Different strokes for different folks

The 26th of March saw the first MotoGP race (motorcycle racing) for 2017. For those of you who aren’t quite familiar with the sport, only one name needs to be remembered: Marc Márquez – five-time world champion. As dominating as he was on the race track these past few years, expectations were high that, as with the previous two races on the Qatar race track, he wouldn’t perform well. As predicted, he didn’t do well at all, but why? The reason is simply that the Qatar race track doesn’t suit Márquez’s or his motorcycle’s (Honda) driving style.  

In the same way that different MotoGP drivers have different styles, fund managers also have different styles. Roughly two weeks ago (6 April issue) I discussed how investors can invest in different themes, such as the rand, for example, or commodity classes. No different to these, different investment styles can also be seen as a theme in which you can invest. 

Before we continue on how to apply these strategies, however, I briefly need to explain what different styles can be found in equity investments. When we analyse shares, they can be divided into different classes, such as momentum, value, quality and low-volatility stocks, to name a few. 

Momentum, for example, focuses on shares that move strongly upwards, while avoiding or selling shares which decline in value. Value is more focused on shares that deliver higher earnings with lower price-to-book value and lower enterprise value (EV) to earnings before interest, taxes, depreciation, amortisation (ebitda) and earning multiple (EV/ebitda). Quality stocks are valued based on strong returns on equity (ROE) and the lowest possible EV-to-free cash flow ratio, with low-volatility stocks mainly focusing on shares with the lowest possible volatility ratios. 

We decided to apply these different strategies over a period of 15 years and the results were staggering: 

If you had invested in the 15 strongest characteristically style-based shares on a quarterly basis over the last 15 years, it clearly shows that if you had followed a momentum- or quality-driven approach, you wouldn’t only have invested in the most successful strategy, you would have also outperformed the FTSE/JSE All Capped Index (JSE) quite comfortably. 

I have two problems with this, however. First, the data is based on historical performance which carries no guarantee of future performance; and second, that these strategies are narrowly correlated, which would have resulted in more volatility (risk) in your personal portfolio. A momentum- and value-based strategy, however, would have provided you with a much better inverse correlation, which, when applying the MotoGP analogy, would have meant that you wouldn’t have finished first in one race only to finish last in the next one.

When we place these different styles relative to the JSE, the inverse correlation effect doesn’t only become visibly clear, but it also shows us just how badly fund managers performed on “race tracks” that didn’t suit their styles in 2015. It’s only during these last 15 months that names like Investec Value and RECM managed to get back on track. 

I took all of this one step further, however, by running the South African General Equity unit trust sector correlations on all funds to find out which style suits which fund the best. I simply took the two largest funds which best correlated with the momentum style and combined them with the two largest funds that best correlated with the value style. Again, the results were staggering. By applying no further expertise, this combined portfolio didn’t only manage to outperform the JSE over the last 15, five, three and one year(s), but it managed to do so with 13% less volatility. The JSE would have provided you with 47 negative months over the last 10 years, while this portfolio would have only provided you with 43. 

My message this week is this: As is the case with MotoGP, don’t simply choose funds based on the fact that they performed well over the past year or two. The next racetrack might just not suit their styles. Rather combine your styles in such a manner that you always achieve above-average performance.  

Schalk Louw  is a portfolio manager at PSG Wealth. 

This is a shortened version of an that article originally appeared in the 20 April edition of finweek. Buy and download the magazine here.