Strategies Review Q2 2017: Small-cap growth stocks set the pace

April through to June was another strong quarter for the 60 guru-inspired investment strategies tracked by Stockopedia. Followers of Paul Scott and Graham Neary, who write our daily small-cap reports, will know that many growth stocks have been flying for months. And that’s exactly what we’ve seen in our screens modelled on the legends of finance: small-cap growth has been in a sweet spot. But there have also been winners right across the strategy styles.

As expected, the second quarter carried on the trends we saw earlier this year. Growth lead the pack, but Income, Value and Momentum strategies all held up well, while Quality still lagged.

Index valuations stalled and drifted lower in June, which meant it was a flat quarter for the market. There are various possible reasons for that. It could be the market’s just taking a breather as we head into what are usually the quietest months of the year. Certainly Paul has mentioned that those growth stocks that fail to keep up the pace with their earnings forecasts are being punished severely. So it’s clear that there are concerns about stretched valuations in some places.

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A note about the guru strategies

We’re now into the sixth year of tracking these strategies and they’ve become a useful barometer of what’s working in the market, and how different styles behave over time.

As always, here’s a primer for those new to Stockopedia. These strategies cover a range of approaches used by some of the world’s best known investors. They’re categorised as either Quality, Growth, Value, Bargain, Income or Momentum.

Each strategy has its own set of rules, and we constantly screen the market for companies that meet them. At the end of each quarter, the companies passing the rules are held in a portfolio for each strategy, which we track. The models aren’t always realistically investable, and sometimes there may be few companies that meet the rules of some of them. In addition, we don’t account for the drag of trading costs or the bonus of dividend payments.

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It has been a decent 12 months for the overall guru strategy composite - up 32.7% - which is the one of the strongest runs we’ve seen over the past five years.

The 10 Growth strategies produced a composite return of 7.0% in the second quarter, and a 51.9% return over the past year. Charles Kirkpatrick Growth was the best performing strategy, up 21.0%. It did it with the help of stocks like Stobart, On the Beach and Ferrexpo. In the mix among the other top screens were those inspired by Peter Lynch, GARP, William O’Neil and Jim Slater.

Over one year, the Growth at a Reasonable Price strategy is the top performer, with an 82.3% gain. In fact, every one of the Growth strategies has managed a double-digit gain over 12 months.

The catch with Growth strategies this year has been a lack of diversification. For some of them (but not all) we’ve seen low single figures in the folios. When you get big winners, especially in a bull market, that kind of concentration can really supercharge returns. But it’s risky if things go wrong. The good news here is that the available stocks for a number of the strategies has been improving and it’s looking much healthier going into this quarter.

Limited numbers of qualifying shares also impacted on the Income strategies in Q2. The overall composite return (excluding dividends) was 6.3%. Among the main investable strategies, Dividend Achievers lead the pace with a 5.6% return, followed by Dividend Dogs on 4.3%.

Momentum strategies still strong

A few weeks ago I wrote about the academic thinking behind some of the most successful Momentum strategies. The causes of Momentum are invariably linked to investor behaviour and the psychological impact of events like 52-week highs, earnings surprises and earnings forecast upgrades. Overall, it’s an approach that historically does well in bullish conditions, which is precisely what we’ve seen. Drifting prices in June took the edge off the Q2 composite performance, but Momentum has nonetheless been a winner over the past year.

During the spring, the Richard Driehaus screen came out on top with an 8.0% gain, helped by holdings in James Cropper, Impax Asset Management and Burford Capital. It was followed by strategies that track down Earnings Surprises, Bold Earnings Revisions and 52 Week Highs.

The Momentum strategy portfolio are a useful guide to trends in the market. In the first half of the year the Earnings Upgrades screen had a heavy bias towards mining and financials, which were two sectors in recovery. But that’s changed at the half-year. Now there’s a broader spread of stocks and sectors - although a notable decline in the overall number of them.

By comparison, the new Earnings Surprises folio takes a good number of growth companies into Q3. So those smaller-cap stocks will have to keep motoring for this strategy to keep performing well.

Value strategies struggle for options

The Ken Fisher Price to Sales screen leads the Value strategies over three and 12 months, with returns of 19.1% and  69.4% respectively. The problem was that the strategy only held one stock through Q2, and that was Prime People. As it turned out, it was a great selection but a one-stock folio is no guide to the effectiveness of a strategy.

This problem highlights the challenges for Value strategies this year, even though it’s been far from a bad performance from them overall. We’ve seen decent results from screens inspired by Sir John Templeton, Ben Graham, Joseph Piotroski and Bill Miller, but some have struggled for diversification. For instance, the Piotroski Price to Book screen has been dominated by small natural resources stocks this year.

With strategies like Bill Miller and Sir John Templeton, diversification has also been limited, but there have been some big wins. The Bill Miller screen held the strongly performing Morgan Sindall though the quarter, while the Sir John Templeton saw a huge return on the takeover of Waterman.

Mixed returns from Quality strategies

It was mixed news for the strategies that focus on picking up good quality firms. The Muhlenkamp ROE screen took top position in Q2 with a 9.2% gain. That was achieved through solid returns in insurance and housebuilding, with holdings like Hiscox, Beazley, Bellway and Redrow. But on the flipside, the three Warren Buffett inspired screens delivered a flat performance. The Cash Accruals, R&D Breakthroughs and Piotroski High F-Score strategies also had a quiet quarter.

Stockopedia’s Screen of Screens came in with a 7.1% return (up 40% over one year). That marks a welcome return for a strategy that underperformed badly between the summers of 2015 and 2016. You can read our recent write-up of the SoS strategy here.

A final note on the Quality strategies is that the Joel Greenblatt Magic Formula strategy saw a 4.7% gain in the quarter, also taking it to 40% over one year. It’s another Quality strategy that’s come racing back after a lacklustre couple of years. Some of the big winners for it in 2017 have been Wizz Air, Coats, Somero and Gama Aviation.

Expectations for the summer

The market has been on a strong run since last summer but there was a definite break in the momentum during the second quarter. Whether this recent hiatus is just a short period of calm or the start of more unsettled conditions will be a big influence on how the guru-inspired strategies perform over the summer.

Growth strategies have been the superior approach for profiting from the market over the past year. It’s encouraging that we’re actually seeing a rise in the numbers of those companies qualifying for the screens. All things being equal, it’s hard to see any reason for that to change in the coming months - although the companies that do miss their earnings expectations will continue to be punished.

You can explore all of the guru-inspired strategies tracked by Stockopedia here and check the performance here.