Focused on quantitative strategies to trade, Cliff Asness and friends built the first hedge fund implementing highly regarded factor models. The fund continued to grow even after the financial crisis in 2008. In today’s FA Alpha, let’s explore Applied Quantitative Research’s fund and see how it generated massive gains in 2022.
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Founded by Cliff Asness and friends in 1988, AQR is one of the largest hedge funds in the world.
Since its inception, the fund has been focused on quantitative strategies like algorithms and computerized models to trade stocks, bonds, currencies, and commodities.
That makes sense because the name AQR stands for “Applied Quantitative Research”.
Asness and his team’s focus on quantitative research led them to build one of the first hedge funds to implement highly regarded factor models which were introduced by Fama and French.
Their strong computer science and finance background were the main reason for the firm’s success in its early years, and they were called “Gurus” by the financial media.
Utilizing these quantitative strategies, the fund quickly became a well-known success story in the investment industry.
Even though its prestige has been hurt by the financial crisis in 2008, the fund continued to grow and expand in the following years.
However, it has been struggling for the past 5 years. Its quantitative strategies have been consistently underperforming for such a long time.
But as 2022 closes, AQR gets to have a sigh of relief since it had its best year since its inception.
Additionally, not just its flagship funds but pretty much every fund of AQR crushed the market last year.
Net return for its longest-running fund was 55% for the year, and its many other funds recorded massive gains as well.
Let’s have a look at the fund and see if it is well-positioned for the year ahead as well.
Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.
These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.
It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.
See for yourself below.
Looking at as-reported accounting numbers, investors would think that investing in AQR Capital Management is not really rewarding.
On an as-reported basis, many of the companies in the fund are just average performers. The average as-reported ROA for the top 15 holdings of the fund is 12%, which equals the U.S. corporate average of 12%.
However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return in AQR Capital Management’s top 15 holdings is actually 33%.
As the distortions from as-reported accounting are removed, we can see that Apple Inc. (AAPL) isn’t a 21% return business. Its Uniform ROA is 49%.
Meanwhile, The Coca-Cola Company (KO) looks like an 8% return business, but this massive beverage corporation actually powers a 60% Uniform ROA.
To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.
To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.
These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.
Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:
This chart shows four interesting data points:
- The average Uniform ROA among AQR Capital Management’s top 15 holdings is actually 33% which is much better than corporate average in the United States.
- The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
- The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
- The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.
Embedded Expectations Analysis of AQR Capital Management paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to decline in profitability and the market agrees.
Analysts forecast the portfolio holdings on average to see Uniform ROA fall to 27% over the next two years. At current valuations, the market agrees with the analysts and expects a 28% Uniform ROA for the companies in the portfolio.
For instance, Alphabet (GOOGL) returned 37% this year. Analysts think its returns will significantly drop to 20%. And at a 28.2x Uniform P/E, the market expects a decline in profitability and is pricing Uniform ROA to be around 22%.
Similarly, Meta’s (META) Uniform ROA is 40%. Analysts expect its returns to fall to 15% and the market is pricing its returns to decline to 13%.
Overall, AQR Capital Management’s portfolio is composed of high-quality companies that can deliver strong returns in the long term. But investors should consider that AQR is focused on quantitative strategies in which the valuation and pricing of securities are highly important factors. That is why investors should analyze carefully and then make an investment decision on whether to invest or not.
This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.
To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.
Click here to get access.
Read on to see a detailed tearsheet of one of AQR Capital Management’s largest holdings.
SUMMARY and Pfizer Inc. Tearsheet
As one of AQR Capital Management’s largest individual stock holdings, we’re highlighting Pfizer Inc.’s (PFE:USA) tearsheet today.
As the Uniform Accounting tearsheet for Pfizer Inc. highlights, its Uniform P/E trades at 11.2x, which is below the global corporate average of 18.4x, and around its historical average of 11.5x.
Low P/Es require low EPS growth to sustain them. That said, in the case of Pfizer Inc., the company has recently shown 148% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Pfizer Inc.’s Wall Street analyst-driven forecast is for EPS to grow by 38% in 2022 and shrink by 36% in 2023.
Furthermore, the company’s return on assets was 32% in 2021, which is 5x the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 30bps above the risk-free rate. Together, these signal low dividend risks and low credit risks.
Lastly, Pfizer Inc.’s Uniform earnings growth is above peer averages, and in line with peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.