From Bad to Less Bad: A Quantitative Approach to Turnarounds | Bloomberg Indices’ Steve Hou on “Reformers Index,” Baumol Disease, and Structural Inflation

Episode Summary

Executive Summary: Steve Ho argues that inflation is being shaped by structural forces—decarbonization, aging, deglobalization, fiscal dominance, and defense spending—while technology creates deflation unevenly across sectors. He also presents two quantitative Bloomberg strategies: one that identifies equities resilient to inflation surprises, and another that finds “reformer” stocks with improving fundamentals that can generate outsized returns as they move from deeply unprofitable toward profitability.

Main Topics: The 'four D's' and a more inflationary regime (Priority: 5/5): Ho explains that long-run inflation is being driven by structural forces rather than a temporary post-COVID spike. He adds a fifth force, defense spending, arguing these trends make the macro environment modestly more inflationary over time. Technology as deflationary in goods, inflationary in services (Priority: 5/5): He distinguishes between clear deflation in automated tradable goods and persistent inflation in labor-intensive services like healthcare, childcare, education, and rent, using Baumo's disease as the framework. Why 'inflation resilience' should focus on surprises, not levels (Priority: 5/5): Ho describes a Bloomberg quantitative method that screens stocks based on their historical response to inflation surprises, not simply their correlation with inflation levels, producing a portfolio that can outperform even when inflation is falling but still surprising to the upside. The Bloomberg Reformers Index and earnings inflection (Priority: 5/5): He outlines a strategy that targets stocks whose fundamentals are improving from a weak base—often unprofitable companies moving toward break-even or profitability—where the stock price can rerate explosively. Behavioral explanation: attention and underreaction (Priority: 4/5): Ho connects the reformers strategy to research showing price momentum works best in high-attention stocks, while fundamental momentum works best in low-attention stocks that investors have abandoned or ignored. Backtest robustness, attribution, and limitations (Priority: 4/5): The discussion repeatedly emphasizes that the indices are backtested, not live, and that performance is driven largely by selection effects rather than obvious factor tilts, while still being subject to false positives and timing risk.

Key Arguments: Inflation is not merely a transitory phenomenon; it reflects structural undercurrents that can keep the regime modestly more inflationary for years. Decarbonization, deglobalization, aging demographics, fiscal dominance, and higher defense spending all add inflationary pressure by reducing efficiency or raising labor and capital needs. Technology does create real deflation, but mostly in manufactured goods; it does not automatically lower prices in labor-intensive services that make up a larger share of modern middle-class spending. The right way to build an inflation-hedging equity portfolio is to target stocks with positive beta to inflation surprises, especially bad inflation surprises, rather than just stocks that rise when inflation levels are high. A stock can be an inflation beneficiary for reasons that are not immediately intuitive, including higher rates and widening bank net interest margins. The reformers strategy exploits the rerating that happens when a company’s fundamentals improve from very weak to merely less weak, especially when investors are not paying attention. Fundamental momentum differs from price momentum: the first is strongest in neglected, lower-attention names; the second tends to work better in widely followed stocks. The strategy works in part because investors underreact to sustained fundamental improvement and only later recognize it, allowing prices to accelerate asymmetrically. The backtests suggest the return drivers are not just known factor exposures like value, growth, or momentum, but a large selection effect from stock picking within a diversified basket. The portfolio must be diversified because some candidates will fail to inflect or will reverse after entry, making position diversity essential to absorb false positives.

Data Points: Structural inflation framework: 4 D's plus defense - Ho’s macro thesis includes decarbonization, demographic aging, deglobalization, dominance of fiscal policy, and an added defense-spending factor. Consumer price of flagship iPhone Pro: about $1,000+ - Used as an example of tech products whose nominal prices have stayed relatively stable despite massive gains in functionality. Reformers Index portfolio size: 75 candidates - The index holds about 75 names, diversified and weighted roughly by market cap with caps. Reformers strategy hit rate: 51.8% - Average success rate across the total strategy’s trades/candidates in the backtest. Reformers strategy payoff ratio: 1.62 - The winners, on average, pay more than the losers lose, offsetting only modestly above-coin-flip hit rates. Total strategy average total return: 8.8% - Average total return for the full reformers strategy in the backtest. Total strategy median total return: 1.1% - Median total return for the full reformers strategy in the backtest. Tech subset payoff ratio: 2.1 - Technology had a notably high payoff ratio among the reformer candidates. Tech subset average total return: 15.3% - Average return for tech names in the reformer strategy sample. Tech subset median total return: 2.8% - Median return for tech names in the reformer strategy sample. Inflation-sensitive equities benchmark comparison: Green line lagged blue line - The simple inflation-sensitive portfolio underperformed the inflation shock resilient portfolio in the chart discussed. Selection effect vs factor effect: Mostly selection effect - Attribution analysis found most outperformance was not explained by standard factor tilts or sector weights. Historical inflation shock context: 2021-2022 - The discussion references the post-COVID inflation surge and the 2022 inflation peak/hiking cycle. Example sectors in inflation-sensitive basket: Energy, materials, industrials, consumer discretionary, tech - The inflation-shock-resilient basket included more tech than expected and relatively less energy/staples than a naïve hedge would suggest. Backtest start date: April 2007 - The reformers index backtest is shown over roughly 2007 onward. Relative performance in 2022: Strategy drew down less than the broader market - Used to argue the reformers strategy was not simply a high-beta bull-market bet.

Pivotal Quotes: "“The opposite of transitory was really structural.”" — Steve Ho: Ho reframes the inflation debate as one about structural drivers rather than duration. "“What you really care about in order to hedge against inflation is not really the correlation with inflation itself, but inflation surprises.”" — Steve Ho: He explains the design principle behind the inflation-resilient equity portfolio. "“You have deflation because of technology and automation in the tradable sector and goods, and you have low productivity and higher inflation in the higher services sector.”" — Steve Ho: This is his core Baumo’s disease explanation for uneven inflation outcomes.

Implications: Investors should think structurally about inflation and seek equity exposures tied to surprises and reratings, not just obvious hedges. The biggest opportunities may lie in overlooked companies or sectors where fundamentals are improving before the market fully notices.