The best-performing stock market styles

For the stock screens that appear in this publication, this data is often company-specific, involving a combination of quantitative factors (such as liabilities, profit margins and sales growth) and ratios (such as price/earnings multiples or free cash flow yields).

But this isn’t the only data-driven approach. This week’s screen, for example, uses a methodology designed to take a momentum-like approach to investment style. By following whatever approach is working in the market – be it growth, value, quality or momentum – our Strategy screen seeks to mix sentiment with the cheapest, fastest-growing, highest quality or fastest-rising stocks at any given moment (or in practice, each time it is refreshed).

Last year’s 18 selections, which we published on 17 May 2022, therefore represent the best-performing styles (rather than stocks) in the three months prior to that date. That 10 of them posted a loss in the subsequent period – leading to a combined negative total return of 5.1 per cent in the 48-week assessment period – might not come as a surprise when you consider that every individual stock factor we tested had lagged the FTSE All-Share between February and May last year.

As a result, the Strategy screen failed to match the returns from the FTSE All-Share for the fourth time since we started running it in 2013. Over that span, it has delivered a cumulative total return of 156 per cent compared with 84 per cent from the FTSE All-Share. That is, of course, a somewhat theoretical return. While the screens in this column are meant as a source of ideas for further research rather than off-the-shelf portfolios, if we add in a notional 1.25 per cent annual charge for dealing costs, the total return drops from 156 per cent to 126 per cent.

There is a big caveat to this otherwise pedestrian performance, however. Between 2018 and 2020, we softened the criteria of the screens to reduce volatility and add some diversification. When only commodity giant Glencore (GLEN) passed all of the screen’s tests last year, we opted to admit stocks that passed the strongest factor but failed one of the two weaker tests. While we stand by this approach, as we discuss in greater depth below, it has also softened the Strategy screen’s returns. Glencore shares, for example, have posted a total return of 8.5 per cent since we ran the 2022 screen, thereby beating both the FTSE All-Share by 60 basis points and trouncing the average return of its Strategy cohort by 13.7 percentage points.

In fact, if we had only permitted fully qualifying shares (five in 2018, six in 2019 and just one in both 2020 and 2022) the total return since we started running the screen is some way better at 247 per cent, before real-world dealing costs. As we explore below, finding the balance between diversification and test purity is a theme that comes up again this year.

The methodology

The way the Strategy screen works is by assessing the three-month performance of 13 different ‘buckets’ of shares (see chart), each of which represents the most attractive fifth of the FTSE All-Share constituents based on a given strategy criteria (such as high forecast EPS growth, or low price to book ratio). Stocks are then ranked on how many of the best-performing buckets they fall into, with three being a perfect score.

This year, for the third time in four outings, a high proportion of single factors have failed to beat the benchmark. Perhaps it’s a first-quarter phenomenon. Or perhaps it’s evidence that being the cheapest, fastest-growing, highest-returning or rallying share isn’t a virtue in isolation.

It’s a point that was recently echoed in a research note published by Jay Rajamony, head of alternatives at quantitative investment manager Man Numeric. Rajamony found that since 2006, a regularly refreshed portfolio comprised of style factors weighted to their popularity (in descending order: value, momentum, capital efficiency, earnings quality and the small size factor) would have seen its 10-year rolling return premium diminish when compared with the broader market.

The scale of the factor ‘decay’ varies between geographies, with the premium effectively disappearing across Asian equities, falling from around 7 to 2 per cent in North America, and from 5 to 3 per cent in Europe, but the trajectory is consistently negative. The implication, therefore, is that factor-based edges have been slowly arbitraged away.  

The unreliability of isolated factors is a point that the Strategy screen’s author Algy Hall made when he joined our podcast last week to discuss his new book on stock screening, Four Ways to Beat the Market.

Like Algy, it strikes me as logical that factor premia would gradually decay over time. As noted, while markets rarely offer free lunches, they are full of investors looking for any edge available. And because factors have historically been a source of alpha – that is, a feature of stock prices that were typically overlooked by the market – it was inevitable that markets would eventually catch up.

Neither is this phenomenon new, exactly. Although he is known as the father of value investing (and Warren Buffett’s most important teacher), Benjamin Graham was also a quantitative investor. One of his top insights – that investors should look for blue chips trading at significant discounts to their assets – is rarely applicable in today’s markets, precisely because the lesson is so well appreciated.

Does this mean our screens are doomed to lose any edge they might have once possessed, too?

The reality is a little more nuanced, owing to the way the screens are constructed. Because they often combine several factors to whittle down a few good investment ideas, they are more specific and idiosyncratic than isolated attributes. This, as Algy argues, makes screening one of the smartest ways for investors to develop what he calls a “behavioural advantage”. I think he’s right.

2023’s selections

Over the past three months, all but one of the 13 individual stock factors the Strategy screen sifts through has lagged the FTSE All-Share, which has returned 0.3 per cent on a total return basis.

In 2022, there was no clear pattern to those factors in terms of style. Put simply, everything was bad. This time, while everything is again rough, there is a more discernible flavour to the best (or more aptly, least-worst) metrics. The strongest two – high forward EPS growth and low PEG (price to earnings growth) ratio – are concerned with growth, reflecting what on balance amounts to a lukewarm bounce-back in sentiment toward companies with rising profits.

The relative success of a third single factor – stocks with a low price-to-sales ratio – suggests value can still catch a bid, providing a company has the cushion of a readymade and addressable market.

Fortunately, the fact that two of the three factors failed to match the market return doesn’t alter the methodology. Where things get a bit fiddlier is how rigorous we are with the tests.

Because there are around 580 stocks in the FTSE All-Share, it would be rare for more than 20 stocks to pass all three tests. Normally, it’s a lot less; this year, just seven stocks get a perfect score. But while there is a precedent for such a paucity of picks – in its inaugural (and best-performing) run-out in 2013, the screen highlighted six stocks – such a high level of concentration increases the chances of skewed returns relative to the benchmark. That's a concern when almost half of the selections are in one, high-volatility sector (see EnQuest (ENQ), Tullow Oil (TLW) and Drax (DRX)).

As a compromise, I have also included the 21 shares that pass the second-strongest individual factor from the past three months. Further details can be found in the accompanying table and downloadable spreadsheet below.