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History shows there are three clearcut strategies that generate equity outperformance.
Buy small caps in preference to large caps. Buy shares with relatively high book-to-market valuations. And buy stocks that have been going up.
What’s more, these rules hold for most markets most of the time.
That’s the conclusion drawn from the latest instalment of a sourcebook on global investment returns, running back to 1900 and covering 19 developed country markets, produced by London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton for Credit Suisse.
The annual update of their “Triumph of the Optimists” survey of global returns ought to be on every asset manager’s desk for the bell-clear data on offer that lead to conclusions as close to truth as an investor is ever likely to get.
For instance, U.S. small-capitalization shares have returned an average annual 12.2% per year since 1926 against an average annual 9.6% for large caps. This may not sound much, but a dollar invested in small caps in 1926 would have grown to $17,394 by 2011 against $2502 for large caps, assuming dividends were reinvested and the portfolios were rebalanced regularly.
While the U.S.’s small-cap effect may be particularly strong, most developed markets have shown the same effect, with the average outperformance about half that of the U.S.
U.S. stocks with high book-to-market valuations have, over the same period, returned a 12.6% average annual return against 9.0% for low book-to-market equities. A dollar invested in 1926 would have returned 15 times more for value stocks against the low book-to-market growth stocks, assuming dividends were reinvested.
Once again, this investment style’s excess returns have held for most markets in the period since 1975, with value stocks outperforming by an average annual 2.5 percentage points across all markets during the whole of the period, and 3.9 percentage points since 2000.
And finally, there’s momentum. For the U.S., the average annual difference between buying stocks that had performed well during the previous six months and had done poorly over the same period and then holding them for a six-month period, with one month in-between (a fairly standard strategy), would have generated an excess return of 8.4 percentage points a year since 1926. Pursuing such a strategy would have made a buyer of winners about 500 times better off than a buyer of losers by 2011.
In this case, the strategy was a strong winner since 1975 across the universe of markets Dimson, Marsh and Staunton have studied. Indeed, the U.S. momentum effects have been only around two-thirds as strong as those seen on average across developed markets.
So clearly, a winning strategy would be to buy winning high book-to-market small-cap stocks while shorting the low book-to-market large-cap stocks. Right?
Maybe. But only for investors who could bear potentially devastating short and even medium-term reversals. For instance, in the U.K., small-cap stocks did particularly badly relative to the large caps during the late 1980s and much of the 1990s. Meanwhile, value has underperformed for relatively long stretches, such as during the tech and telecom bubble and over the past couple of years. And momentum has suffered occasional and rather dramatic reversals in the order of 20% or more.
Put them all together and a perfect storm could make an investor very, very poor, very quickly.
But if the same investor were happy to leave these strategies to a black box, returning to it only, say, every five or maybe 10 years, said investor would likely prove to grow very rich indeed. If only such an investor existed.
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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