“…You may think you should invest in these poor companies as they are going to improve because the management will change, or they will be taken over, or their results will pick up with the economic or business cycle. But each day you wait for such events, these companies destroy a little bit more value. Good companies do the opposite…”
In this sixth and final part in a series of six articles, we look at how you can look to trade the Markets, be it full time, part time or occasionally.
Every one reading these articles will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.
We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.
The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought. We hope you find some benefit in one or some of the articles. The Sixth article here features another very important topic : Investment styles : understanding value, quality, growth and momentum
“…Momentum investors are much more confident about their ability to time the market than their quality and growth counterparts, and are willing to trade very regularly to adjust their holdings…”
Ever since Benjamin Graham popularised the concept of value investing back in the 1950s with his classic book The Intelligent Investor, investment styles have been carefully identified, classified, and theorised.
Today, with economies recovering from the pandemic, the investor press is abuzz with commentaries about the ‘turn from momentum to value’, the ‘return of quality’, and the ‘eclipse of growth’. What, exactly, are they talking about? The final article in our series on essential investment principles looks at the four most commonly discussed approaches to stock picking: value, quality, growth and momentum.
Value investing is perhaps the best known style, and the first to be formally identified and defined. Value investors seek to buy companies perceived to be trading at a low price relative to their inherent worth: their assets, profits, cash flow, and dividends. The idea is that if some kind of catalyst lights a spark – a turnaround plan, a takeover, a positive profits forecast, or a change in market conditions – the share price will ignite, as the market begins to take notice.
Favourite hunting grounds for value investors include sectors currently out of favour (or that are simply less glamorous), relatively under-researched small caps, and emerging markets. They often include unheralded companies quietly offering essential everyday services, like house builders, travel agents, commercial property, banks, and firms in unfashionable industries like oil and gas and tobacco.
The style is closely associated with some of the best known names in investment – and indeed economics – history. As noted above, it was identified and theorised by Benjamin Graham, firstly in his 1934 book Security Analysis, and some 20 years later in The Intelligent Investor, still one of today’s best selling investment books. Economist John Maynard Keynes was an early advocate, attributing the success of the Cambridge University endowment fund he managed during the inter-war years, which beat the UK market by an average of 8pc a year, to the ‘careful selection of a few investments’ according to their ‘intrinsic value’. Warren Buffet, the most successful investor of all time, was for many years a disciple of Graham, though he later developed a style somewhat closer to quality investing. Joel Greenblatt, founder of the hugely successful value-driven Gotham Capital hedge fund, considers the style as simple common sense, comparable to ‘carefully examining the merits of a house purchase by looking at the foundation, construction quality, rental yields, potential improvements and price comparisons on the street, neighbourhood or other cities.’
Value has a long history of strong performance. Modestly priced stocks have in the long run returned significantly more than the broader market. They can endure long fallow periods, as in the 1960s when investors were distracted by fast-growing, modern companies like Xerox, IBM and Eastman Kodak, and during the late 1990s dotcom boom. They have always recovered strongly, however, rewarding investors who have kept the faith.
But value investors have always faced particular challenges. They must be ever wary of falling into ‘value traps’: buying cheap shares that have become cheap for a reason, with no catalyst on the horizon. And shares can flatter to deceive, sometimes sputtering briefly into life before falling back because they are not driven by the solid fundamentals that generate lasting returns. Then there is the risk of losing out: while value investors are waiting for their carefully chosen stocks to take off, they fail to benefit from the shares that are currently performing well.
In recent years the style has come under severe pressure as value stocks have performed poorly relative to other styles, and indeed market indices. The Russell 3000 Value index – the broadest measure of value stocks in the US – over the past decade it has risen by only 80pc over the past 10 years, against the S&P 500 index return of more than 150pc. During that time stocks of fast-expanding growth companies have returned more than 240pc. Last year the MSCI index of global value stocks fell some 12pc, way behind its growth counterpart, which soared nearly 22pc. Warren Buffet’s holding company Berkshire Hathaway, after decades of outstanding performance, has marginally underperformed cheap S&P 500 tracker indices over the past decade.
Indeed according to some estimates value investing is suffering its worst run in at least two centuries. Research by one quantitative fund manager indicates the performance of value is now the worst since at least 1826: the value factor in stock markets is now down 64pc from its peak in 2007, going beyond the previous record – a 59pc fall around the turn of the last century.
Many reasons have been offered. Since the financial crisis bank stocks have struggled at particularly low valuations, with financial institutions facing tougher regulations and low interest rates curtailing their profitability. Oil companies are fighting to prove their continued relevance as long-term investments as the energy transition gathers pace. And changes in market dynamics are making value harder to measure. The intellectual property, brands and powerful market positioning of many of the new technology companies, for example, cannot be quantified as readily as the tangible balanced sheet assets that value investors have traditionally relied upon. Then there is the ‘warping’ of market dynamics by innovations such as exchange traded funds (ETFs) and sophisticated, algorithmic hedge funds, which tend to push up growth stocks, making it harder for value equities to shine through.
The gradual emergence of the global economy from the pandemic offers an opportunity for value stocks to re-emerge. The style tends to do well as economies come out of recession and investors look for bargains. And indeed there have been clear indications of a turn over the past few months from growth to value stocks. Financials, energy, materials and industrials have picked up as tech and health stocks have fallen back somewhat. BlackRock’s $14bn iShares MSCI USA Value Factor ETF has risen almost 40pc since November, against a 23pc gain for its momentum counterpart. How strong the turn will be remains to be seen.
Quality shares many characteristics with the value, but advocates point to subtle but important differences. Like value advocates, quality investors also look for reasonably valued companies, including those that might have been overlooked in favour of more fashionable trades. But they give greater weight to established companies with strong earnings growth and cash positions, and below-average debt-to-equity ratios. They look for resilient companies with long-term growth potential. Sustainable growth in profits and cash flow over a long period of time increases the intrinsic value of a company, value that can be continually renewed and compounded if gains are reinvested back into the business.
Quality investors are willing to pay high valuations for high quality companies with strong competitive positioning that allows them to continually outperform their rivals. They are not too proud to buy obvious market favourites if they believe the fundamentals are right. Examples of quality investments include Games Workshop, a company with a fiercely loyal customer base that continues to grow, and hardy perennials Unilever and Diageo.
For quality advocates, popular metrics like earnings-per-share (EPS) ratios are less important than return on capital employed (ROCE), roughly, a company’s operating cash flow divided by the sum of shareholders’ equity and net debt. They argue it is quite possible for a company to generate rising EPS at the same time as it employs increasing amounts of capital at falling and inadequate rates of return, thereby eroding the fundamental measure of shareholder value even as earnings increase.
Despite his long association with value investing, this for many years has been the key metric for Warren Buffet, who wrote in his 1979 letter to Berkshire Hathaway shareholders that the ‘primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share.’ And it is at the heart of the investment philosophy pursued by the ‘British Buffet’, Terry Smith, whose popular Fundsmith Equity fund has consistently beaten the MSCI World Index over the past decade.
Smith’s deceptively simply strategy bets on a relatively small number of companies, held for the long term, without overt attention to the flux of the macro economy. Fundsmith buys companies with sustainably high cash rate of returns, and with significant intangible assets – often referred to as ‘moats’ – such as brand names, patents or client relationships, that are difficult for competitors to break down.
Smith is sceptical investors can time markets effectively. For him every day spent waiting for less highly valued companies to come good is a day wasted. In one of his many acerbic market commentaries he writes: ‘A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ. You may think you should invest in these poor companies as they are going to improve because the management will change, or they will be taken over, or their results will pick up with the economic or business cycle. But each day you wait for such events, these companies destroy a little bit more value. Good companies do the opposite. With a good company, time is on your side.’
Nick Train, manager of another successful UK fund, Lindsell Train Global Equity, adopts a similar approach, taking big holdings in a handful of predictable, low-risk companies. Through the chaos of 2020 the fund made only one new investment, and stuck with all of its prior holdings. In Train’s words: ‘Owning a few things which you’re confident are resilient is less risky than owning a wider range of assets or securities where you have much lower levels of confidence – both in your understanding of the assets and their sustainability … our intent is to have big holdings in very predictable, low-risk companies – very substantive reliable assets.’ He likes companies that have stood the test of time, noting that people never tire of things that taste good, inform, or entertain.
Quality investors place high store on ‘conviction’, picking a few good shares and sticking with them, avoiding ‘diworsification’, the selection of a broad range of stocks that more or less follows the index. They also argue investors should simply trust the long-term wealth generating power of the market. As Train puts it: ‘We … have no idea what’s going to happen in the next six months, but in the longer term we’re confident that markets will do what they’ve done for the past 200 years – steadily go up – albeit with volatility along the way.’
Quality investment places a premium on picking winners: its selections can be highly valued from the outset, so there is little margin for error if they fail to continually grow. Growth investors also look for companies capable of solid long-term growth, willing to reinvest most of their earnings back into the business.
But they are somewhat less discriminate, generally investing in a good number of companies, some of them small, in the hope that at least some will see outstanding growth, while the rest will not have a significant impact if they do badly. Growth investors point to research indicating that long-term investment performance is concentrated in very few stocks, so their net must be cast wide to catch them. According to research by Hendrik Bessembinder of Arizona State University, between 1926 and 2016 just 90 out of a total of more than 25,000 companies generated half the excess returns from the US stock market.
Growth investors typically focus on industries driven by technological transformation. In recent years they have been heavily invested in the world’s major tech stocks, notably the so-called ‘FANMAG’ equities – Facebook, Apple, Netflix, Microsoft, Amazon and Google – and clean energy pioneers like Tesla. For growth investors the dizzying valuations of these companies identifies them as precisely the kind of groundbreaking outliers that Bessembinder argued all serious investors should hold.
The UK’s leading asset manager, Baillie Gifford, pursues a tried and tested growth style, its flagship Scottish Mortgage Investment Trust, which produced stellar returns through 2020, heavily invested in world’s most attractive growth companies. Biotech is another rich field for growth stocks: the Biotech Growth Trust’s net assets have grown by 769pc over the past decade, beating even Scottish Mortgage. Small-cap funds also tend to have a growth bias, as it can be easier to rapidly grow profits when starting from a lower base. Stocks such as Boohoo and Just Eat have produced outstanding returns over the past few years.
The distinction between growth and quality stocks can be very fine. Apple and Visa, for example, have risen by more than 1000pc over the last decade, as their free cash flow per share has soared by more than 500pc, figures qualifying them as bona fide growth stocks. In the near future they may come to be regarded as quality stocks, perhaps not delivering the same stellar returns, but still doing much better than other investments.
Growth stocks are rather dependent on benign economic conditions, performing handsomely through the current era of low inflation and interest rates, which has helped them generate ever high cash flows on the assumption of ever higher profits. A return to higher rates of inflation would put a spoke in the wheel. A growth portfolio can also be quite expensive to maintain, requiring more regular trading than value or quality strategies.
The momentum style shares much with growth investing, but works within a somewhat shorter time frame. Momentum investors try to ride a trend to its conclusion, or at least a peak on its journey. They seek to buy stocks that are currently performing well, staying for maybe three months to a year before taking some profit, or selling completely. They are disciplined about setting profit targets and stop-losses, as we discussed in an earlier article in this series. Momentum investors are much more confident about their ability to time the market than their quality and growth counterparts, and are willing to trade very regularly to adjust their holdings.
The term ‘momentum’ was coined by US fund manager Richard Driehaus, who made a fortune by letting his winners run and dropping losers. Rather than buying low and selling high, Driehaus advocated an aggressive approach of buying high and selling higher. For Driehaus the market is an emotional place in which systematic value-based processes can be overwhelmed by surging trends, which investors would be well advised to seek to ride.
As with growth shares, momentum stocks have enjoyed benign economic conditions over the past decade. Over the last 15 years a ‘no-thought’ portfolio of the top momentum shares has out performed the FTSE 350 index by 11pc a year, and has doubled in the past five years. Investors who piled into the top tech stocks during the pandemic (and who got out when their prices started to fall earlier this year) have been richly rewarded: Tesla, for example, rose by nearly 700pc.
The principal challenge for momentum investors is market timing. Momentum stocks tend to badly underperform falling markets. Though their vector has been decisively upwards over the past decade, momentum shares were severely knocked back during the financial crisis, at the end of 2018, and when the stock market plunged at the outset of the pandemic. And as mentioned their wings were clipped earlier this year. Momentum, of course, comes to an end. But it can resume. Investors selling at the end of a cycle risk miss risking much of the upside if a share they have sold recovers. And the need to trade regularly to enter and exit shares can make it an expensive strategy as platform fees mount up.
When value and momentum converge
This overview has sought to highlight the similarities as well as the differences between the four major trading strategies. Momentum investing is clearly quite different from value trading. But there is a continuum. Value and quality share many characteristics, as do quality and growth, and growth and momentum.
And as market cycles change, value shares can be reclassified as momentum stocks. As economies recover from the pandemic, and markets rebalance towards shares outside the tech sector, like financials, energy, materials, and industrials, some funds are beginning to relabel certain value stocks. Investors in the iShares MSCI USA Momentum Factor ETF, for example, are being warned in advance that certain tech stocks, like Amazon and Netflix, are going to be replaced as holdings by erstwhile value shares such as Wells Fargo and Occidental Petroleum, which are now swinging back into fashion.
It’s worth noting in conclusion that all of the styles discussed in this article share something very important in common: a belief in the potential of active stock picking, as against those who don’t think it possible to beat the market – a lively debate we looked at in our previous feature.
Interestingly, Benjamin Graham, who popularised the notion that there are different investing styles, gradually turned towards passive investment, writing in 1976, the year of his death, that ‘I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity when “Graham and Dodd” was first published, but the situation has changed … Today I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost … I’m on the side of the Efficient Market school of thought.’
The passionate arguments of today’s advocates of value investing, and those subscribing to alternative styles, show that contra Graham belief in the ability of intelligent investors to beat the markets is still very much alive.