Foundations for a rally

Housebuilders' first-quarter effect

Here's how it works: in the first week of the year all you have to do is buy a selection of the UK's largest housebuilders and hold them for three months. At the end of March, phone your stockbroker or spread-betting company and close your positions but, most importantly, tell them to send you a cheque with your profits. It may sound simple, but if you had followed this trading strategy you would have made a profit in the first quarter of the year on no fewer than 28 of the past 33 years, netting an impressive 11.1 per cent average quarterly gain. There are eight housebuilders in the FTSE 250: Barratt Developments (BDEV), Bellway (BWY), Berkeley (BKG), Bovis (BVS), Galliford Try (GFRD), Redrow (RDW), Persimmon (PSN) and Taylor Wimpey (TW.)

Table one: Housebuilders' first-quarter performance since 1980

Superior investment return

The housebuilders not only outperform the benchmark UK index on average more years than not - 28 up years since 1980 compared with 24 up years for the FTSE All-Share index - but the quarterly return on the sector is significantly higher at 11.1 per cent compared with the average first- quarter return of 3.3 per cent on the market (see table one). And it gets better.

That's because we can also pair trade the sector against the UK market by buying shares in the eight FTSE 250-listed housebuilders and simultaneously short-selling the market over the first quarter.

Since 1980, if you had bought a selection of shares in the housebuilders at the start of January and simultaneously sold short the FTSE 100 to the same value (a proxy for the FTSE All-Share), this trade would have produced a positive return during the first quarter in no fewer than 28 of the past 33 years. The average return from this long-short trading strategy has been an eye-watering 7.7 per cent. And, remember, this strategy not only improves the chances of generating a positive return during the first quarter, but it also reduces risk.

Reducing investment risk

Granted, the 7.7 per cent net quarterly return following my pair-trade strategy is less than the 11.1 per cent average return made by simply buying a selection of the UK's housebuilders at the start of January. However, a quick glance at the results in 2008 and 2009 illustrates why this long-short trading strategy has its merits. To recap, the UK stock market fell off a cliff in the first three months of those years, ending the quarter down over 10 per cent. But even in the face of a savage sell-off across global equity markets, a strategy of buying the housebuilders and short-selling the market produced a positive net return of 4.4 per cent and 26.6 per cent, respectively, in the first quarter of 2008 and 2009.

Risk aversion

These recent experiences highlight the risk-averse nature of this long-short trade. Namely, if markets are rising - as they traditionally do during the seasonally strong winter months - then, given the even stronger seasonal bias of the housebuilding sector, the odds are heavily skewed towards the sector outperforming the market as a whole. However, if markets fall in the first quarter - as they have done during nine of the past 30 years - then the housebuilding sector is far less likely to fall with the market. In fact, there are five years - 1992, 2001, 2003, 2004 and 2009 - when the UK stock market fell in the first quarter, but the housebuilding sector still produced a positive return. In these instances, investors would have made gains on both sides of the pair trade.

Reasons for the phenomenon

Housebuilding is a highly-seasonal business with newsflow and sales firmly skewed towards the all-important spring selling season. So at this time of year there is increased interest in the sector as investors focus on price trends and the strength of the underlying housing market. And as companies have a firm bias towards reporting financial results in the first quarter - since the majority have calendar or January year-ends - this also brings into focus the merits of the housebuilders.

There is also another reason why the sector outperforms the general market in the first quarter: this time of the year is when investing in 'cyclical' or 'value' stocks - ie, those that are very sensitive to changes in macroeconomic conditions - does well. Moreover, with mortgage rates at multi-year lows and housebuilders' profits getting a lift from cheap land acquired during the depths of the recession, the sector is enjoying relatively benign conditions at the moment even in the face of a dire mortgage lending market and an anaemic UK economic recovery.

Table two: FTSE 350 Housebuilders' key financial data

A smart way to trade

Clearly, no trade is guaranteed to produce a profit and the sector is clearly susceptible to general market weakness and profit-taking following the sharp re-ratings enjoyed last year. But it's worth noting that only once (in 2000) in the last 33 years has the housebuilders' index fallen more than the UK market when equities ended the first quarter in negative territory. On the other eight occasions when the UK market fell in the first quarter, the housebuilders outperformed the index by an average of 11.9 per cent. In other words, it's pretty rare to see the sub-sector underperform in this specific three-month period when the general market falls. Moreover, when the market rises, we can expect absolute outperformance.

Therefore, my recommended trade is to buy shares in the eight housebuilders above in equal portions and hedge off this long position by simultaneously taking out a short position on the FTSE 100 to create a classic long-short pair trade. The aim is to try to generate the 7.7 per cent 'alpha' the housebuilders sub-sector has returned in the first three months of the year since 1980. For the short side of this trade, I am advising using a short ETF on the FTSE 100, Deutsche Bank db-x daily index tracker (TIDM: XUKS).

A major benefit of this type of long-short pair trade is that we have an effective hedging mechanism in place to guard against periods of heightened risk aversion. Moreover, dealing costs can be kept low by trading through execution-only brokers. There is, of course, the chance that this could be the one year, as was the case in 1985, when the housebuilders sector falls and the market rises, in which case we would lose on both sides of the trade. But that is a risk I am willing to take as I believe that a modest investment in housebuilding shares is more likely than not to produce solid profits in the next few months. More adventurous investors may wish to skip the hedge and buy shares in the housebuilders outright.

Small-cap stock picks

In June this year, I gave an investment seminar to no fewer than 350 delegates as part of Investor Chronicle's 2012 event programme at the BMA headquarters in central London. My topic was how to profit in a low-growth environment and, having outlined the macro backdrop and implications for asset classes and segments of the equity market, I selected five stocks that I firmly believed would do rather well in the second half of 2012. We have not been disappointed because these five shares have risen on average by 32 per cent in the past six months, comfortably outperforming the FTSE Small Cap and Aim indices and absolutely trouncing the mega and mid-caps. In fact, my small-cap stock picks have created over 18 per cent of alpha against both the FTSE Small Cap and FTSE 250 mid-cap indices.

If you attended the seminars and followed my advice, or bought into these plays following my subsequent articles in Investors Chronicle, I would run your profits on all five companies. I will offer further updates on all five companies early next month and will also update my US Dog Share portfolio. which is currently up around 2.6 per cent since the start of October compared with a 1.6 per cent fall in the S&P 500 index in the same time.

Performance of Simon's stock picks from IC seminar on 18 June