There are many investment strategies, but few have the strength of statistical evidence to support their use by investors. Every investing strategy has its advantages and disadvantages, and it is important to know the track record of an approach over time.
Warren Buffet's first mentor, Benjamin Graham, was the maven of value investing. Graham's basic formula included several criteria. For example, a stock under consideration should be two-thirds or less of tangible book value, two-thirds of net current asset value and total debt should be less than tangible book value.
In "The Little Book That Beats the Market," Joel Greenblatt picked up the Graham theme with a few variations. Greenblatt's model searches for solid companies trading at attractive valuations based on high returns on invested capital (ROIC) and a high earnings yields. The latter is the inverse of the price/earnings (P/E) ratio. Testing this formula over the period from 1988 to 2009 resulted in a compound annual growth rate of 24% compared to 10% for the S&P 500 Index.
Some value managers may use different formulas, but the one commonality is the search for a methodology that successfully finds undervalued stocks. Holding periods before selling vary, and Buffett has evolved to the point where he claims that his holding period is forever. The downside to the value approach is that it can take a long time before the market recognizes the intrinsic worth of a business. In theory, value increases when a stock gets cheaper, and in a massive financial collapse and bear market such as the one in 2008, value investors get pummeled because they don't cut their losses.
In 2008, Buffett placed a bet with a hedge fund manager that an S&P 500 index fund would beat a portfolio of hedge funds over the next 10 years. Buffet's bet was clearly winning in early 2015 as Vanguard's S&P 500 index fund rose more than 63% compared to a portfolio investing only in hedge funds that returned 20% after fees.
The percentage of mutual fund managers with the skill to beat a market index is also dwindling. In 2014, only 14% of actively managed mutual funds beat the major stock market benchmark indexes. When the results for 2015 are released, it may very well be less than that.
Index funds, especially from operators such as Vanguard, reward investors with ultra-low management costs. The compounding advantage of lower fees translates to an enhanced investment return over time. Index investors also assume that markets are completely efficient, or nearly so. This assumption is reasonable in light of the failure of most portfolio jockeys to perform better than the averages, but the issue of portfolio drawdown remains.
Unless investors have reputable market timing systems, they will stay fully invested even during generational bear markets such as the one in 2008. A portfolio that loses 50% requires a 100% return just to get back to even.
An old Wall Street saying is that the trend is your friend until it ends. Value investors focus on fundamental analysis of a security, while trend followers mostly ignore it. In the wild commodity bull market of the 1970s, trend following gained many adherents, and investors such as Paul Tudor Jones and John Henry made fortunes by sticking with the upward trend and letting profits run. However, trend followers cut losses short quickly and don't allow losses to get out of hand in contrast to the downside of value and index investing.
The most straightforward trend-following strategy involves going long on markets with recent positive returns and selling or shorting those with recent negative returns. Many investors utilize moving averages as an entry or exit technique. For example, some trend followers sell a stock or index if the 200-day moving average is penetrated to the downside. Others use different moving averages in a breakout technique that tells a trader to buy the security when a moving average is penetrated to the upside. Mebane Faber published a simple and successful strategy that stays long on a market if it is trading above the 10-month moving average and exits when price falls below that level.
Ned Davis Research devised an elegant trend-following model, the Three-Way Asset Strategy, using three- and 10-month moving averages. The model includes stocks, Treasury bonds and gold with the objective of beating the stock market with less risk. Investors buy one or all of the three assets if the three-month moving average is trading above the 10-month, and sell if the opposite occurs. The results over the last 45 years are impressive.
If an investor simply buys and holds a stock index fund such as the S&P 500, the compound annual return is 10.5% with a Sharpe ratio of 0.35. Portfolio drawdown is enormous at -51%. The Three-Way Asset Strategy unquestionably beats the buy-and-hold stock strategy, with a compounded annual return of 13.1%. What is even more impressive is volatility is lower, the Sharpe ratio at 0.63 is higher and portfolio drawdown is -21% compared to -51%. Investors with the discipline to stick with this trend-following system have a good chance to beat the stock market with lower risk.
There are no guarantees on Wall Street, but investors can stack the odds in their favor by choosing a statistically valid approach and applying it consistently. Stop guessing, and become the intelligent investor that Graham wrote about many years ago.