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4 investing methods that beat the market

Should you join the traders and attempt to beat the market?

I don’t think the market is always efficient and – unlike my virtuous co-blogger here on Monevator – I invest some of my money accordingly.

Please note: I’m not suggesting you should try to beat the market at home. I don’t even think I should!

For most, the best results will come through passive index investing. The chances that you or I will follow in Warren Buffett’s footsteps are tiny, whether his returns are down to luck, skill, or cheap money from his insurance operations.

Some people are drawn to active investing for reasons other than greed and delusion, however. There’s intellectual stimulation, an interest in business, the sheer challenge, and an aversion to having fun in the evening.

So if you’re an incurable moth and the market looks like one giant candle, what’s the best way to get burned?

Why I like value investing

When it comes to the quixotic – and for the last time optional and ill-advised – goal of trying beat the market, I think value investing has the edge.

Most of my favourite investors were value investors, from Benjamin Graham and Warren Buffett to Sir John Templeton, Walter Schloss, and even The Motley Fool writer Stephen Bland.

They all backed their judgment that the market isn’t always efficient, and found that a value-based investing method was the best way to root out the truffles from beneath the wood and the trees.

I like value investing because it makes logical sense. Buy the unloved stuff that stinks, and sell it when it doesn’t. If you’re looking for profits in real-life that’s not a bad formula, so it seems a good place to start hunting for profits in the stock market, too.

I also like value investing because I’ve noticed most people can’t do it. Oh they talk about contrarianism and buying cheap, but most of their investments are in companies that have been doing well, and that look fully valued to me. Often in life you can get paid for doing something that others can’t or won’t do.

A final reason I like value investing is because even the high priests of the efficient market have anointed it as a market-beating strategy.

After all, they can hardly refute the data1, which consistently shows that over the long-term, stocks with value-based metrics (such as a low price-to-book value) have outperformed the wider market:

(Click to see the value premium writ large)

(Click to see the value premium writ large)

Source: Credit Suisse/London Business School

Of course, efficient market supporters don’t see value as a violation of the efficient market.

They typically either think that value investors are taking on more risk to get higher their rewards, or else they think that there was a genuine anomaly in the market due to ignorance, but now it is being whittled away by everybody knowing about it.

I’m not so sure. I’m more in the emerging camp of behavioural finance, which takes the notion of human beings as rational creatures, and puts them in a silly hat then plonks them on a photocopier to make duplicate asses of themselves at the Christmas party.

Metaphorically speaking, you understand.

People will always be foolish, greedy, scared, and more interested in jam today than Victoria sponge tomorrow. I therefore suspect that value anomalies will persist, too, although whether you or I will profit from them is another matter.

Small companies deliver bigger returns

It’s not only value that beats the wider market, as it happens.

A few famous growth investors have been successful. In the UK, Jim Slater found fame as a stock picker of small, fast-growing companies. Slater did have a value tilt though, in that his metrics centered on the PEG ratio he made famous, which aims to prevent an investor overpaying for growth. Some other growth investors all but dismiss valuation altogether.

Growth has a poor record when statisticians crunch the numbers, tending to underperform value shares over multi-year periods.

In focusing on smaller companies, though, Slater was on the side of another proven market-beating strategy:

(Click to enlarge the small company's outperformance!)

(Click to enlarge the small company’s outperformance!)

Source: Credit Suisse/London Business School

Unlike with value, I can easily believe higher risk is the reason for the higher returns from smaller companies.

Very small companies – which are the ones that have delivered the highest returns – are illiquid and often difficult to trade, which adds to risk in the academic sense, and so to higher returns.

Higher yield, higher returns

In the UK Neil Woodford has soundly beaten the market by investing in dividend-paying stocks, as we never seem to keep hearing these days.

Few other income investors have Woodford’s record. But the performance of equity income investment trusts as a class has been very good compared to the market for as long I’ve been watching, suggesting to me there may be more at play than just a clutch of lucky managers and a fair investing climate for dividends.

Sure enough, professors at the London Business School report that high yielding shares have also beaten low yielding shares over long periods of time:

(Click to enlarge)

(Click to enlarge)

Source: Credit Suisse/London Business School

The success of high over low yield is to my mind value investing in another guise.

High yield occurs when a company’s price is depressed, perhaps because of uncertainty about its future or the unpopularity of the sector. Sometimes companies are punished just for paying dividends – it’s hard to believe now, but in the 1990s income was barely discussed by most investors and journalists, if not actively looked down upon.

Yet the cash flow suggested by a strong dividend usually indicates there’s at least some money-making going on at the company.

If things don’t turn out as bad as feared – so the dividend is not cut or worse – then high yield shares can keep on paying a high income, and you might see their share price rise in time. Both factors will boost returns.

The trend really is your friend

Hedge funds and others have been able to profit from all sorts of anomalies over the years.

The book More Money Than God offers an excellent history of a succession of hedge fund pioneers spotting inefficiencies and then exploiting them until others join the feast and the easy profits are gone. (The market might not be 100% efficient, but it’s definitely no mug!)

A common thread to many hedge funds’ success is momentum, in which they find and back trends they see in the market.

To over-simplify, momentum means that if prices are rising then they will tend to keep rising, and vice versa. Such trends should not exist according to efficient market theory. Prices should follow an unpredictable random walk.

One of the biggest investing upsets in the past couple of decades though was the discovery that momentum – long derided by both academics and value investors – does in fact exist.

I still feel queasy when someone shows me a rising price chart as the rationale for a share price going up some more. Yet at the market-wide level, the proof is in the data:

(Click to enlarge)

(Click to enlarge)

Source: Credit Suisse/London Business School

Of all these market-beating metrics, momentum is the biggest challenge to the efficient market hypothesis, in my humble opinion as a blogger as opposed to a Nobel prize-winning economist. It shouldn’t exist.

That said, I should stress for novice investors that there is an immense difference between the amateur stargazing that passes for momentum investing on bulletin boards, and the Phd-heavy supercomputing-powered high frequency stuff done by hedge funds.

Even hedge funds have been failing to match the simplest combination of equity and bond ETFs lately, so perhaps academics will have the last laugh (although hedge fund returns are also crippled by their enormous fees).

Can we exploit these market-beating strategies?

Let’s end by asking the obvious question: Could we use these stock picking methods to beat the market ourselves?

I can’t give you a definitive answer. What has worked in the past might not work in the future. I’m on-board with the idea that at least some anomalies will vanish, if they’ve not already, as the mostly-efficient market ferrets out the inconsistencies.

However I do think it’s not an entirely discreditable aim to try use these proven market beating methods to boost your returns.

One sensible approach might be to tilt your passive portfolio to try to capture some of the potential outperformance, rather going whole hog into one market-humiliating venture or another.

Even some of the passive investing gurus recommend as much, suggesting minor additional allocations towards specialist ETFs or tracker funds tilted towards small companies or those with higher yields.

But here’s a few things to consider before you get carried away.

Firstly, the academic research showing the outperformance I’ve cited looks at market wide data, and typically ignores costs.

We can’t forget about costs as private investors, and in the UK it’s hard to invest across the market based on these themes too, although some outfits such as The Munro Fund have tried to change that.

US investors enjoy access to a wider range of passive vehicles, including ETFs that seek to capture these extra gains. You might consider buying into one of these US-listed ETFs if you’re keen, but remember that introduces currency risk, withholding tax, and other complications.

Secondly – and in semi-contradiction to my earlier paean to value investors – just because some metric has previously worked across tranches of hundreds of shares, that doesn’t mean it’s a sure way to pick a handful of stocks.

  • Buying a basket of 250 low price-to-book small cap shares and mechanically shuffling them year-on-year for an academic study is one thing.
  • Buying four or five penny shares you fancy because they seem cheap is quite another thing, and likely an explosive and painful one in most hands.

Finally, academics typically crunch their data over very long timescales. You may well find that a measure such as low price-to-book value outs itself through extra returns over shorter periods – or that it does not – but in any event that’s not what I’m claiming here.

I’m just pointing out what academics have found has worked over periods of 60-100 years or so. But that’s beyond even my investing time horizon, however much I skip the booze and hit the gym!

  1. This graph and those that follow comes from the London Business School researchers behind the Credit Suisse Global Returns Yearbook 2013, which is a treasure trove of interesting data. []
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{ 17 comments… add one and remember nothing here is personal advice }
  • 1 57andrew February 28, 2013, 12:35 pm

    I’m increasingly moving towards index ETFs but I have also picked up a few beaten down names that might be turnarounds. Currently I’m punting on TCG, VLX & LAM. Not big ££ to limit downside but in my view disproportionate upside when I bought them. I think having a dual- pronged approach is perfectly sensible provided you understand the risks you run. Buying Tesco at 298p was a brilliant decision on my part. Sadly I’d first gone in at 420p!!!! Indexing protects you from extreme shocks in the form of profit warnings but also means you went get multi-baggers.

  • 2 DIY Investor (UK) February 28, 2013, 1:05 pm

    Yes, I like income/dividend investing, which, I guess is a form of value investing.

    Although I’m now retired and drawing down the income, the big returns have come from reinvesting the dividends over the years within my sipp.

    I seem to recall reading one of the CS reports a couple of years back which suggested around 90% of long term returns on equities came from the growth and reinvestment of dividends.

    Lots of interesting stuff to look at.

    Cheers,

    John

  • 3 BeatTheSeasons February 28, 2013, 1:18 pm

    Another way of trying to ‘beat the market’ is tweaking asset allocation when you think certain asset classes are going to perform better than others. For example, the current consensus on this blog seems to be that bonds are absurdly overvalued (due to irrational pessimism plus government manipulation of the market) and therefore you should be 100% in equities. You might also want to avoid residential property outside London for a few more years.

  • 4 The Investor February 28, 2013, 1:27 pm

    For example, the current consensus on this blog seems to be that bonds are absurdly overvalued (due to irrational pessimism plus government manipulation of the market) and therefore you should be 100% in equities.

    If one was going to go down this path (and classic passive investing mantra warns you not to, as we know) then I’d agree with the first part of your statement but not the second.

    If someone is meant to have some proportion of their assets in bonds due to their risk profile or similar, but can’t stomach buying bonds at today’s high prices, personally I’d suggest they can currently half-meet the safety cushion aspects of bonds by replacing them with cash in a “high” (if only!) interest savings deposit account.

    In contrast, skipping bonds and going 100% into equities is flagrantly throwing asset allocation out the window, IMHO. It’s doubling down on the divergence from strategic passive allocations.

  • 5 Curious-Sarah February 28, 2013, 1:45 pm

    Dear BeatingTheSeasons — You can do that yes but isn’t that what people do that makes them earn less than the market? (Messing about and trying to be clever I mean). These professors who created this data/graphs have not shown that trying to be clever works, as far as I know. 🙂

    With best regards!

  • 6 57Andrew February 28, 2013, 1:47 pm

    “If someone is meant to have some proportion of their assets in bonds due to their risk profile or similar, but can’t stomach buying bonds at today’s high prices, personally I’d suggest they can currently half-meet the safety cushion aspects of bonds by replacing them with cash in a “high” (if only!) interest savings deposit account.”

    I think the key statement is “due to their risk profile”. I am retired (tho’ not yet 60) and I have done exactly what you suggest. I have only one pure bond in my pension fund – with a 2015 maturity – and my bond allocation is actually in cash. But if I were 25 and with 30-40 years of investing ahead of me I would probably agree and shoot for 100% equities with maybe some commodities thrown in. It also depends on when you entered the market. Its a different proposition entering today than if you entered in the last 12-24 months and have a profit cushion built in.

  • 7 The Investor February 28, 2013, 1:54 pm

    @57Andrew — I agree with some of that, as we all thrashed out on my bonds post the other day. But the comment I was responding to said “the consensus on this blog is…” and “therefore 100% equities” and I wanted to make the statement that this is definitely not the case, for either me or my co-blogger, though doubtless it is for some commentators.

    I was 100% in equities four years ago, and I’ve got no dogmatic objection to it. But it is a big risk, and most people shouldn’t take it.

    The ‘profit cushion’ factor is irrelevant. Money is money, however you got it. You can still lose it! 🙂

    @Curious-Sarah — Indeed! Marking timing moves (and costs) by investors was shown to reduce US returns in the 1990s from something like 11% to under 3%. Most of this was due to poor switching decisions. To be fair though, the general feeling is it’s people chasing strong performers, rather than doing what’s being suggested here and reducing what seem to be over-valued winners. (Though I am sure that’ll hurt most private investors long-term, too, because they’ll get it wrong).

  • 8 57Andrew February 28, 2013, 2:07 pm

    @The Investor, fair comment although I think it is unrealistic to believe that you will always time your exits / switching perfectly so having a profit cushion to me does matter. If I sold my TCG shares today I’d have ~3.5x my original punt money (roughly – I entered at 26p) so if it falls now by 10% and for whatever reason I want or need to sell I wouldn’t feel too bad. If I had entered at 90 and exited the same 10% down I’d be pretty hacked off. Maybe it is the same money but to me it isn’t irrelevant. It has a psychological relevance.

  • 9 Greg February 28, 2013, 2:07 pm

    There are a number of ETFs even in the UK that attempt to tap into these anomalies. Perhaps they are worth a look. (I haven’t looked at any in detail.)

    XSEW – Equal Weight S&P500 (Equal weighting gives a small & value bias.)
    L6EW – Equal Weight Euro Stoxx-600
    LEMV – “Minimum Variance” Euro Stoxx 600 ETF (Picks a changing 300 of the 600 stock available to minimise variance. Not quite the same as in the article but the same sort of idea)
    LMMV – Minimum Variance Emerging markets ETF. (I like the idea of this one, particularly as there must be a more diverse selection to choose from.)
    MVUS – Minimum Volatility S&P500
    PSRM /PSRF / PSRE – “RAFI” index of EM, US & EU markets, with the same sort of idea, basing the weightings on a number of factors, but giving a value bias.
    EUDV / UKDV / USDV – “Dividend Aristocrats” ETFs for EU, UK & US markets.

    Any I’ve missed? (I know the US has ones like CSD; A “spin-off” ETF but I’ve only listed ones on the LSE. I’m not aware of any momentum based ETFs.)

  • 10 The Investor February 28, 2013, 2:45 pm

    @57Andrew – Psychological relevance perhaps, but no logical relevance. 🙂 The market doesn’t care what price I bought at, and nor should I. What I should care about is the potential I see in each asset I own or might own from this point forward.

    I definitely don’t believe you can time your exit/switching perfectly. Far from it! 🙂 But I don’t see any relevance in that, to be honest.

    The point is that I as a stockpicker I want to hold a collection of assets that I think will outperform the market over some timeframe given where I am today, not that will recoup/grow some proportion compared to my initial buy prices.

    What you’re describing is the extremely common phenomenon of price anchoring, and it’s one of many psychological biases that can reduce your returns.

    @Greg — Excellent and on-topic, thanks for those! 🙂

  • 11 Metodej February 28, 2013, 3:32 pm

    I’d agree with Greg that equal-weighting is one of the easiest way to beat the market; see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1787045

    EW does make sense for a broad single market index, however I’d be very cautious about buying an equal-weighted multi-national index. Difference in stock movements in such an index is not only due to the perceived performance of individual companies (which gives rise to under/overvaluation) but also by quite a few external factors that are not shared intra-index.

  • 12 William Cowie February 28, 2013, 4:13 pm

    I, too , am a value investor. Warren Buffett is who persuaded me to begin with, but the more I’ve looked into it, the more I believe in it. And you’re right, it is especially true when it comes to smaller companies.

    The price of a stock pretty much has only two components: EPS and PE. Earnings are what they for every company, and if the company you invest in has growing earnings, that’s strength. If a company has a high PE, you always run the risk of the price not keeping up with the earnings. But if the price reflects a low PE to begin with, and the company is healthy and profitable, what, is the PE going to go down even further? Not bloody likely (as the Brits love to say).

    A low PE is your protection from Mr. Market’s vagaries. Why? Because Mr. Market can’t ever argue about the earnings — they are what they are. The only say Mr. Market has in a stock price is the PE multiple. And if that multiple is low when you buy, your risk of Mr. Market changing his mind is at a minimum.

    There is a reason why many people stay way from value investing: it is a lot more work than any other kind. You have to dig and dig and dig to find the gold nuggets. Most people, fortunately, are too lazy for that. And too impatient, because value investing usually only works when you’re looking at horizons of more than two whole years…

    And that is where Warren Buffett saw most of his early success: digging a lot and being patient.

  • 13 Trystero March 2, 2013, 5:18 pm

    Could you please provide a title of the paper from which come the graphs in your article.

    Excellent reading.

  • 14 Greg March 2, 2013, 5:53 pm

    I’ve just had another quick look at these new minimum variance ETFs and while very new, I’m very impressed with the idea.

    I’ve been to the Ossiam and iShares sites and taken a look at their various ETFs covering the EU, US, EMs & World.

    The Ossiam ETFs are a bit more expensive (TERs of 0.65% – 0.75%) than the iShares ones (TERs of 0.2% – 0.4%) but they are so new I don’t have much more information about them. Confusingly, they have overlapping tickers for different bourses.

    http://www.ossiam.com/index.php/products/etf-product-range
    and
    http://uk.ishares.com/en/rc/funds/overview/DEVEQUITY
    http://uk.ishares.com/en/rc/products/EMMV

    If you click through the Ossiam site, there is quite a lot of information – here’s a holdings breakdown of the EM ETF.

    http://www.ossiam.com/index.php/solutions/ossiam-etf-emerging-markets-minimum-variance-nr-usd?tab=expositionOn

    It seems to work though. Looking at http://www.morningstar.co.uk/uk/etf/snapshot/snapshot.aspx?id=0P0000TYKM&tab=2 the volatility is massively less than the index as a whole.

    I’ll definitely be keeping an eye on these products. (I never rush into things.) It seems to me that they are hugely different to just cap-weighting. (e.g. GB & Switzerland make up 65% of the EU ETF and US & Japan make up 85% of the World one!)

  • 15 The Investor March 3, 2013, 10:20 am

    @Trystero — As said in the article the data is from the Credit Suisse Yearbook 2013 research, though this is from the associated exec summary type material and may not be so widely available.

  • 16 NaeClue March 8, 2013, 8:29 pm

    You might beat the market by taking on more risk than the market. In other words expected returns are higher for higher risk, but not guaranteed. Going for small caps is taking on more risk. Going for value (troubled companies Mr Market does not like) is taking on more risk. There are not many free lunches. Wierdest thing of all is the low volatility anomaly – maybe that is a free lunch, or maybe it will stop working now a lot of people know about it.

  • 17 The Investor March 8, 2013, 10:21 pm

    @NaeClue — Yes, I pointed to that view of risk in the article. 🙂 As I say I don’t really agree with the pure academic viewpoint, I don’t think the market is entirely efficient. I am not convinced value shares, in aggregate, are more risky, for example, in terms of how I’d use the word risk. (Which is much closer to how Buffett would…)

    Whether/how anyone can profit from the inefficiencies is another matter altogether — clearly the overwhelming majority of active managers industry cannot at a sufficient level to offset their charges, for instance.

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