With the Springboks in the midst of their European tour, I couldn’t help but think that this actually presented the perfect opportunity to explain how factor investments work.
Although Faf de Klerk may be one of the best rugby players in the world, he probably wouldn’t have made it into the Springbok team if he decided to change his position from scrumhalf to prop.
I believe without a doubt that he is extremely talented, but let’s face it: weighing in at 80kg, he would have had more than just a little bit of trouble facing off against someone like Tendai “Beast” Mtawarira, who weighs in at around 120kg.
But make no mistake – Beast will also have his fair share of trouble in the position of scrumhalf, because as fit as he may be, being everywhere on the field all the time will be a drag with an extra 40kg in weight.
In the same way that we find different positions on the rugby field, fund managers also have different investment styles.
I have made several references to different investment themes in the past that investors can follow, such as the rand or IT cycles. So too investment styles can be used as a theme to invest in.
Before I continue, let me briefly explain the concept of styles in share portfolios.
When we analyse different shares, they can be divided into different categories, like momentum shares, value shares and quality shares.
Momentum investors focus mainly on shares that rise sharply, while avoiding or selling shares that decline in value.
Value investing is more focused on shares that have a higher earnings yield, a lower price-to-book ratio and a lower enterprise value (EV) to earnings before interest, taxes, depreciation, amortisation (ebitda) and enterprise value-to-ebitda ratio (EV/ebitda).
Quality shares are valued based on strong returns on equity (ROE) and the lowest possible EV-to-free-cashflow ratio, with low volatility shares that focus mainly on shares with the lowest possible volatility ratios.
We decided to test these different strategies based on data for the last 16 years and the results were quite surprising:
If you had singled out the 16 shares with the strongest style characteristics on a quarterly basis over the last 16 years, it becomes clear that if you had followed a momentum- or quality-driven style approach, you wouldn’t just have followed the most successful strategy, but you also would have outperformed the FTSE/JSE All Share Index (JSE) quite comfortably.
There are, however, three problems with this. Firstly, the data is based on historical figures which, as we know, offers absolutely no guarantees for future performance.
Secondly, these two strategies correlate narrowly with each other and would have caused much more volatility (risk) in your personal portfolio.
Finally, individuals who followed these two investment styles this year would have had a tougher time than Faf de Klerk would have facing off against Beast in a scrum.
A momentum- and value-driven strategy, however, would have given you a much better inverse correlation, which would have given you the opportunity to both scrum well and move about more freely like a scrumhalf.
When we place the various investment styles relative to the JSE, not only do we notice this inverse correlation effect graphically, but it also shows us how tough value fund managers had it up to the end of 2015.
Over the last three years, however, with the JSE not performing too well, value has started to emerge once again.
My message is simple: as with my Faf and Beast analogy, you shouldn’t only choose funds based on their performance over the last year or two.
Just because they performed well under one set of circumstances, does not mean that they will perform as well when those circumstances change.
Rather combine your styles in such a way that you end up with an above-average performance.