That's one reason why I maintained a strategy all this year of targeting small caps, the one segment of the market that benefits most from the ultra easy and unorthodox monetary policy that central banks have been employing to try to boost economies suffering anaemic levels of growth. It is also the main reason why I have been sanguine about the general market sell-off since the middle of September since all of the equity investments I have recommended this year have been focused on niche plays at the smaller end of the market. That's not to say that my share recommendations are completely immune from a general rise in risk aversion, no equity investment can possibly be. However, by targeting undervalued special situations priced at discounts to intrinsic value of a company's assets, I have managed to build in a safety net into my stock selections and one that is more likely to attract similar like-minded investors.
Fundamental-based approach
It is a fundamental-based approach that will ultimately attract other medium and long-term investors who are more concerned with generating decent returns over a reasonable time horizon rather than trying to make quick-fire gains. Another benefit of this specific approach is that general market corrections will have less of an impact on my stock selections. That’s because, day traders aside, readers who are following my advice are basing their decisions on sound fundamental analysis and, importantly, most of my special situations have a visible exit strategy worth holding out for.
For instance, the three investment companies I have recommended: LMS Capital (LMS), Spark Ventures (SPK) and BP Marsh & Partners (BPM), are following investment strategies that will enable shareholders to benefit from decent total returns through a combination of share price upside, capital returns and dividends. In the case of BP Marsh, the initial public offering (IPO) of the company’s largest investment, Hyperion Insurance, is a mighty attractive reason not to succumb to short-term market jitters. I have also targeted companies offering products and services that have an immediate and importantly, quantifiable, benefit to the businesses of their clients so actually benefit when companies' purse strings are tight and finance departments are looking to generate savings or outsource functions to better value operators. Software companies Netcall (NET) and Sanderson (SND) fall into this category. They have also adapted their business models well to technological change and have been smart in creating products to commercialise opportunities offered in new markets. We also get healthy income flows from both companies which is a prerequisite for my Sirp approach to investing.
Positive newsflow
I have also made a concerted attempt to target companies where there will be positive news flow in the months and weeks ahead in order to benefit from a positive tailwind even if other investors are bracing themselves in a turbulent market headwind. This is precisely the reason why my 2012 Bargain Share Portfolio has performed so well in the face of the general 'risk off' market environment we have been witnessing for the past eight weeks.
It's worth pointing out that as part of my stock picking process I try to take a general market overview to understand the overall macroeconomic backdrop, and then apply my findings to individual sectors to decide which segments of the market I should be targeting at any one given time. I then screen companies within these sectors to whittle down the number of potential investment opportunities to which I then apply my fundamental analysis. Having done my research, I then weigh up how the technical situation looks for my short-list of potential investment opportunities. Only when I can tick all the right boxes do I advise readers to buy into these special situations.
Regular readers of my columns over the year will know that I also use an academic approach to investment analysis, too. So with the most profitable month of the year almost upon us, it’s time to investigate the case for one of my profitable trades of the year.
Betting on a Christmas rally
Christmas is always an expensive time of the year, but not for everyone. That's because December is one of the most profitable months to be investing in equities. It's not a lottery either as we can mitigate the risk of making a loss by following some pretty hard and fast rules, which I uncovered while writing my book, Trading Secrets: 20 Hard and fast ways to beat the market (FT Prentice Hall, 2008).
You've probably all heard of the Santa Claus rally - the market's tendency to rise, often on low volume, in the run-up to Christmas. But you may not appreciate how consistent it is. Since 1980, the FTSE All-Share has risen no fewer than 26 times during the month and only fallen six times. True to form, in the past three years the market rallied 1.85 per cent during the month in 2009, 7 per cent in 2010 and 1 per cent last year.
It's worth noting, too, that the odds are stacked heavily in your favour. During the 26 'up' years since 1980, the average December gain has been 3.26 per cent. Even allowing for the six 'down' years as well, the average monthly gain is still around 2 per cent.
Moreover, the chance of taking a big hit during December is much less than at other times of the year. Even during bear markets, the size of December's falls - around 0.5 per cent on average - has been pretty modest. The UK stock market has only been in a bear market four times during December in the past four decades, so any potential hit is unlikely to be that severe. In turn investors become less risk averse and more likely to play the markets.
It is also apparent that it takes something significant to derail the UK market during December. For instance, in 1980, it was political strife during Margaret Thatcher's first term in office and a UK recession that sent the market tumbling by almost 5 per cent. Two decades later, the bear market got its claws into investors' portfolios in 2002, sending stocks down by a similar amount. However, these kinds of losses are pretty rare and the other four down December months in the past three decades were not major losers.
Reasons for Santa Claus rally
So why does the market gift investors such healthy returns in this way? There are three main reasons:
■ Window dressing. For fund managers chasing bonuses, performance is everything and they seek to maximise it at year-end.
■ Seasonality. The fourth quarter has been a great time to be invested in equities as the UK stock market generally; it has only fallen seven times in the three-month period since 1980, and overall has posted an average gain of 3.8 per cent.
■ Christmas trading. Most of December's outperformance tends to come in the second half of the month. This has everything to do with Christmas falling in the final week of December, which has a direct impact on how markets behave around this time of the year.
Improving the odds of a Happy Christmas
There's a simple reason why December gains are so weighted to the final fortnight: volume. It is common to see trading volumes tail off in the run up to Christmas, as dealers and traders shut up shop for the festive period. As liquidity dries up, the only market participants still trading are likely to be buyers of shares. So conditions are ripe for the market to rise on low volumes - which is exactly what happens.
In the past 30 years, the UK market has risen no fewer than 26 times in the period from 11 December to 5 January, falling only four times. The average gain has been 2.66 per cent, even allowing for the down years.
If anything this trend seems to be getting stronger as the market rose by over 5 per cent over this 25-day period in both 2008 and 2009, 2.3 per cent in 2010 and 3.4 per cent in 2011. Not only is that better than the historical average, but there are also far fewer down days, so the risk of banking a loss on this trade is lower. By comparison, the odds of the UK market rising in the first 10 days of December are no better than 50:50.
It’s also worth noting the influence on stock prices of 'Triple witching' - when quarterly index and stock options and futures derivative contracts are settled on Euronext. This has a noticeable impact on UK equity markets at this time of the year. You don’t have to be trading futures and options to see its effects. Since 1998, the market has risen no fewer than 10 times and only fallen four times across the 10 trading days either side of triple witching day in December (which this year falls on the 21st). It doesn’t take rocket science either to understand why this happens because with a seasonal investing tailwind in the fourth quarter, it's only reasonable to assume that most investors holding 'in-the-money' options by the mid-December option expiry date will be long of the market. Therefore, it is in their interest to make sure that these contracts are settled at the highest possible prices, so they tend to bid up the market to ensure this happens.
A year-end rally is even more likely if you consider that the market has risen on average over 75 per cent of the time on the two trading days prior to Christmas and the three trading days following Boxing Day. So, with Christmas Day falling on Tuesday this year, and option expiry the previous week, it means that no fewer than 10 of the 16 trading days that fall this year between Tuesday 11 December and Friday 4 January have historically been very strong days. Put like that, would you bet against a Christmas rally?
MORE FROM SIMON THOMPSON .....
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Trading Emissions, Indigovision, Henry Boot (A rerating beckons, 12 November 2012)
Elementary: Simon Thompson's guide to stock picking (9 November 2012)
Spark Ventures (Time to spark a re-rating, 8 November 2012)
LMS Capital (Capitalise on LMS, 7 November 2012)
Stanley Gibbons (A stamp of authority, 5 November 2012)
Molins (A share ready to smoke, 29 October 2012)
BP Marsh & Partners (A hyper value buy, 26 October 2012)
FTSE 100 Trading strategy (A smarter option, 25 October 2012)
Sanderson (Online growth drives Sanderson, 23 October 2012)
IQE (Take that and rally, 19 October 2012)
Communisis (Trading buy: Communisis ready to fly, 19 October 2012)
Noble Investment (Noble's missing commission, 16 October 2012)
