Six years of investing trends through the lens of the StockRank Styles

Back in April 2009 — a little over 10 years ago — world stock markets reached an inflection point. No-one knew it at the time (though some later claimed they did) but it was the moment when negative momentum triggered by the financial crisis stopped and equity prices started rising. These were the very early days of a new bull market.

At the point of maximum pessimism – almost to the day of the market hitting a post-crisis low – a star fund manager called David Dreman was fired as a subadviser to the $2.9 billion DWS Dreman High Return Equity Fund.

After running the fund for 20 years, Dreman’s misdeed had been to stick faithfully to his contrarian value investing style. High exposure to financial stocks had savaged his recent performance, and his three and five year returns weren’t much better.

And what happened next? Well, inevitably, Dreman went on to slay the market as it roared back to life (and handily outperform the new managers of his old fund). But that isn’t quite the end of the story. In an interview shortly afterwards, the battle-scarred value manager remarked:

“Low P/E investing is a proven strategy, and this is exactly the kind of market we do well in—many great stocks got knocked down to levels we have not seen since the 1950s. Over the next five years the stock market could possibly double.”

On this point, Dreman was wrong. It actually only took four and a half years for the Samp;P to double (…and eight and a half years for it to triple).

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Dreman’s experiences are a good illustration of the way different investment styles zig and zag over time. In his case, cheap, out of favour contrarian stocks fell flat through the slump but paid off handsomely in the recovery. In the years afterwards, value strategies came under pressure again, but other styles flourished.

With the introduction of Stockopedia’s StockRanks six years ago – and then the launch of the StockRank Styles – we’ve been able to get a much better look at how these style trends change. Before we dive into what we’ve seen over that time, here’s a quick reminder of how this analysis works…

StockRanks show the investment strengths and weaknesses of any share in a single number. You’ll find these at the top of any StockReport. They work by scoring and ranking every stock in the market — from 0 (poor) to 100 (excellent) — based on exposure to the three factors of Quality, Value and Momentum. (We use a combination of several measures to make the calculation for each factor).

This three-factor model makes it simple to understand the investment profile of any stock. When you mix and match different exposures to different factors you get a framework of wining and losing investment styles – and these are the StockRank Styles. You’ll also find these at the top of every StockReport.

The Styles map to different investing tastes which come in and out of vogue in different market environments. Here’s an easy visual way to think about the framework:

Super Stocks, High Flyers, Turnarounds and Contrarians represent the positive styles, with high exposure to two (and three in the case of Super Stocks) of the main factors. Meanwhile, Sucker Stocks, Momentum Traps, Value Traps and Falling Stars represent the losing styles. They only have high exposure to one (or none in the case of the Sucker Stocks) of the same factors.

What’s worked over the past six years?

We’ve now got six years of Styles performance data ranging between the early summers of 2013 and 2019. So what has the general trend of the market been like over that time?

The answer is pretty positive. The FTSE All Share is up over that period but some years have clearly been better than others. The obvious wobbles of note from the chart below came in early 2016 ahead of the EU referendum, and late 2018.

(Incidentally, the spike down in February 2018 was triggered when the Dow Jones suffered its worst intraday fall in market history… only to come bouncing back days later.)

But when you look beneath the surface, what kinds of investing styles were really paying off?

A solid start

The chart below represents what our analysts Tom and Oli call the ‘hit rates’ of the StockRank Styles – and this one is for the year April to April 2013/14.

This was the strongest year for the Styles over this period. The chart shows very considerable percentage win rates – stocks that achieved positive returns – among the winning styles. Of the Super Stocks that year, 91% of them were winners. But among the Sucker Stocks – the low quality, expensive, declining shares – the win rate was just 33%.

Note that Contrarians – the higher quality, cheap stocks – trailed the positive styles – and this was something we saw more of later in this period. It was a sign that the momentum factor was having more influence than value.

When momentum misfires

This next chart represent the worst year for the Styles over the past six years – and that was last year, 2018/19.

While the winning hit rates were generally down across the board, the pattern of winning styles beating losing styles remained intact, as it has right across the six year period.

So why were the win rates muted in the very latest 12 month period? One answer is that with the market falling from October 2018, this chart captures a period when momentum came under pressure just as value was continuing to underperform, meaning that two factors were misfiring. It certainly seems that momentum took a hit last autumn and it’s taken some months for the factor to turn positive again.

The overall picture

It can be easy to extrapolate stories from individual years, but to get the big picture we need the six-year view – and here it is:

This is a much broader assessment of how the Styles have performed in recent years. The positive styles, particularly the Super Stocks and high quality, high momentum High Flyers, have enjoyed solid average win rates of around 64% each.

But among those winning styles, Contrarians – the quality, value approach – have undoubtedly suffered. This has not been a period (certainly in the UK) that value investors like David Dreman would have relished.

Even among the losing styles, momentum has had the edge on value. You can see that you’d have done slightly better finding winners among ‘strap in and hold on tight’ Momentum Traps than you would have done picking up pennies in front of a steam roller with the Value Traps. Neither of those styles looks like a particularly tempting bet, though.

And as for Sucker Stocks… well, the average win rate was, as we’d expect, at the very low end. But before we dismiss them out of hand, it’s worth looking at more data about these speculative, lottery ticket-type shares. Why, if the average hit rate is so low, does anybody buy them? Well, here are a couple of charts that help to explain it…

The first shows the distribution of returns of Super Stocks over the past six years. This chart shows you the worst performing 5% of stocks over on the left, right through to the best performing 5% of stocks on the extreme right.

Buying baskets of stocks with the highest exposure to Quality, Value and Momentum doesn’t guarantee a win, but it has offered a higher probability of success – just over 60%. It’s a steady line; the heaviest losses have been contained, and at the winning extreme there have been some very solid performances.

Next we have the distribution of returns for Sucker Stocks – and straight away you can see those rare lottery wins. Sucker Stocks that actually paid off, did so with a bang. For those who found them, the return was substantial, but my word the probability of doing that was low.

This chart shows that low exposure to Quality, Value and Momentum results in a very low chance of a positive gain most of the time. But just as importantly, it shows why that doesn’t necessarily deter people. Those big wins look attractive, but investors in this space usually lose.

Finally, here’s a chart that brings this all together. The blue bars show the median win for each Style, the red bars show the median loss and the orange bars show the average gain or loss, taking into account the hit rate.

If anyone needed telling that it’s a war out there, this chart gives ample illustration. To the left you can see that when Sucker Stocks win, they produce significant gains. But the median losses for them are considerably higher and the average return (at nearly -20%) proves that this territory should come with a wealth warning.

It’s been a similar story for the Momentum Trap and Falling Star styles in recent years. High exposure to single factors – in these cases Momentum and Quality – has resulted in some strong median wins, but also strong losses, and the average returns are negative.

This makes sense because stocks with high single-factor exposure can be very vulnerable. In the absence of quality and attractive value, high momentum stocks can turn on a dime and collapse when investor sentiment changes. Likewise, stocks that look good quality but are expensive and lack momentum are prone to falling hard and failing to recover.

Towards the right of the chart, the median wins and losses tighten up and the average returns start to turn positive. This is the higher probability two- and three-factor end of the market. Contrarians, admittedly, have suffered in these conditions. But, overall, a blend of styles has delivered superior returns on average over the past six years.

High quality, high momentum High Flyers have led the two-factor models, which is understandable given that momentum has been such a powerful factor in this market. But overall, the three factor Super Stocks, with high exposure to a blend of Quality, Value and Momentum have offered the highest overall average returns.

Where now?

What are the conclusions from all of this and what does it mean for individual investors?

For a start, it can be very helpful to get to grips with the three main factors that drive stock market returns and the exposure that different stocks have to them. Mixing and matching Quality, Value and Momentum creates investment styles that change in their effectiveness through different timeframes. So this kind of approach can help to improve your investment process to focus on higher probability areas of the market.

Our findings show that value and, in particular, contrarian (quality, value) approaches have been under pressure for much of this period. But a blend of quality and momentum – in the form of High Flyers – has been a much more powerful strategy – and Super Stocks even more so. While momentum has suffered over the past year, these two styles have held up well, showing the resilience of two- and three-factor strategies.

In addition, the return distribution across the StockRank Styles framework over this period shows why speculative, low probability shares are so hard to resist for many investors. The payoffs with these stocks can be big, but they are very rare – and the numbers tell us that most of them end in disappointment.

*Thanks again to Tom and Oli for all the data work.

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