dividends more prevalent. Lastly, the devil is always in the detail when it comes to implementing these fundamental screening strategies i.e you might have a world-class theoretical engine powering an index but stick it in an ETF and it can easily fall over.

That said, it’s worth looking at the chart below which shows one of the US Buyback ETFs available here in the UK – this is from Amundi and has the ticker BYBG. The ETF was launched back in 2015 and the return from the ETF is in black, compared to the return from the S&P 500 index which is in red. As an aside the benchmark S&P 500 index outperformed the ETF after Covid through to the end of 2022 (all those surging tech stocks) but has since been comprehensively trounced by the buyback ETF.

There is one last challenge – there are only two buyback ETFs that I can see on my screen available in the UK : they are

-          Amundi ETF S&P 500 Buyback ETF, ticker BYBG, AuM £65m, TER 0.15%

-          Invesco Global Buyback Achievers ETF, ticker SBUY, AuM £35m, TER 0.39%.This ETF was launched back in 2014 and has an equally impressive record, consistently out pacing MSCI World trackers

So, just two ETFs with a combined AuM of just £100m.  It’s not exactly a huge vote of confidence by investors for what seems like a brilliant fundamental strategy.

Warner

Photo by Chase Yi on Unsplash

I want to finish with a short aside from the excellent US equities team at Arbrook. We frequently feature their stock picks – which are all their US Equities portfolio – because they fish in what we think is a compelling investment space: sensibly priced, mid to large-cap stocks with decent growth prospects which are missed by most momentum-based investors.

This time they’re focusing on a familiar name Warner Bros Discovery (WBD), a major player in the streaming wars. Their view is that Warner is a quality content player ( I agree), focused on higher profitability (I agree) with a better investment propositio than either Netflix (I agree) or Disney (I disagree and own Disney).

“For legacy “old” media players the stock price performances of recent months can be determined by a simple check as to whether they are Netflix or not. As a result of the earnings season, we are comfortable on a couple of things:

1. Netflix cannot be structurally more profitable than peers and

2. Warner Bros. Discovery will return to pre-streaming profitability (and most likely higher than Netflix) over the next few years.

Netflix does not own content production, we believe it is that simple but time will tell. In recent times Warner Bros. Discovery (WBD) and Paramount (PARA) have been similar stocks. Both are legacy media with cable networks in decline, both went through significant mergers, both have debt, both attempting to right their streaming strategies and both attract an odd amount of commentary from industry talking heads. That is where the similarities end, however. This quarter WBD announced they had made an adjusted operating profit. in their streaming division – we do not believe even Disney can claim this yet.

Paramount on the other hand announced significantly higher spending on their streaming product. This sent shares down over -28% on the da.  Our opinion is this boils down to quality of content and breadth of franchises. With Warner’s other large content rival, Disney, we believe the difference between them is WBD are squarely focused on profitability first.

Warner’s streaming profits were a year ahead of guidance. As explained earlier this year, WBD have a “lot of wood to chop” in terms of righting a business neglected under AT&T but with globally dominant assets. A tough financial discipline and willingness to monetise content where others like Netflix do not is the best path forward, in our opinion, rather than chasing subscriber growth through wanton content spending. As with many higher latency situations, we find it takes the market a while to appreciate what is happening. Interestingly WBD stock was initially down -4.9% on the earnings but by the time the market had finally digested what was going on, the stock finished up almost the same at +4.5%. “