How to avoid high StockRank underperformers

Wednesday, Mar 22 2017 by
110

It's been a cracking start to the year for stock markets, and an even stronger start to the year for high StockRank shares. While the benchmark FTSE All Share Index is now up 4.2% since the end of 2016, the top 10% of UK stocks as ranked by the Stockopedia StockRanks has more than doubled this performance, generating a 10.0% return.

The participation in this rally has been broad. In our performance tracking we focus on investable shares above a £10m market cap. Excluding the microcaps, there were 120 UK stocks ranked 90 or above at the end of 2016. Of these, 91 have been winners (with higher share prices today), while 28 have been losers (with lower share prices today).

58cc5c9ae5f51Untitled_spreadsheet_-_Goog

Performance of 90+ StockRanks Year to Date

While these headline figures make great reading, it's no comfort for those who have bought the losers, and as ever, among the losers are some popular shares.

Picking losers is inevitable in the stock market. Not even Warren Buffett is immune (he bought Tesco at the top after all). So the key to enduring profits is twofold. Minimising the number of losers bought, and minimising the scale of the losses from each.

When things don't Go-Ahead

An example of a high ranking share that took a hit recently is Go-Ahead Group . Go-Ahead Group is a very well known company in the UK. It's been a member of the FTSE 250 index for a long time and operates many London buses and English rail franchises. Perhaps as a result of its status, many subscribers own it.

I purchased some shares in GOG on 17th Feb when the stock rank was 99. They released some poor results and now the stock rank is showing as 65 but I cannot find any discussion or advice on whether to sit tight and ride it out.

Markets can be brutally unforgiving on profit warnings. Here's a chart of Go Ahead Group's price collapse on its profit warning announcement and afterwards. (with annotations drawn using Stockopedia's great new Technical Charts ).

GO-AHEAD_Share_Chart___Live_Charts_and_T

Last summer we conducted a study of 245 profit warnings in an eBook titled the Profit Warning Survival Guide. If you haven't already read it, I highly recommend it. We built a model…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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66 Comments on this Article show/hide all

simoan 25th Mar '17 47 of 66
1

In reply to post #177630

Ed,

I'm with bestace here and think you have misrepresented the investment approach Terry Smith uses which is based on high ROCE and operating margins and with a real focus on free cashflow. As it happens I have just read the Annual Report for his Emerging Equities Trust and it could not be clearer.

So yes, it's all about finding quality companies but if you mentioned the "M" word to him I believe at the very least you would receive a stare that would freeze a thousand suns! :) I am assuming that M plays a large part in the "High Flyer" strategy but I am not really familiar with it. And if you told him the shares he owned were not good value and expensive... well, good luck! Value is very much in the eye of the beholder and I am sure he would not agree as his valuation methods are different to those used by the Stockrank algorithm which seems to be based on more conventional concepts of Value. 

And that's the point I was trying to make; there are certain companies and sectors that will never be in the top StockRanks but still make great long term investments, and if you're not careful, you can just end up buying lots of overpriced cyclical stocks.

All the best, Si

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Trigger14 25th Mar '17 48 of 66

In reply to post #177684

Quite! I didn't think Terry Smith's approach had anything to do with momentum. I thought he was more of a high quality 'value' investor like Buffett - I.e. focussing on defensive compounders which he believes are long term undervalued. Of course his picks score very highly on quality factors (but he would do substantially better than just picking based on quality rank). There is some correlation with momentum rank (but noticeably much less) - this is probably just because his picks have been doing well.

Blog: Quality Share Surfer
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underscored 25th Mar '17 49 of 66

In reply to post #177738

Fascinating story, perhaps a return to the facts would be more useful. The top ten Terry Smith shares posted earlier by Ed are all high momentum rank shares. Perhaps rather than telling Ed that the facts presented to you are wrong there is an opportunity here for you to learn something you didn't know before you read this thread.

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simoan 25th Mar '17 50 of 66
2

In reply to post #177741

Fascinating story, perhaps a return to the facts would be more useful. The top ten Terry Smith shares posted earlier by Ed are all high momentum rank shares. Perhaps rather than telling Ed that the facts presented to you are wrong there is an opportunity here for you to learn something you didn't know before you read this thread.

But this is a self-defeating argument put forward by Ed. Momentum plays absolutely no part in his stock selection (that is a well publicised fact) or when to buy and sell (and he hardly ever sells). He typically holds 30-40 shares, so you'd expect, given relatively equal holdings of each within his fund that the Top 10 at any one time will contain those that have risen the most and hence have a higher M score.

All the best, Si

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dmjram 25th Mar '17 51 of 66

In reply to post #177744

To assess whether Smith buys into momentum stocks or not in practice as opposed to what is stated as the initial stock selection criteria we'd need to know how he balances his cash flows into the holdings on a month by month basis - unfortunately that isn't disclosed so we're not in a position to know.

Also remember momentum includes fundamental improvements such as earnings upgrades and not just price momentum. Good and improving fundamentals from a high quality company sounds pretty much what he buys and is a good description of many QM factor stocks he holds. And also the converse seems to hold when he sells - from memory Serco for example was dumped as its fundamental momentum deteriorated.

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underscored 25th Mar '17 52 of 66
1

Swedish Match too.

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Edward Croft 25th Mar '17 53 of 66
9

In reply to post #177684

Re-reading my comment I can certainly see I spoke a bit rashly without properly presenting the argument.  That's normally the case in comments rather than articles.  I'm actually on a break right now and have had a couple of beers... so apologies if I stoke the fire rather than put it out !

Before I read the above replies to my comment I was writing a blog about the cult of the celebrity fund manager - but it was triggered by some Neil Woodford marketing rather than Terry Smith.  Given the Fundsmith comments I think I may have found another angle for the piece.  I've always found that if you hit a nerve there are ideas worth exploring !

Don't get me wrong, Terry Smith is an awesome man, and a great inspiration.  I've still got a very old copy of "Accounting for Growth" from the 1990s.  What he's doing at Fundsmith is very commendable... he's been smashing the market.

But I do stand by my comment that what he's doing is replicable through factor investing principles.  He pretty much states he's a factor investor anyway.  Global equities, high quality, high sustained ROCE, mostly defensives/healthcare/tech, not much leverage, reasonable valuation, strong free cashflow, large caps. https://www.fundsmith.co.uk/fund-factsheet  There are a few soft factors in there.... but they are all factors.  

I've not done the analysis, and I likely won't have time in the next few weeks, but I would almost guarantee that if you modelled the above factors and built a "Fundsmith-esque" portfolio you'd find an almost identical return to Fundsmith.  If you lowered the bar, and added smaller caps - you'd probably do even better. 

I've explored these ideas plenty before.  Way back in 2012 I showed that Neil Woodford hadn't done any better than a simple systematic Quality Income portfolio (i.e. he's a factor investor) - http://www.stockopedia.com/content/should-you-pay-... - and Warren Buffett has been famously modelled as a factor investor in Buffett's Alpha.  I'm going to blog further on this - hopefully next week... but what makes these investors (Smith, Buffett, Woodford) stand apart, is their ability to stick to a defined process.  Most fund managers can't. 

As to the question of whether Fundsmith is a "momentum" investor or not... let me elaborate. 

Firstly I never said Fundsmith bought high price momentum shares.  I simply said his portfolio had high Quality+Momentum (QM) characteristics.  Frankly one look at his portfolio and you can see it's been high momentum all the way!  By definition, in a buy and hold portfolio,  you can't outperform the market unless your equities have stronger momentum than the market!  Anyone buying Fundsmith since 2012 was buying a momentum fund.

58d6e04f1d076Screen_Shot_2017-03-25_at_2

To explain this further... There are 2 ways to profit in the market - from mean reversion, or from trends.   You can only profit from mean reversion if you actively sell when prices revert.  If you don't ever sell, you can only outperform from momentum.  (by definition).  An outperforming value investor can only not be a momentum investor if they are actively selling their outperforming holdings. 

If you consider Warren Buffett.  He started as a smart Graham-esque, informed Deep Value style investor.  He bought undervalued deep value stocks for the 'last puff' of profit - before they went broke.  He was active. He bought cheap, he sold when valuations normalised. That's not momentum. That's contrarian mean reversion investing.  

But Buffett grew tired of it, after a few bad investments (including a certain textile mill).  So he became a Q+V investor... but found he had to pay up for quality - I'd say he eventually became more of a QM investor.  CocaCola, Washington Post,  American Express - all classic quality momentum plays. And he likes to hold forever... which requires persistent momentum to outperform.

It's odd.  Momentum investors are very friendly to the concept of value.  But Value investors find Momentum an affront to everything they stand for.  I really think everyone should come to terms with the simple reality that prices both mean-revert (value) and trend (momentum).  

Classifying someone as a momentum investor is not an affront to the "value" investment philosophy that they market.  Value and Momentum are perfect bedfellows.  After all, there's value and momentum everywhere

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Trigger14 25th Mar '17 54 of 66
2

In reply to post #177771

Yes totally agree. You could characterise someone like Terry Smith or Buffett as a 'momentum' value investor (rather than a 'reversion to mean' value investor). But interestingly these investors appear to ignore momentum as a factor when choosing what to buy. This has always seemed a bit strange to me, as the kind of high quality long term compounders they are trying to identify should display strong price momentum in the longer term. I think using momentum as a factor as well in a High Flyer type strategy makes a lot of sense. However, I can also see that if you are very confident in your assessment of long term quality then it can make more sense to buy the dip. Also I think if you have a large fund and a concentrated portfolio it is much more difficult to take advantage of price momentum because of insufficient liquidity.

PS I think we need to be careful to distinguish between the characteristics of a share when the investor decides to buy it and the characteristics of his current holdings. This is particularly relevant for momentum. All investors should want their holdings to have good momentum but not all would choose to buy shares which already have high momentum. 

Blog: Quality Share Surfer
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Trigger14 25th Mar '17 55 of 66

In reply to post #177741

I'm not sure if you really read my post before replying but you probably should have as your response is quite rude - patronising but totally misses the point. Perhaps you should take the 'opportunity here for you to learn something you didn't know before you read this thread'. As I said in my previous comment, there is a (weak) correlation with the momentum rank and his holdings. However, this does not mean his approach is based on momentum. If you are a successful buy and hold investor your current holdings will show greater than average momentum regardless of your approach.


Blog: Quality Share Surfer
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Trigger14 26th Mar '17 56 of 66
2

In reply to post #177774

FYI a useful relevant article setting out difference between' reversion to mean' value and 'momentum' value investing: https://intrinsicinvesting.com/2016/03/08/quality-companies-vs-cheap-stocks/

Blog: Quality Share Surfer
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Edward Croft 26th Mar '17 57 of 66
2

In reply to post #177771

This is a particularly good comment from Terry Smith:


Another obsession I have been surprised about is that with “cheap” shares. I have been asked whether a share is cheap many more times than I have been asked whether the company is a good business. This obsession often manifests itself in the critique of our strategy which goes something like, “These companies may be high-quality, but the shares are too expensively rated.” This is almost certain to be true, as from time to time the share prices are sure to decline, but it misses the point. If you are a long-term investor, owning shares in a good company is a much larger determinant of your investment performance than whether the shares were cheap when you bought them.  


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Bonitabeach 26th Mar '17 58 of 66
3

In reply to post #177786

Dear Ed,

Terry Smith is very right and also very wrong.

The investor in NEXT who purchased shares in say August 2015 is likely to end up as an extremely long term investor indeed; just to see his money back.

58d7aecfdbed8Chart-next-2622017-1.png

Compared to the investor who purchased in 2011 "investment performance" could not be more different.

Can you overpay for a "good" business?  

Yes you can.

Bonitabeach

 

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bestace 26th Mar '17 59 of 66
3

In reply to post #177771

apologies if I stoke the fire rather than put it out !

Stoke away! that's what these pages are for, isn't it? Perhaps you will allow me to do some stoking of my own...

My first post was prompted not so much by your comment that his top 10 stocks were classic QM plays (just by looking at the QM rankings in the table you provided, it's difficult to disagree), but more by this comment:

Terry Smith... is a classic High Flyer owner.

That's where I humbly disagree. From the post you linked to on the High Flyer strategy, you have outlined some of its characteristics which are quite simply anathema to the Fundsmith approach, in particular these two quotes:

These kinds of shares tend to be more volatile than the market

That top 10 list of the Fundsmith portfolio looks full of defensive stocks, so one would expect the fund to be less volatile than the wider market. Indeed looking at the fund itself, its beta is something like 0.86 over 3 years compared to the MSCI World index.

few shares can stay a High Flyer for too long...either the stock or the company runs out of steam. So running a portfolio like this requires active management - regular portfolio rebalancing to keep jumping into the next set of High Flyers before the previous set runs out of steam.

That simply isn't the Fundsmith way. Their funds display minimal active management. They aren't looking to jump into the next set of High Flyers because they are 'buy and hold' merchants. The active management required of the High Flyer strategy is just incompatible with the Fundsmith philosophy.

I agree with you that their philosophy can be modelled on a number of factors, which is why I suggested a Stockopedia guru screen based on this philosophy would be of interest - all the more so if their record is easily replicable given that they have absolutely trounced the markets since inception. I had a go at creating my own Fundsmith screen which threw up some interesting results, but I don't know if it's possible to filter by sector or industry grouping, which is important as that forms a key part of their screening process.

Stepping away from Fundsmith for a moment, it looks to me like the term 'momentum' is being conflated to mean a few different things.

Firstly, I'm not sure I buy this distinction between mean-reverting value and trend-following momentum. Surely when the mean-reversion happens, we see momentum at the same time - the price is likely to be heading northwards from a low base so will be at or around 52-week highs, while the trigger for the mean reversion could be improving fundamentals and brokers playing catch up. That may not be momentum investing, but aren't those characteristics the definition of momentum?

By definition, in a buy and hold portfolio, you can't outperform the market unless your equities have stronger momentum than the market! Anyone buying Fundsmith since 2012 was buying a momentum fund.

That strikes me as diluting the definition of 'momentum' to the point of becoming meaningless. It implies every buy and hold investor is a momentum investor. Well yes, if a momentum investor is someone who aims to have their stocks increase in share price. Don't all investors want that? Are we all momentum investors now? because if so, the 'momentum' tag becomes redundant.

Here's my understanding of momentum investing: I think there is a distinction to be made between on the one hand an investor who consciously focuses on momentum characteristics as part of their screening and stock selection process, and on the other hand an investor who ignores momentum characteristics but believes that by focusing on Q and/or V characteristics, momentum will manifest itself eventually through a rising share price and fundamentals.

For me, a momentum investor is someone who falls into the first of those approaches. Coming back to Fundsmith, in as much as it is possible to stereotype any investor with a specific label, I therefore believe Terry Smith is not a momentum investor and that his fund is not a momentum fund. But that doesn't mean his fund won't show momentum in the form of a rising fund price.

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bestace 26th Mar '17 60 of 66
3

In reply to post #177792

I don't think Next (LON:NXT) would interest Terry Smith, and as far as I am aware it's never been in his portfolios.

Yes it's historically had high ROCE and operating margins, but it's a fashion company which means it's subject to the vagaries of consumer trends, which are unpredictable. More than that it's a middle of the range fashion company, so it's at risk of losing trade to customers who can trade up or trade down. It's also carrying a fair amount of debt.

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underscored 26th Mar '17 61 of 66
2

In reply to post #177780

I will row back from some of that, indeed I had not read your post properly :) I have come across a tendency in some of those that consider themselves value investors to think themselves better than others. They tend to take great offence at momentum.

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Edward Croft 26th Mar '17 62 of 66
3

In reply to post #177798

Bestace -  Let me explain a bit further.  I have yet to see one of Fundsmith's investments that doesn't fit the "general" High Flyer style.  i.e. high QM and low V.  I've dug through quite a few Fundsmith archives and it seems that most of his investments have a similar ranking profile to this:

58d802f763d15MICROSOFT_Share_Price_-_MSF

We're actually working on some new 'style' categorisations that mark any stock as a high flyer with a Q:V:M from 60:40:60 to 100:0:100.  In my mental classification, this is what I mean by high flyer as a "style"... though the community tends to think of these stocks at the more extreme end of the scale (due to my original article).  When we start publishing the Style classifications (which may be within months) almost every Fundsmith stock will be labelled the 'High Flyer' style - which simply means a 'good company, with strong momentum, that is fairly expensive'.

The extreme of this archetype has recently included stocks like Fevertree and Boohoo - which may be temporarily smashing it but may not have any kind of sustainable long term competitive advantage (unlike companies like Microsoft).  Investing in those kinds of extreme stocks definitely requires careful portfolio management and ultimately rebalancing.... but Fundsmith isn't aiming for those kinds of shares.

Fundsmith aims for a buy and hold 'forever' portfolio. Selecting forever stocks that you never sell requires a very, very high quality bar.   If you don't ever want to sell then you have to be 100% sure that your stock has a sustainable competitive advantage. Measuring this kind of 'quality' requires a different approach to the one taken in the overall Quality Rank.  What Fundsmith aims to do is focus on perennially high return on capital companies that generate strong persistent free cashflow and gross margins.  This is similar to the "Franchise Factor" component of the Quality Rank.  If we broke down the Quality Rank -  Fundsmith stocks would most likely have even higher Franchise Factors than their overall Quality Ranks. 

The very highest franchise factor stocks tend be 'perennial compounders' - the companies that almost year in, year out, manage to reinvest their earnings at very hight returns on capital to grow sales and earnings well ahead of inflation.  If sales and earnings grow above the market, then this will eventually be reflected in an outperforming share price. They may not outperform every single year, but over time they will tend to beat the market significantly in more years than they don't.   This causes above the market price momentum sustained over multi year periods.  

That doesn't mean that someone like Terry Smith is using a factor like "1 year Relative Strength" as a selection rule.  But as he focuses on finding perennial compounders (and is good at it), it does mean that his overall portfolio will include many shares that persistently exhibit strong 1 year Relative Strength. But this is an emergent property of his selection process rather than an explicit one.  I imagine if you regressed Fundsmith against certain market factors you'd see a fairly strong momentum correlation.  


PS - Just to close.  Most investors are indeed buy and hold investors.   But most investors match or underperform the market.  So, no I don't think we can say that all B&H investors are momentum investors nor do they exhibit momentum characteristics !



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Trigger14 26th Mar '17 63 of 66

In reply to post #177807

OK thanks for that very gracious of you. I know exactly what you mean - I am quite the opposite of a value evangelist / momentum sceptic so mortified you mistook me for that! I think momentum is closest thing to the private investor's free lunch

No hard feelings :)

Blog: Quality Share Surfer
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WhaleHQ 28th Mar '17 64 of 66
1

Thanks for that Ed.
I didn't realise how much I trade until I entered my investing history into the folios tab, it was an eye opener and I now know it has cost me a fortune particularly on my biggest winner which went up 4 times in the period I owned it, my continued trading has cut my profit by at least a third of what it should have been. Every-time it hit a new high I worried it was drastically over priced, which it probably was, but the market didn't think so. Finally I sold the entirety of my holding and the market cap has continued to race north. I still look at the share price and wonder if I should buy back in, but I think it is now tremendously overpriced.

So I'm going to put this down in black and white and hope the god of the commitments biases can help me out:

I am going to hold for a minimum of two years unless something critical changes within the fundamentals of the company,

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tomomo 31st Mar '17 65 of 66

Ed. You mentioned historic StockRanks will be available in chart form later this year. Will these (and the constituent factor ranks) be super-imposable on the price charts?

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PhilH 31st Mar '17 66 of 66

In reply to post #178587

A pop-up chart after hovering over the relevant rank would be good.

Possible to add that to the existing stock report?

Hopefully
Phil

Professional Services: Sunflower Counselling
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