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Choosing a portfolio of stocks can seem like a daunting task, especially if you're new to the process. So many thousands of listed companies, so little time. Maybe you’ve years of experience but have struggled to bring consistency to your results. In either case, the key is understanding what pays off in the stock market, selecting a strategy that works for you, and having the discipline to stick to it.
Richard Rumelt, author of the excellent “Good Strategy, Bad Strategy”, once said “a strategy is a set of coherent actions designed to meet a challenge.” The challenge for most investors is developing a plan that not only meets their goals but also aligns with their routines, psychological traits, and tolerance for risk.
Over the coming weeks, we'll be introducing you to a range of proven stock market strategies curated from the classic literature of the genre. We’ll be assessing what it takes to implement each style and help you self-assess whether they might fit you.
This introductory article lays out a master framework I’ve long used to make sense of seemingly conflicting strategies. Consider it a “Strategy Map” to help navigate the terrain.
It’s true that active, institutional fund managers often have a difficult time beating the market. Fund managers, on average, underperform by the aggregate level of their fees each year and because cash balances they hold act as a drag on performance. It would be impossible for the arithmetic to settle any other way.
But that doesn’t stop them trying. Many active managers do beat the market in a typical year, but in their effort to join the winning group, they chop and change their holdings. All this portfolio turnover generates price volatility in the market, providing great opportunities for smaller, more nimble, investors.
Institutional investors have become too large. Most funds run hundreds of millions, or billions of dollars in investment funds. When they buy and sell shares, they do so in size. Their movements are like whales moving through the market sea. As a small investor, you can take advantage of the pricing inefficiencies they leave in their wake. And what’s more, you can capitalise on the significant opportunities they leave in smaller companies that are too illiquid for them to efficiently price.
Many investors in stocks think that share prices are driven by news flow, that some announcement will happen in upcoming months that will propel share prices higher. It could be drilling or mining results, or a regulatory approval for a biotech stock, or taking a punt that company results will be better than forecast.
These expectations are driven by narratives, so it’s little surprise that as private investors, we tend to load our portfolios with “story stocks” - companies listed based on future expectations alone. While news events do impact individual shares, on average, story stocks often disappoint. The FTSE AIM All Share, the junior market in the UK, tells a 20 year story of “story stock” pain.
Here’s what Ben Graham, the pioneer of Value Investing, had to say on the matter:
"In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Ben Graham.
What he meant is that what really drives stock returns is the statistics behind the stocks, not the stories associated with them. Over time, the weighing machine does its work, and that’s what drives share prices. To develop an effective stock market strategy, we have to select shares that the weighing machine rewards, and ignore those that it doesn’t.
So what should we weigh? Well, many overcomplicate this, and stock markets are full of jargon designed to confuse, but it’s easier than it seems.
One hundred years of stock market evidence shows that the weighing machine rewards a limited set of characteristics. I repeat myself on this point regularly, but three of the most powerful and well rewarded characteristics are the Quality, Value and Momentum of each stock.
Return Driver | How it works | Why it works | How long? | What it takes |
---|---|---|---|---|
Quality | Good stocks beat junk stocks | Good companies are often a little boring and have little chance of doubling in a year. Investors prefer to chase excitement, so they regularly undervalue quality stocks. | 1 year to forever | Patience and Diligence. |
Value | Cheap stocks beat expensive stocks | Cheap stocks often have temporary problems. This turns investors away from considering them, often leading to over-sold, extreme valuations. | 1 year to several years | Courage and Contrarianism. |
Momentum | Strong stocks beat weak stocks | Investors are reluctant to buy shares at new highs, which underprices stocks that are benefiting from a step change in potential. | 3 months to 1 year | Agility and Ruthlessness. |
If you build a portfolio of shares that share these measurable traits, and manage it sensibly through time, you can beat the market. Simplicity and consistency are key. While the art of stock picking gets all the press, it’s more often the combined traits of the group of shares you own that drive the returns. As the great Ben Graham wrote late in his life:
As we circle around the Strategy Map we will dig into the kinds of financial ratios and metrics with which you can objectively measure the Quality, Value and Momentum of each stock. As you will likely already know, we have designed Stockopedia’s StockRanks as simple to use combined measures of these core return drivers.
Many great investors have developed their investment strategy around just one of these core “QVM” return drivers, often ignoring the elements that make up the others. We categorise the core approaches as follows:
At the intersection of these three basic strategies there is further adventure. With apologies for sounding biblical, but “Three begets Seven”. If we draw Quality, Value and Momentum as circles on a Venn Diagram, we can see the intersections clearly, and map them to some more classic styles.
And at the heart of the Venn diagram:
The following graphic illustrates most of these approaches with some quotes from luminaries of each genre.
In this article series, we’ll be going deep into each of these key investment styles. While the nuances of each approach can get into the weeds, it’s important to state up front that simple rules often beat human judgement. We humans can find it incredibly hard to stick to simple rules, even when proven to work. We tend to over-ride them as we get emotional or believe our expertise can add value. It’s the same for all of us.
Let me give you an example.
Imagine you are taken with the idea of the “Deep Value” approach to the stock market - of buying a dollar for 50 cents. You learn that Benjamin Graham searched for companies whose share prices were so cheap they were priced below the value of their “net current assets” - which essentially means they are valued so cheaply that you are buying all their property, plant and equipment (and more) for free.
Well, some “simple rules” for this kind of strategy could be to screen for shares with a “Price to Net Current Asset Value” (P/NCAV) of less than one, buy the cheapest 20 stocks with no more than 6 in a single sector, with a minimum market capitalisation of £5m. Each year do the same thing again. If you took this approach, you could have more than quadrupled your money over 8 years at a 19% compounded rate (spreads and yields included).
While it looks attractive in hindsight, the realities of living this method are much more gruelling. Could you stomach the kinds of horrible looking shares that this strategy invests in? The down-and-out stocks, beaten up relics, basket cases and stocks that literally nobody else wants to look at? Could you pick your moments to deal carefully in illiquid shares that averaged a more than 5% bid-ask spread? Could you stomach the volatility of the ride, and the steep drawdowns, especially when some of the individual names may go bust? Could you watch in regret as your friends have all the fun in popular market names? As we’ll see in our Deep Value investing articles, it takes courage and contrarianism to put this kind of style to work, but more than this, it takes a commitment to simplicity and simple rules that most investors can’t stomach. (To be clear - buying Graham bargain stocks is not something I recommend for novices!)
It’s vital to understand yourself, your willingness to invest in certain kinds of shares, your time availability, your financial goals, and your risk tolerance before rushing to implement a stock market strategy. Many investors get so excited at the prospect of discovering a strategy that “works” that they throw their money at it, without realising that it takes time for return drivers to work. The interludes can be galling.
As we saw above, it’s perfectly reasonable to build a strategy around just one return driver (like Deep Value), but the truth is that what drives the market changes in different eras. Momentum stocks dominated during big bull runs (think 1990s or 2010s) while Value stocks have dominated more counter-cyclically (e.g. 2000s). Quality may be a universal, but often gets significantly over-valued when investors “flee for safety” leading to weak returns thereafter. Investors that focus on a single style can sometimes find themselves at the wrong end of history, underperforming for a period of time. But as with anything in life, the more you commit to a chosen path, the more likely you can attain mastery even in tough markets.
I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times. Bruce Lee
Can you psychologically stick to a strategy in its bad times? If not, then taking a more blended approach can make sense. It can help you maintain more emotional control. Given value and momentum often zig when the other zags, a “half-and-half” approach to your portfolio can reduce the periods of significant under-performance.
Alternatively, if you are an attentive investor, and willing to monitor market trends, you can switch between strategies when the market cycle changes. At the extremes of bear markets, bargain stocks are bountiful, but in trending bull markets they disappear. Switching from value to momentum and back again can pay dividends.
While this piece is just an overview, we hope you’ll gain insights as we circle around “The Strategy Map” in coming weeks. Each week we’ll introduce a new style with an overview that includes the following:
We’ll also be following up each overview article with a focused piece about stocks of interest that qualify for various rulesets. We’ll also be illustrating ways to use the Stockopedia service to explore these stocks further.
We know that most investors are bottom-up stock pickers, but taking a more top-down, holistic approach to stock market strategy is a fresh lens. We hope you enjoy this series and that it brings you some enlightenment, aha moments, and encourages you to build up your library of stock market classics.
We’ll be recommending scores of books in this article series. Some of the books referenced in this article are recommended as a starting point for any serious investors library:
About Edward Croft
I'm the co-founder and CEO here at Stockopedia.com - with one goal - to help private investors beat the market. I've a passionate belief that the use of data-informed investment processes are the best way to improve investment results. I've a background in science and wealth management and have spent years building a superb cross-functional team here to deliver on our vision. We aren't finished yet - there's so much to deliver. These days, other than managing the business, I spend a lot of my time on educational activities, researching markets and sharing learnings. Do connect with me here in the comments section or at Twitter/X.
Disclaimer - This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
Thanks for the article Ed. I was a bit surprised you mentioned Carl Icahn as his reputation & stock $IEP has taken a bit of a beating recently from a short attack. See the following article for some background.
Thanks for the kind encouragement all. I'm trying to reserve a lot of time for content work now... so hopefully I can amp up my output in the coming weeks.
As a relatively new investor still finding my way and with a few mistakes behind me really looking forward to this series to help me find ”my strategy” and how to execute it effectively. Exactly the sort of thing I was hoping for when I joined. Big thumbs up from me
Great article. Glen Arnold has also researched into the great investors at length with some fantastic books which I’ve enjoyed reading - particularly his book about the Valuegrowth Investor.
Great article Ed. I wondered where you had been. Investing is hard though…
Ben Graham NCAV Bargain invested in UK since inception +500%
Ben Graham NCAV Bargain invested in Europe since inception ……+0.07%
Investing is hard….are our Messiahs merely the statistically inevitable lottery winners?
Thanks Ed. Since joining Stockopedia, my stock selection has improved dramatically. This should take it one stage further
Really useful article Ed, particularly for a novice like myself who got lucky/cocky in the last bull market and then learnt some hard (expensive) lessons when happy hour closed and market conditions became more challenging.
Looking forward to the next installments.
Have this close as a simple reminder. Useful for avoiding the 'suckers' i.e. some of those stock picks in the magazines.
Just reviewing my portfolio - 'sucker stock' is a genius term. If it works don't fiddle.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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this is brilliant. wonderful article.