Even though we tested some single factors that did lead to strong market outperformance, the two-factor strategies we tested were substantially better. For example, if we combine the first quintile performance of all the one and two-factor strategies we tested, and sort them from best to worst, the best single factor performance (achieved by applying a low price-to-book ratio to mid-cap companies) was at position 69 (the next was at position 91). All the strategies that performed better were two-factor strategies.
The most surprising result we found, especially for value investors, is that price movements over previous 6- and 12-months (6- and 12-months price index) were factors in each of the 10 best performing two factor strategies we tested. This is not what we learned as classical value investors. We learned that the more a company share price declined, as long as it became cheaper in terms of valuation, the more attractive it was as an investment.
With our back testing we found that valuation still matters, but it has to be applied in a different way. You first have to look for the 20% of companies that increased the most in price over the previous 6-months and then sort these companies by price-to-book value and buy the 30 companies with the lowest price-to-book value.
At this point you may be asking yourself the same question we have - the results we have shown are all based on historical financial information, but what does this mean for my future investment returns? The simple answer is we cannot say for certain, but we have a good idea. We now know what strategies were very successful in arguably one of the worst 12 years in terms of stock market performance in at least half a century.
For the next 10 years the top performing strategy we tested of buying the lowest 20% of companies by book value of the 20% of companies that have increased the most in price over the past six months will most likely not be the best strategy. But it will still give you outstanding market beating returns. In the past 12 years the strategy returned just under 1160%, compared with the market portfolio 30.54%. Does it really matter if the strategy falls to position 20 of the strategies we tested and generated a total return of 670%? Most likely not, because you would probably have outperformed 99% of all investment funds worldwide. This means that the strategies that performed the best over the past 12 years may not do so over the next 10 years, but they will still be amongst the top strategies in terms of overall returns.
But what will happen if everybody starts using the best performing strategies; surely they will stop working, you may be thinking. If everybody does they will definitely stop working as investors pile in and push up prices to where these companies would not be undervalued anymore. But as Joel Greenblatt in his book, ‘The Little Book That Still Beats The Market’ mentioned, the reason everybody will not follow strategy is because it doesn't work all the time. And as soon as it stops working investors will abandon it like they abandoned the top performing investment fund we mentioned above. Most likely at exactly the wrong time; just before the strategy would substantially start outperforming the market once again. Remember the best performing strategy we mentioned outperformed the market only 83% of the time and had negative returns in three of the 12 years. In one of the last years, or one of the other years that the strategy didn't outperform the market, it would most likely have been exactly the time when investors abandoned the strategy.
One last point we would like to mention. Do not for a minute think that it is easy to follow these strategies. If you see what companies they come up with you will immediately start analysing them and for example say, ‘There's no way I am investing in that industry at the current time’, or ‘Look at this company's financial statements, it’s completely hopeless’. That may be so with one or two of the companies that the strategy comes up with. That is the reason why we suggest that whatever strategy you follow you invest in a minimum of 30 companies. This means that even if one of two companies go bankrupt, the others will do extremely well and your overall performance will still be outstanding.
We sincerely hope that you found the study of value and it substantially improves your investment returns. If it has, or if you have any comments or suggestions please let us know.