In recent research we have written about the current market preference for good stories, over valuation and other more traditional metrics. We also suggested that there might be more interest in simplicity over complexity. The hypothesis being that the more risk averse we are the more simple we would like a company story to be. That simplicity could come from an industry structure perspective and/or from a “number of different macro and consumer drivers” perspective.
In an attempt to test this more empirically, we have created a rudimentary complexity index. We have done this by taking into account the number of sectors any given company chooses to represent its business and the geographic diversity of the overall business. What we miss are other factors such as market structure and clarity of message.
The index is created by dividing the number of reporting sectors by the percentage of sales that are in the US. A company with one segment and 100% of its business in the US has a complexity index of 1, while a company with 5 reporting segments and 25% of its business in the US has an index of 20. We have adjusted where reporting segments are geographic so that we do not double count. While, to a degree, companies can choose how many segments they report in, the segmentation is supposed to reflect the way in which they run the business and we are extrapolating this to assume that the more segments, the more complex to manage, and the more complex to manage the more complex for an investor to understand.
Following on from the piece we wrote last week on Capital Goods, we plot the complexity index against current value for the sector in the chart below. There is not enough of a correlation to suggest anything too compelling, but the very complex names appear relatively more attractive from a valuation perspective. This might perhaps mean that there is a lower limit of complexity, below which it does not matter and consequently there is no correlation with value in the current market. However, above a certain degree of complexity it does matter in the current market and that complex stocks are penalized. We are doing further work on other sectors and the most complex stocks seem generally undervalued.