How To Make Money In Stocks Part 6: Identify spread divergence 5 comments

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As a fundamentals-based investor, I am always looking to find bargain buys on the basis of value and I often try to spot trends (see my blog Trendspotting) which could lead to a re-rating of particular stocks. Once one has identified a particular trend, he can find companies which have particular leverage to that trend. A useful framework for finding good companies is identifying a divergence in its revenue-costs spread, which is of course an elaborate way of describing the income.

The spread is simply the numerical difference between A and B (ie. A-B). The spread will widen/diverge if (1) A goes up while B remains the same; (2) A remains while B decreases; (3) A rises more than B or declines less than B. The most divergence is of course when A rises while B drops. A concept that is easily applied to the earnings framework for companies.

The key benefit for thinking about earnings as a spread between revenue and costs is that it compels the investor/trader to think about the components of income individually insofar as they contribute to the spread (which is also the profit margin). Often, the fundamental factors driving revenue are independent of that driving costs. Identifying stocks where certain trends favour revenue growth while other particular trends point to cost decrease ie. a form of spread divergence, could suggest a stock with potentially explosive profit margin growth.

The most obvious example would be banks. The business model for commercial banks is to borrow funds at a lower interest rate (depositors, inter-bank loans, wholesale market) and then lend it at a higher one (home loans, business loans, credit card loans etc), thus capturing the spread (see "Financials/Business Model"). Typically the borrowed funds are short-term while the bank loans offered are longer-term, because long-term interest rates are usually higher than short-term ones --- thus enabling the bank to make spread profits. In the early 1990s, when America was recovering from a recession triggered by housing-induced banking failures (sounds familiar?), the Federal Reserve lowered federal funds rates (short-term rates which it controls) aggressively, enabling banks (and many speculators) to benefit enormously by borrowing cheap and investing in higher-yield instruments like long-term Treasuries, stocks etc. The financials turned out to be among the best performers as a result of this Fed policy-driven spread divergence.

There are so many such drivers of revenue-costs spread divergence around, depending on the industry. For refining companies, it would be the refining spread, which will widen if petrochemical product prices (a function of refining capacity and product demand) grow faster than crude oil input prices (often subject to supply-side pressure). For manufacturers, revenue could be driven by industrial or consumer demand (which is in turn a function of trends that should be identified) while costs depend on raw material prices. An article I had written about stocks to buy to ride on the global inflation trend illustrates an application of this approach: capital-intensive businesses could be a way to go, since depreciation costs are flat, while selling price (revenue) could be adjusted in-line with inflation; this in effect transforms the inflationary environment to the company's advantage.

Another reason why thinking in terms of spread divergence is useful is because it can be applied to other areas other than the P&L statement. Specifically, it can also be used for balance sheet analysis, particularly for those industries whose stock valuations are more driven by NAVs (Net Asset Value) than by earnings --- for example, property. A favourable asset-liability spread divergence, driven by, say, rising property prices (culminating in higher asset valuations for holding properties) even as inflation rises (hence lowering the real value of debt liabilities), could mean higher NAVs than recorded on book. This model can easily be applied to other industries, such as shipping companies, steel traders, mining companies.

At the end of the day, what is important is that individual investors/traders need a consistent framework for crafting buy/sell decisions in a disciplined manner. Identifying possible outperformers on the basis of potential spread divergence is, in my view, as good a framework as any.