From Bad to Less Bad: A Quantitative Approach to Turnarounds | Bloomberg Indices’ Steve Hou on “Reformers Index,” Baumol Disease, and Structural Inflation
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Podcast Summary
In this episode of Monetary Matters, Jack Farley interviews Steve Hou, Senior Quant Researcher at Bloomberg, who presents a compelling framework for understanding today's economic forces. Hou argues we've entered a "structurally, modestly more inflationary regime" driven by five key forces: decarbonization, demographic aging, deglobalization, debt/fiscal dominance, and rising defense spending. The conversation explores the Baumol Effect - how productivity gains in manufacturing don't translate to service sectors, creating uneven inflation experiences. (16:57)
- Core discussion centers on systematic approaches to finding investment opportunities in overlooked, fundamentally improving companies through Hou's "Reformers Index" strategy
Speakers
Steve Hou
Steve Hou is a Senior Quant Researcher at Bloomberg, working extensively on the Bloomberg Indices team. He specializes in developing systematic investment strategies and has created innovative approaches to inflation hedging and fundamental momentum investing. Hou is active on social media discussing macroeconomic trends and quantitative investment strategies.
Jack Farley
Jack Farley is the host of Monetary Matters podcast, focusing on macroeconomic trends and investment strategies. He conducts in-depth interviews with financial professionals and researchers, exploring complex economic topics for ambitious professionals seeking investment insights.
Key Takeaways
Embrace the "Five Ds" Inflationary Framework
Hou identifies five structural forces creating a modestly inflationary environment: Decarbonization (costly transition from carbon-intensive industries), Demographic aging (labor shortages in service sectors), Deglobalization (moving away from efficient China-centric supply chains), Debt/Fiscal dominance (high debt levels constraining policy), and Defense spending increases globally. (00:34) This framework helps investors understand why inflation may persistently run above historical norms, enabling better portfolio positioning for this new regime rather than expecting a return to the deflationary pressures of the 2010s.
Understand the Baumol Effect's Investment Implications
Technology drives deflation in manufactured goods while service sector costs rise due to wage competition from productive sectors. (10:00) Hou explains that while iPhone capabilities have exponentially improved, prices stayed flat, demonstrating real deflation. However, childcare, healthcare, and education costs surge because these labor-intensive services can't automate easily, yet wages must compete with high-productivity tech sectors. Investors should position for this K-shaped inflation - long technology deflation beneficiaries while avoiding service sector margin compression.
Focus on Inflation Surprise Beta, Not Inflation Correlation
Rather than investing in stocks correlated with inflation levels, target companies with positive response to inflation surprises while controlling for growth expectations. (24:08) Hou's research shows tech companies often have high inflation surprise beta because they can rapidly adjust productivity when facing cost pressures. This approach outperforms traditional inflation hedges like energy and materials because it captures companies' actual pricing power during unexpected inflationary shocks, providing protection when you need it most.
Target Fundamental Momentum in Low-Attention Stocks
The greatest returns come from companies transitioning from "bad to less bad" fundamentals while being ignored by investors. (31:48) Hou's Reformers Index identifies companies showing consistent fundamental improvement from negative territory - like Uber, Palantir, and Robinhood's transitions from losses to profitability. The key insight: price momentum works best in high-attention stocks, but fundamental momentum works best in neglected stocks where investors underreact to early improvement signs, creating asymmetric return opportunities.
Implement Systematic Trend-Following for Fundamentals
Success comes from systematically tracking fundamental trends rather than predicting future inflections. (46:08) Hou creates candidate watch lists of companies showing improvement patterns, then holds positions as long as fundamental momentum continues. This quarterly rebalancing approach captures substantial portions of multi-year improvement cycles without requiring perfect timing. The strategy maintains ~75 diversified positions to manage false positives while letting winners compound, achieving similar returns to tech indices without traditional quality stock exposure.
Statistics & Facts
- Steve Hou's Reformers Index achieved a 51.8% hit rate with a 1.62 payoff ratio, meaning winners outpaced losers by 62% on average. (53:13) In technology stocks specifically, the payoff ratio reached 2.1, demonstrating the asymmetric return potential when fundamental momentum strategies work in overlooked companies.
- The Reformers Index comprises approximately two-thirds small and mid-cap stocks, with 75 total positions weighted roughly by market cap with caps to prevent over-concentration. (49:48) This composition reflects that smaller companies more frequently experience the unprofitable-to-profitable transitions the strategy targets.
- Over the past 20 years, the Reformers Index matched the total returns of both the technology sector and NASDAQ (QQQ), despite never investing in traditional quality momentum stocks. (40:12) This performance was achieved through systematic fundamental momentum rather than buying established profitable companies.
