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How does a South African investor who has shunned collective investment schemes in favour of do-it-yourself share trading beat all those highly paid asset managers around the world who are working in the value space? It can be done, with some careful selection.
James Saft explains one option: a stock-picking technique that focuses on shares that have been floundering for a long period. This approach is based on an observation that moving slowly on undervalued shares makes more money in the long-run than snapping them up. In part this is perhaps because the duds disappear before you’ve had time to get your hands on them.
Holding what was cheapest a year ago, rather than buying what is cheapest today, seems to massage your returns. This article is a fascinating look at the concept of “slow trade”, a term coined by value fund manager Ben Inker of GMO LLC. – JC
Slow trade investing: a nifty stock-picking technique to eliminate cheap duds
By James Saft
Ben Inker, of value-investing-orientated funds house GMO LLC, coined the slow trade term to describe a fascinating phenomenon: if something looks good from a value perspective now, you usually do better by waiting a year.
“The slightly odd fact is that moving slowly on value-driven decisions has simply made more money historically than moving immediately would have,” Inker, who is co-head of asset allocation at GMO, wrote in a note to clients.
“Buying the assets that are cheapest at any given point in time has been a profitable strategy historically, but buying the assets that were cheapest on average during the past year, or odder still, the assets that were cheapest a year ago irrespective of their valuation today, has done even better.”
First, let’s look at the data.
Between December 1978 and June 1999 a portfolio comprising equal weights of the two cheapest equity markets outperformed the broad market by 2.8 percent per year in the following year.
Make one little adjustment – hold not what is cheapest today but what was cheapest one year ago – and you up your outperformance to a whopping 7.4 percent annually.
Since June 1999 the outperformance is less, just 1.8 percent annually, as against just an 0.4 percent annual outperformance if you buy what is cheapest in real time. Quite possibly the diminished effect since 1999 is because the globalization of both money flows and policy have cut into the advantages you can wring from country effects on portfolio construction.
Take it to a stock level and the advantages of buying what was cheap a year ago still stand out, according to Inker. If you buy the cheapest 10 percent of the market on a price to book basis you’ll have outperformed the market by 2.5 percent a year since 1965. Do the same thing lagged by a year and you outperform by 3.5 percent.
Even more impressive, the slow trade play seems to be able to help compensate for the general underperformance of cheap stocks since 1992. If you were to have bought the cheapest 10 percent of the market, measured by price to book, since 1992 you would have actually underperformed by 1.6 percent a year. Do it on a one-year delay and you still get a 2 percent outperformance.
THE WHY AND THE HOW
So why is this happening? Even more importantly, what can we do with the information?
Inker thinks the phenomenon is partly explained by momentum within markets. There is a long observed and well documented tendency for markets to exhibit momentum, meaning that securities tend to keep going in the direction that they are currently traveling. As to whether this is due to some law of nature, or is simply down to a lack of imagination among investors, I could not tell you, but momentum in markets exists.
Stocks, or countries for that matter, get cheap by underperforming. If something has underperformed for long enough, or violently enough, to get to the bottom of the barrel, it is reasonable to expect it to carry on underperforming for a while.
“Countries that were cheap a year ago have had time for that bad momentum to get out of their system, as it were,” Inker writes.
At the stock level, it may also be that waiting a year allows you to buy what has crashed but miss out on those companies which are also going to burn. Think about it: a certain number of companies every year don’t just fall in value, they cease to exist, or fall out of the broadest of indices into penny stock territory. Buying what was cheap a year ago means, by definition, you will miss a certain number of these depth charges, because they will no longer be there when you come to buy them.
As to what we do with this info, here is where things get difficult. GMO, in part because we can’t fully explain why the slow trade works, has been loath to use it on a pure basis, preferring instead to take account of the forecasts for the last year on a blended, or what they call “sliced” basis, also using discretionary overrides. That too has shown outperformance.
The broader take-away may be that the value approach has validity – that buying cheap stuff by and large is the way to go – but that by not rushing you can avoid fighting part of the inevitable battle with market momentum.
That sounds like it is worth waiting for.
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