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The power of simplicity

Simple defensive and value investing have done better than most fund managers in the past 12 months
The power of simplicity

Thanks in part to the fallout from the EU referendum, no-thought value investing has beaten most active fund managers recently.

Our basic value portfolio (an equal-weighted basket of the 20 highest dividend yielders at the end of June) rose by 12.4 per cent in the third quarter (Q3), even excluding dividends, which easily beat the 6.7 per cent rise in the FTSE 350.

There were two main contributors to this. One is that sterling's weakness has boosted many overseas earners: HSBC, Petrofac and Vedanta all rose nicely. The other is that sentiment towards some cyclicals was depressed in late June but has since recovered, as it seems - for example, from purchasing managers' surveys - that the near-term hit to economic activity won't be as bad as feared. This has boosted domestic cyclical stocks such as Persimmon, Galliford Try and Amec.

 

 

Performance of our no-thought portfolios  
 In Q3Last 12MLast 3YLast 5Y
Momentum13.115.339.983.3
Negative momentum2.915.1-35.4-30.7
Value12.423.530.883.1
High beta14.74.1-27.321.6
Low risk9.722.423.955.9
Mega-caps4.715.23.524.1
FTSE 3506.712.78.740.6
Price performance only: excludes dividends and dealing costs 

 

 

These two factors have also contributed to a big rise in high-beta stocks. Our basket of these rose 14.7 per cent in Q3, thanks to rises in Glencore, Vedanta and Evraz as well as in some financial stocks.

If this suggests that value and high-beta portfolios have much in common, it shouldn't. Their longer-term performance is very different. Value has done well in the past five years, whereas high-beta has done badly.

A big reason for the latter has been pointed out by researchers a AQR Capital Management. They say that some bullish investors cannot express their optimism by borrowing more to buy stocks generally. Instead, if they want geared exposure to the market, they buy high-beta shares. This means that such stocks are often overpriced, and so they subsequently do poorly.

The cause of value stocks' good performance is less clear. We should distinguish between types of value stock. Some have good yields because investors are wrongly underestimating their growth prospects, in many cases because they pay too much for 'exciting' growth stories and not enough for what Warren Buffett calls 'moats' - things that give a company some monopoly power. This has traditionally been the case for defensive value stocks such as utilities, tobacco and some big food and drink producers.

However, these are mostly not among the very highest yielders. Instead, these are to be found among the most cyclical stocks. These have outperformed in recent years not because they've been genuine bargains, but simply because the risk of recession has not materialised and so investors have been well rewarded for taking it. Our value stocks have done well in the past five years, but this is the counterpart of the fact that they did appallingly badly in 2008-09 when high-yielding mortgage lenders were pretty much wiped out.

It's not just value stocks that did well in Q3, however, to continue a long run of success. Two other longstanding strategies also beat the market.

One is momentum. Our basket of the 20 best-performing stocks in the 12 months to June rose by 13.1 per cent in Q3. Granted, this is due in large part to big rises in just two stocks: Boohoo and Hochschild. But so what? A strategy that gives us one or two big winners and no significant losers is well worth adopting.

This continues a trend. It means momentum stocks have beaten the market in the past one, three and five years.

The converse of this is that negative momentum has done badly. Its underperformance in Q3 means that it has done horribly over the past three or five years: it did, however, have a brief spell of good performance earlier this year when bombed-out mining stocks bounced back.

These two facts suggest that investors tend to underreact to both good and bad news. If a stock enjoys some good news, they stick too much to their prior belief that the stock isn't very good and so fail to update their beliefs sufficiently. This causes share prices to rise less than they should, with the result that the shares are underpriced even though they appear to have risen nicely. The converse is true of stocks that suffer bad news; investors pay too much for the hope of a swift turnaround.

All this confirms what Narasimhan Jegadeesh and Sheridan Titman pointed out 15 years ago - that simple momentum investing pays off nicely.

You might wonder why investors haven't cottoned on to this, and so eliminated the anomaly. In the case of negative momentum it could be because there are big obstacles to short selling, which mean that rational investors cannot fully express their negativity towards stocks. In the case of positive momentum, it might be because momentum stocks carry benchmark risk: there's a small but significant danger they'll underperform rising markets, which will cost a fund manager his job.

A second strategy to have paid off well is defensive investing. Our portfolio of the 20 lowest-beta stocks (subject to no more than three from any one FTSE sector) beat even a nicely-rising market in Q3. This continues a long outperformance.

As with momentum investing, this corroborates longstanding research; the evidence for the outperformance of defensive stocks dates back at least as far as 1972.

Why does the outperformance persist? One reason is the same as that for momentum doing well - benchmark risk. Defensive stocks run the risk of underperforming a sharply rising market, something that fund managers want to avoid. A second reason is the counterpart to the poor performance of high-beta stocks; if the latter are overpriced it follows that defensives will be underpriced.

Herein, though, lies something odd. In the past 12 months, our simple no-thought value and defensive strategies have beaten almost all active fund managers. Only three funds in Trustnet's database of all companies funds have beaten our value portfolio, and only five have beaten our defensive portfolio. And this is based on comparing their returns including dividends to our returns excluding dividends.

In part, this reflects poor performance by active managers generally: only 14 funds of 257 in the All Companies sector have beaten Scottish Widows UK tracker fund in the past 12 months. One reason for this is that fund managers have been wrongfooted by the reversal this year of some trends that had previously helped them - for example the fall in domestic cyclical stocks after the Brexit vote and the recovery of mega-cap resources stocks. Also, over the past 12 months, mega-cap stocks have beaten the market. The counterpart to this is that most stocks have underperformed market indices (which are weighted by market capitalisation), which has hurt those funds that were underweight in mega-caps.

There might be a lesson here. In volatile times, our judgment can mislead us. It might, therefore, be better to stick with simple strategies that have a proven track record, such as value momentum and defensives. You don't need to think to do well.

 

Our new benchmark portfolios

These are our new no-thought portfolios. All consist of equal-weighted baskets of 20 stocks with a market cap of more than £500m, taken from the IC's stock screens.

These portfolios are precise embodiments of what are in fact only rough strategies. For example, the 21st best-performing stock in the past 12 months doesn't get into our momentum portfolio, even though it obviously has momentum. And one might define momentum or beta in ways other than I have - as the best performer over 12 months, or based on monthly returns over five years. These portfolios are intended to test more general hypotheses, about the success (or not) of general strategies. I don't pretend they are the best way of implementing these strategies.

Note that our momentum portfolio is heavily weighted towards resources stocks. This makes it especially risky.

Note too that our defensive portfolio is formed by brute maths. For example, Melrose gets in because doing badly while the general market has done well gives it a negative beta in recent months, which means that even over a longer period it has a low beta. If I were to tweak this portfolio by using judgment, I'd probably exclude Melrose and have some bigger-name defensives instead.

 

Momentum (the best performers in the past 12 months): Acacia Mining, Anglo American, Asos, Boohoo, Centamin, Electrocomponents, Evraz, Fevertree Drinks, Fresnillo, Glencore, GVC, Hochschild, Indus Gas, Kaz Minerals, Micro Focus, Polymetal, Premier Farnell, Randgold, RWS, Sirius Minerals.

Negative momentum (the worst performers in the past 12 months): Aldermore, Capita, Capital & Counties, easyJet, Essentra, Interserve, Marks and Spencer, Melrose, Mitie, N Brown, Next, Nostrum, Pearson, RBS, Restaurant Group, SIG, Sports Direct, Stagecoach, TalkTalk, Thomas Cook.

Defensives (the lowest-beta stocks in the past five years, subject to no more than three from any one sector): Breedon, BTG, Cineworld, Consort Medical, Emis, Euromoney, FirstGroup, GVC, Imperial Innovations, Indus Gas, James Halstead, KCom, Melrose, Nichols, Primary Health, Rank, Redde, Stagecoach, TalkTalk, Telecom Plus.

Value (the highest-yielders): Aberdeen Asset Management, Berkeley, BP, Carillion, Debenhams, easyJet, Galliford Try, HSBC, Interserve, Legal & General, Man, Marks and Spencer, Mitie, N Brown, Nostrum, Pearson, Persimmon, Phoenix, Redefine, TalkTalk.

High beta (the highest-beta stocks in the past five years): 3i, Aberdeen Asset Management, Centamin, Etalon, Evraz, Fresnillo, Glencore, Henderson, Hochschild, IPF, Jupiter, Kaz Minerals, Lonmin, Mondi, Schoders, Sirius Minerals, Standard Chartered, Thomas Cook, Travis Perkins, Vedanta.

Mega-caps (the biggest stocks): AstraZeneca, British American Tobacco, BHP Billiton, BP, BT, Diageo, GlaxoSmithKline, Glencore, HSBC, Imperial Brands, Lloyds Banking, National Grid, Prudential, Reckitt Benckiser, Rio Tinto, Royal Dutch Shell, SABMiller, Shire, Unilever, Vodafone.