Testing the philosophy over time
History shows that a combined strategy of value and growth is the best approach to investing long-term
The trick to a sound investment philosophy is to find a repeatable, simple and proven process that greatly reduces human subjectivity and bias.
This process must give you volatility that is lower than the benchmark, but with a high base rate of success.
It’s far more difficult than you think. There are many equity managers scattered around the world, all trying to beat Mr Market (the World Index) or a country index, typically from one of two schools: “value” investors or “growth” investors.
Of course, even those from the same school get different results. Portfolio managers often apply their process inconsistently because they are, after all, human beings who often act differently from how they think they should. This has opened the door to the fascinating field of behavioural finance, which has exploded many investment myths.
Human beings shouldn’t chastise themselves for irrationality, of course.
Sir Isaac Newton, the father of physics, was suckered into investing in one of the earliest recorded bubbles, the South Sea Trading Company. Twice, Newton bought and sold shares over an 18-month period, before selling out and clocking up a £20 000 loss. Now this happened in the 1720s to a rational, intellectually gifted human being.
But, as Von Goethe once said: “To think is easy, to act is difficult. To act as one thinks is the most difficult of all.”
It’s true also that investment styles go in and out of favour. Growth investors can outperform value investors for long periods of time and vice versa. The thing is not to panic.
Another fact is that, given the reasonable efficiency of the market, it is quite rare for managers to outperform Mr Market over the longer term.
It is recognising this fact that has pushed large funds into tracker funds or ETFs. The problem with tracker funds, the way I see it, is that the investor assumes all the market risk. A better way to do it is measure the volatility of the market and manage it, so an individual portfolio carries less market risk than the benchmark.
How do you find an investment strategy that navigates around all these variables?
After much searching, I found one US fund management house that had tested numerous strategies over more than 75 years, compiling a data set that considered all the statistical pitfalls like data mining, the look-ahead bias, survivorship bias and other pitfalls. Over that period of time, all the value and growth strategies would have been tested.
The conclusion was that a combination of the fundamental (value) and momentum (growth) investment strategies provided the best risk-adjusted returns. Both the undiluted “deep value” strategy and the “go with the flow” momentum strategy came short at some stage.
It’s a strategy I’ve applied since 2006 to a portfolio of global equities. The base rate of 85% this produced meant that, 85% of the time, the returns beat the market, including over 10-year rolling periods. As it stands today, US stocks make up roughly 55% of my portfolio, which contains about 50 global stocks.
In the US, the health sector is considered sexy right now.
The stock in this portfolio which I believe fits the criteria of the combined strategy is called Gilead Sciences.
Gilead is a research-based biopharmaceutical company, listed on the Nasdaq, which earned about half of its $25bn revenue in 2014 from treatments related to chronic hepatitis C.
Today, it has a market cap of $171bn, is trading at a price-to-earnings ratio of 12 and a price-to-cash flow ratio of 10, and delivers a dividend yield of 1,5%.
To my mind, Gilead trumps other pharmaceutical companies — like Celgene, Eli Lilly and Bristol-Myers Squibb — which appear to be in a price bubble or an intrinsic economic bubble.
There is, of course, a health warning: shares like Gilead are for the long term (10 years plus). Equity markets, as the last 75 years illustrate, can be volatile over the short term.
To my mind, Gilead trumps other pharmaceutical companies