Should you join the traders and attempt to beat the market?

I don’t think the market is always efficient and – unlike my virtuous co-blogger here on Monevator – I invest some of my money accordingly.

Please note: I am not suggesting you need to try to find an investing method to beat the market at home. I don’t even think I should!

For most people, the best results will come through passive index investing.

The chances of you or I following in Warren Buffett’s footsteps are tiny, regardless of whether Buffett’s returns are down to luck, skill, cheap money from his insurance operations, or the fact he’s never spent more than $10 on lunch.

People are drawn to active investing for reasons other than greed and delusion, however. Some better ones include intellectual stimulation, an interest in business, the sheer challenge, and an aversion to having fun in the evening.

So if you’re an incurable moth and the market looks one giant candle, what’s the best way of going about getting burned?

Why I like value investing

When it comes to the quixotic – and for the last time entirely optional and usually ill-advised – goal of trying beat the market, I think value investing has the edge.

Most of my favourite investors were value investors, from Benjamin Graham and Warren Buffett to Sir John Templeton, Walter Schloss, and even The Motley Fool writer Stephen Bland.

They all backed their judgment that the market isn’t always efficient, and found that a value-based investing method was the best way to root out the truffles from beneath the wood and the trees.

I like value investing because it makes logical sense. Buy the unloved stuff that stinks, and sell it when it doesn’t. If you’re looking for profits in real-life that’s not a bad formula, so it seems a good place to start hunting for profits in the stock market, too.

I also like value investing because I’ve noticed most people can’t do it. Oh they talk about contrarianism and buying cheap, but most of their investments are in companies that have been doing well, and that look fully valued to me. Often in life you can get paid for doing something that others can’t or won’t do.

A final reason I like value investing is because even the high priests of the efficient market have anointed it as a market-beating strategy.

After all, they can hardly refute the data1, which consistently shows that over the long-term, stocks with value-based metrics (such as a low price-to-book value) have outperformed the wider market:

(Click to see the value premium writ large)

(Click to see the value premium writ large)

Source: Credit Suisse/London Business School

Of course, efficient market supporters don’t see value as a violation of the efficient market.

They typically either think that value investors are taking on more risk to get higher their rewards, or else they think that there was a genuine anomaly in the market due to ignorance, but now it is being whittled away by everybody knowing about it.

I’m not so sure. I’m more in the emerging camp of behavioural finance, which takes the notion of human beings as rational creatures, and puts them in a silly hat then plonks them on a photocopier to make duplicate asses of themselves at the Christmas party.

Metaphorically speaking, you understand.

People will always be foolish, greedy, scared, and more interested in jam today than Victoria sponge tomorrow. I therefore suspect that value anomalies will persist, too, although whether you or I will profit from them is another matter.

Small companies deliver bigger returns

It’s not only value that beats the wider market, as it happens.

A few famous growth investors have been successful. In the UK, Jim Slater found fame as a stock picker of small, fast-growing companies. Slater did have a value tilt though, in that his metrics centered on the PEG ratio he made famous, which aims to prevent an investor overpaying for growth. Some other growth investors all but dismiss valuation altogether.

Growth has a poor record when statisticians crunch the numbers, tending to underperform value shares over multi-year periods.

In focusing on smaller companies, though, Slater was on the side of another proven market-beating strategy:

(Click to enlarge the small company's outperformance!)

(Click to enlarge the small company’s outperformance!)

Source: Credit Suisse/London Business School

Unlike with value, I can easily believe higher risk is the reason for the higher returns from smaller companies.

Very small companies – which are the ones that have delivered the highest returns – are illiquid and often difficult to trade, which adds to risk in the academic sense, and so to higher returns.

Higher yield, higher returns

In the UK Neil Woodford has soundly beaten the market by investing in dividend-paying stocks, as we never seem to keep hearing these days.

Few other income investors have Woodford’s record. But the performance of equity income investment trusts as a class has been very good compared to the market for as long I’ve been watching, suggesting to me there may be more at play than just a clutch of lucky managers and a fair investing climate for dividends.

Sure enough, professors at the London Business School report that high yielding shares have also beaten low yielding shares over long periods of time:

(Click to enlarge)

(Click to enlarge)

Source: Credit Suisse/London Business School

The success of high over low yield is to my mind value investing in another guise.

High yield occurs when a company’s price is depressed, perhaps because of uncertainty about its future or the unpopularity of the sector. Sometimes companies are punished just for paying dividends – it’s hard to believe now, but in the 1990s income was barely discussed by most investors and journalists, if not actively looked down upon.

Yet the cash flow suggested by a strong dividend usually indicates there’s at least some money-making going on at the company.

If things don’t turn out as bad as feared – so the dividend is not cut or worse – then high yield shares can keep on paying a high income, and you might see their share price rise in time. Both factors will boost returns.

The trend really is your friend

Hedge funds and others have been able to profit from all sorts of anomalies over the years.

The book More Money Than God offers an excellent history of a succession of hedge fund pioneers spotting inefficiencies and then exploiting them until others join the feast and the easy profits are gone. (The market might not be 100% efficient, but it’s definitely no mug!)

A common thread to many hedge funds’ success is momentum, in which they find and back trends they see in the market.

To over-simplify, momentum means that if prices are rising then they will tend to keep rising, and vice versa. Such trends should not exist according to efficient market theory. Prices should follow an unpredictable random walk.

One of the biggest investing upsets in the past couple of decades though was the discovery that momentum – long derided by both academics and value investors – does in fact exist.

I still feel queasy when someone shows me a rising price chart as the rationale for a share price going up some more. Yet at the market-wide level, the proof is in the data:

(Click to enlarge)

(Click to enlarge)

Source: Credit Suisse/London Business School

Of all these market-beating metrics, momentum is the biggest challenge to the efficient market hypothesis, in my humble opinion as a blogger as opposed to a Nobel prize-winning economist. It shouldn’t exist.

That said, I should stress for novice investors that there is an immense difference between the amateur stargazing that passes for momentum investing on bulletin boards, and the Phd-heavy supercomputing-powered high frequency stuff done by hedge funds.

Even hedge funds have been failing to match the simplest combination of equity and bond ETFs lately, so perhaps academics will have the last laugh (although hedge fund returns are also crippled by their enormous fees).

Can we exploit these market-beating strategies?

Let’s end by asking the obvious question: Could we use these stock picking methods to beat the market ourselves?

I can’t give you a definitive answer. What has worked in the past might not work in the future. I’m on-board with the idea that at least some anomalies will vanish, if they’ve not already, as the mostly-efficient market ferrets out the inconsistencies.

However I do think it’s not an entirely discreditable aim to try use these proven market beating methods to boost your returns.

One sensible approach might be to tilt your passive portfolio to try to capture some of the potential outperformance, rather going whole hog into one market-humiliating venture or another.

Even some of the passive investing gurus recommend as much, suggesting minor additional allocations towards specialist ETFs or tracker funds tilted towards small companies or those with higher yields.

But here’s a few things to consider before you get carried away.

Firstly, the academic research showing the outperformance I’ve cited looks at market wide data, and typically ignores costs.

We can’t forget about costs as private investors, and in the UK it’s hard to invest across the market based on these themes too, although some outfits such as The Munro Fund have tried to change that.

US investors enjoy access to a wider range of passive vehicles, including ETFs that seek to capture these extra gains. You might consider buying into one of these US-listed ETFs if you’re keen, but remember that introduces currency risk, withholding tax, and other complications.

Secondly – and in semi-contradiction to my earlier paean to value investors – just because some metric has previously worked across tranches of hundreds of shares, that doesn’t mean it’s a sure way to pick a handful of stocks.

  • Buying a basket of 250 low price-to-book small cap shares and mechanically shuffling them year-on-year for an academic study is one thing.
  • Buying four or five penny shares you fancy because they seem cheap is quite another thing, and likely an explosive and painful one in most hands.

Finally, academics typically crunch their data over very long timescales. You may well find that a measure such as low price-to-book value outs itself through extra returns over shorter periods – or that it does not – but in any event that’s not what I’m claiming here.

I’m just pointing out what academics have found has worked over periods of 60-100 years or so. But that’s beyond even my investing time horizon, however much I skip the booze and hit the gym!

  1. This graph and those that follow comes from the London Business School researchers behind the Credit Suisse Global Returns Yearbook 2013, which is a treasure trove of interesting data.

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