Buying stocks that go up, and selling the ones that go down seems like a simple way to beat the market. It turns out that when it comes to Australia, it's by far the best.
Morgan Stanley's team of quants have just published a study of the most effective "factors" in the Australian stock market over 26 years and concluded that "momentum" trumps them all by a long way.
Value investing hasn't worked well at all, while "growth" has been awful. "Deep value" too has been poor, while investing based on earnings revisions signals and measures of capital use have fared well.
Factor-based analysis is becoming increasingly prevalent in financial markets. That is, identifying factors or characteristics that can be used to predict or explain a security's performance. Once these factors are identified, an investment strategy can then be put to work.
For instance, the most successful momentum factor is to buy shares that have the highest total return over 12 months, and sell those with the lowest. This ranked a 10 out of 10 based on Morgan Stanley's Quant Factor Efficacy Score.
An example of a "value" factor is to buy shares that are cheap, based on a low book to price ratio (that is, the reported accounts assign a higher value to assets than the share market). But this scored a one out of 10. A "growth factor" is "year on year revenue growth" but that scored a zero out of 10.
Morgan Stanley's research isn't saying that value and growth fund managers have done poorly – some have done well, although plenty have let investors down. Rather, the team's findings show that systematically implementing these styles would not have worked. Meanwhile, simply buying what goes up and selling what goes down would have been a better approach, the bank found.
Insights
The research gives us some interesting insights into the Australian stock market by being able to compare which factors perform consistently when compared to other markets, and which do not. "Momentum" actually works better in Australia than in Canada, the US and just about anywhere in the world. (It doesn't work in Japan).
In fact, a simple strategy of buying a basket of the top 20 stocks with the highest trailing one-year returns would have outperformed the S&P;/ASX 200 by 8.8 per cent per annum since 1990.
Momentum has also improved in strength since 2010, and it works best in the mid-cap space, which is also unusual compared to other markets. The quants suspect this is because as stocks with momentum behind them grow in market cap, they attract more attention from investors and sell side analysts.
"The resulting increase in attention reinforces the strong momentum of those stocks, and vice versa. The threshold effects resulting from stock shifting across market cap cohorts is likely stronger in Australia compared to other global markets," the analysts wrote.
The "dividend yield" factor – (buying stocks with high pay-outs relative to the share price), has surprisingly also performed poorly. But that's going back to 1990. Until recently, a high dividend yield was considered more a value signal, but in the insatiable quest for income that has ensued since 2010, it's considered a measure of capital use. Over six years, the efficacy of the dividend yield factor has improved considerably.
One group of factors that displayed high returns was the earnings revision factors – that are tied to broker upgrades and downgrades. Despite the apparent waning influence of sell-side brokers, this has become a more powerful indicator since 2010.
The poor performance of growth factors was also notable. The research showed that investing in stocks with either the highest earnings growth estimates and those with the lowest, underperformed the index since 1990. However, those with more middle-of-the-range growth estimates actually outperformed.
Cash flow yields
Some "capital use" factors fared well such as net-buyback yield (buying stocks where the share count fell and selling those that issued more shares) while the best value factor was to buy companies with high free cash flow yields.
One of the challenges with value investing is timing. So Morgan Stanley has attempted to combine their findings to create "quant lenses" to effectively improve stock selection and timing. One is what they call "reinforced value" which is to buy cheap stocks, but only when earnings upgrades are outpacing downgrades.
Another lens they created is smart momentum – which is to pick stocks with a rising share price that brokers are upgrading and that their team of analysts rate highly.
Based on their research, the quants picked 10 stocks (seven buys and three sells).
They already had a win with their top pick Bluescope, which initially gained 11 per cent after its management delivered another earnings uprade in late January (although it has since come back a bit). BlueScope displayed both "Smart Momentum" and "Reinforced Value" traits and also fitted with Morgan Stanley's broader outlook for commodities and the Australian dollar.
Oz Minerals, Mineral Resources and Metcash also screened well in its momentum and value lenses, while Macquarie, South32 and Ansell came up as buys.
The three stocks the models warned against were Woolworths, Syrah Resources and Healthscope.
While many are betting on a turnaround at Woolworths, the quants say its share price has poor momentum, it is expensive on a price-to-free-cash-flow basis and its earnings revision ratio is negative. Syrah also screens poorly with negative price momentum, negative free cash flow and a highly negative earnings revision ratio.
