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Where to be a value investor

Where to be a value investor
June 23, 2016
Where to be a value investor

We know that momentum investing often works, in two different senses. One is that simple strategies of buying recent winners beat the market on average. The other is that a strategy of buying the market when its price is above its 10-month average, and selling when it is below, has paid off well in recent years not just for the All-Share index but for several sectors and for Aim, too.

Nevertheless, value investing still has a place, as a simple test shows.

To see this, let's go back to basics. If value investing works, then a stock that has fallen for no good reason should subsequently recover, as value investors step in and buy it. If this is the case, then the volatility of longer-term returns (say one or two years) will be less than that of shorter-term returns (say one month), because falls will be followed by rises.

If, however, momentum investing dominates then falls will be followed by further falls, and rises by further rises, so longer-term returns will be more volatile than short-term ones.

And if share prices follow a random walk in which past returns have no power to predict future ones, then the volatility of longer-term returns will be the same as that of shorter-term returns.

All this gives us a simple test of when and where value rather than momentum investing works. If the ratio of long-term volatility to short-term volatility is above one (when volatility is annualised) this is a sign that momentum investing works. If, however, the ratio is below one, then value investing works.

My table shows the results of this test for some interesting sectors. The first and third columns show the ratio of annual volatility to the annualised volatility of monthly returns, and the second and fourth columns show the ratio of two-year volatility to monthly volatility (again, both annualised).

Volatility ratios
since 1995since 2003
Annual/monthlyTwo year/monthlyAnnual/monthlyTwo year/monthly
All-Share index1.101.211.161.20
Oil & gas0.830.880.820.85
Miners1.121.171.171.26
Food producers0.940.870.950.83
Tobacco0.890.850.800.84
Pharmaceuticals1.131.380.900.98
Telecoms1.271.571.011.04
Utilities1.151.351.111.38
Banks1.091.181.060.90
IT software1.372.211.251.26
IT hardware1.532.811.671.96

Most sectors have volatility ratios of more than one, implying that momentum works. This is true for the All-Share index as well: hence the success of the 10-month average rule.

But there are some exceptions. Oil stocks, food producers and tobacco stocks have volatility ratios of less than one, suggesting that value investing works here, because falls are more likely than not to be followed by rises, and vice versa.

There's a pattern here. Value investing tends to work for big defensive stocks (although utilities are an exception to this) whereas momentum works more in speculative growth sectors. Note, for example, the especially high volatility ratios in IT stocks.

One big fact corroborates this pattern. Two sectors have gone 'ex-growth' since the 1990s: pharmaceuticals and telecoms. Both have had lower volatility ratios in their ex-growth period than when they were growth sectors.

There's a reason for this pattern. It's to do with uncertainty. If a company's prospects are especially uncertain - say because it is young and small or producing a new product - investors won't trust their own valuation of it. Instead, they'll put some store by others' opinions. This will tempt them to buy when others are buying, thus generating momentum.

But if companies are established and familiar, investors will have more confidence in their own valuations and so will be more willing to be contrarians. This will embolden them to buy when others have sold, thus causing value investing to work. Big familiar companies tend to be defensives: the oil majors, tobacco companies and, in recent years, big pharmaceutical companies.

The point here is simple. Investing is a matter of horses for courses. Applying either momentum or value blindly across the board will sometimes fail - as value investors who lost money during the tech bubble will remember. What we can say, though, is that value is more likely to work for familiar, big stocks and momentum to more speculative growth stocks.