Bargain Hunter, Part of the Herd or Lone Star; what is the Best Investment Strategy?

 

You’ve set your financial objectives, ascertained a level of risk that you are comfortable with and now it’s time to build your investment portfolio; Muckler thinks it’s very much like putting together your fantasy rugby XV.

 

Rugby has traditionally been described as a game for people of all sizes – the most successful teams will combine strength with speed, dependability with flair, doggedness with elan, and that is not a bad blueprint for an investment portfolio; make sure you secure your own ball with some stalwart investments and then look to score out wide with a couple of show-ponies.

When putting together a portfolio investors will employ different strategies to achieve a balance between defensive, cautious or adventurous investments to ensure that the result is a basket of products that delivers the desired outcomes without keeping them awake at night.

But finding the right investment style for you can be difficult, and may change according to individual and market circumstances; there are many investment strategies that work in different market environments.

A Which? Report compared the styles of contrarian, momentum, value, growth and quality investing in the US and compared each to the performance of the S&P 500 share index over a period of ten years.

Contrarian investing – purchasing and selling in contrast to the prevailing sentiment of the time – delivered the best returns, 303% over the period, while growth investing – seeking capital growth – returned 120%.

‘a 303% return over ten years’

Value investing – seeking undervalued stocks – delivered 126% and quality stocks – those selected according to certain characteristics deemed by the strategy to identify a ‘quality’ company,  provided a return of 128%.

The S&P index returned 121% over the period, meaning that only the contrarian strategy led to significant outperformance, although it should be viewed with the caveat that index trackers were used rather than individual stocks.

Which? concentrated on US markets and when This is Money took global MSCI indices to see how shares from around the world performed with different strategies, results were rather different.

Its investigation tracked the growth of the MSCI all country momentum, value, quality and growth indices and compared them with the MSCI all country world index, FTSE 100 and S&P 500; there was no contrarian index for the sake of comparison.

Its conclusion was that there is no set strategy that has performed best on an annual basis globally, but most of the time at least one or two of them would beat the S&P 500 or FTSE 100, suggesting that having a plan can work, but that plan will need to adapt according to what is going on in the world.

‘probably a recipe for disaster’

During the study years, momentum and value stocks were the best bet in year 1, whilst the following year saw growth and value stocks as the best global performers, with the relevant MSCI indices growing 25% and 27% respectively.

These results suggest that if you go ‘all in’ on a particular strategy, you would have to switch to suit the markets as conditions change; a huge commitment and requiring you to time markets, probably a recipe for disaster.

Better then to build a balanced portfolio – make sure your front row delivers the performance you need, and then go looking for a bit of pizzazz – different strategies, working together to give you the result you want, whilst spreading your risk.

Here is a closer look at the various investing styles:
 

Momentum investing

 

Momentum investors find a stock that is on the rise and go along for the ride; momentum traders don’t mind buying high if they can sell even higher.

Once a stock is on a roll the theory is that it will keep moving for some time and the greater the amount of money that is being invested, the quicker an asset’s value will rise.

Buy for less than you sell for and you will make money; momentum investing works well where there is positive sentiment in a bull market, but the requirement to time your entry and exit points means that it can be a risky strategy.
 

Contrarian investing

 

Contrarian investors go against the market and against the fabled ‘wisdom’ of the crowd; they aim to identify stocks or funds that no-one has considered or that have become unloved.

They may select quality and value stocks or funds but often require brave calls that conflict with existing top performers.

Contrarian investing has been likened to the experience of eating alone in a restaurant; seeking a stock that has become unloved by the market but that you, and maybe you alone, think has the ability to go back up.

Contrarian investing can be where an emotional attachment to a particular stock or strategy costs dear; the danger is of doggedly hanging on to a stock in the belief of the inevitability of its renaissance when in fact it goes bust.

This is not a simple strategy – some stocks may be unloved because their potential is not noticed, but some could simply be heading for the buffers.

One way to achieve access to a contrarian style is by buying a ‘special situation fund’ that identify unloved companies and spreads your risk by investing in a range across different regions and sectors; the Fidelity Special Situations fund delivered annualised growth of 19.5% between 1979 and 2007.
 

Growth investing

 

Growth investors look for companies whose value is set to rocket based upon forensic research into the company’s balance sheet, its fundamentals such as its price-to-earnings ratio and prospects for the sector it is operating in.

The objective is to assess whether a company has the ability to grow and outperform; the risk is that a company doesn’t grow as much as you thought, at all, or even falls in value.
 

Value Investing

 

Value investors also want growth, but at the right price; they don’t want to over pay for a stock as that already affects their return.

A value stock is a company that is underpriced by the market and a key measures used by a value investor is the price-to-earnings ratio; a company’s share price compared with its earnings and then compared with other companies within its sector.

A lower p/e ratio than its competitors could mean a stock is good value, as long as other fundamentals such as its balance sheet and management strategy are sound.

Another metric is a company’s net asset value (NAV); whatever the company owns such as property or stock, minus whatever it owes.

If the share price multiplied by the number of shares is lower than the NAV of the company this could spell potential to the value investor.
 

Quality investing

 

Quality investors combine growth and value strategies and may be just a little contrarian; they see growth potential and price as important but also want to find something of quality but undervalued.

Quality investors buy from the market when share prices are below their intrinsic value and seek to distinguish between stocks that are quality and those that are low quality; better to buy a quality stock at a high price than a low quality one at a price that seems good value.

An example is that during the tech bubble investors put money into businesses with good ideas, but with poor fundamentals such as strategy, management or finance and therefore failed.

Quality investors compare p/e ratios and also consider the future prospects of a company such as its market outlook and its management strategy; the risk is that a stock may look cheap because it is on the way out.

Again there are fund managers that do a lot of the leg work in terms of identifying and researching companies in search of quality.
 

Gelling the team

 

The world’s most illustrious investor Warren Buffett has amassed a $60 billion fortune by employing a combination of growth, quality and value investing strategies.

The so-called Sage of Omaha identified companies that he believed were worth more than their market value, and then invested in them for the long-term; Buffett believes that when an investor buys into a business it should be with the mindset that they own it, not just a slice of it – look for quality management, a durable competitive edge and low capital expenditure.

His investments tend to be market leaders with a strong brand name – Coca Cola, McDonalds and Gillette; a good history of solid earnings growth.
 

A fund or investment trusts that employs the strategy you want

 

A fully diversified portfolio across sectors and businesses could comprise around thirty individual stocks, which could require a lot of research and trading commissions; it may be cheaper and less time consuming to let a fund’s manager and its analysts do the heavy lifting.

An actively managed unit trust, OEIC or investment trust will deliver an instantly diverse portfolio of between 30 and 60 stocks, thereby spreading the amount of risk you are taking. You can diversify by investing in a number of funds that do different things in different regions, but you should also be able to add diversity in terms of the investment strategy employed by the manager of the funds you select.