The main reason why the sharemarket "works" so well
is that nearly every investor has a different opinion on the
future of a particular share. For every investor using a share
selection method and seeking to buy shares in a particular
company, there has to be an equal number of investors using
alternative methods who are seeking to sell.
Quite obviously, many investors - and that includes professional fund managers (who, overall, are unable to "beat the market") - must be using share selection methods that (overall) don't "work" very well.
Some share selection techniques - for example, buying shares trading on high Price/Sales ratios or on high Price/Earnings ratios - work quite poorly. But there are always enough exceptions (at least over the medium term) that some investors will believe that their favourite "growth" share is worth this high valuation. Usually what happens is that the company grows strongly, but the share price had anticipated most of that growth and appreciates at a lower rate than the market average!
So to invest successfully in the sharemarket it is necessary to firstly choose a sensible share selection method. One that is based upon both sound investment theory and which has been shown to work in practice over a reasonably long period of time.
A chimpanzee throwing darts at the share table in a newspaper once outperformed a professional fund manager. However, despite the champanzee's advantage (i.e. competing against a fund manager, not against the market average) it is unlikely to be able to repeat this performance over several time periods. The reporting of this share selection method is also probably biased in favour of this one successful result, as no-one has reported on the performance of other animals (e.g. bulls, bears, stags) that play an important role in the stockmarket.
Secondly, no share selection method will work all of the time. If a method works most of the time or only some of the time (and does no harm at other times), then it could still generate significant, above average profits over the longer term. So once you have chosen the "right" method, it is still necessary to apply that technique consistently over a long period of time, allowing its superior profits to steadily accrue.
For example, "growth" investing "worked" in the 1980's while "value" investing has been better in the 1990's. So, if you tried "value" investing in the 1980's, then switched to "growth" investing" in the 1990's, you will probably be rather disillusioned with the sharemarket! However applying either method consistently over both decades would have worked out quite well.
Assuming you started investing sometime in the last twenty years - and not knowing in advance which method would "work" best in the immediate future - the most consistently reliable results would have been achieved by investing 50% of your portfolio in "growth" shares and 50% in "value" shares over both decades.
Diversifying your investments between shares selected by different "successful" methods is just as important as diversifying between shares of different companies, diversifying internationally and diversifying across time.
A successful share selection method is not about making instant riches. It is about adding a few percentage points to your investment returns - year in and year out. But compounding that little extra annual return over a few decades will make you very rich!
A simple - but valid - share selection criteria would be
"indexation". Indexation involves buying and holding
the largest company shares which guarantees achieving a return
similar to the market indices (and historically that has been
better than owning interest bearing investments).
Other advantages of this method are (1) that it is very simple and requires no investment knowledge or ability, (2) it requires little management time or effort, (3) you don't need to buy a computer or pay for information or investment advice and (4) brokerage costs are extremely low (as shares are seldom sold).
An investor can keep all of the advantages of indexation's "buy and hold" strategy and improve long term expected returns by exploiting the "small company effect". Instead of owning shares in the very biggest companies, buy a well diversified portfolio of "smaller" and medium sized companies - which offer superior growth prospects and are usually more "under-valued" relative to the largest company shares.
Annual returns from this strategy would vary from that of an "index" portfolio, but overall "smaller" company investments should add an average of an extra 1-3% per annum to your investment returns. This is one of the simplest and most reliable ways to boost your long term investment wealth!
Other research has suggested that the "small company effect" is actually caused by "neglect". That is, shares that sharebrokers do not follow tend to be under-valued relative to widely followed shares. If you can buy shares that are under-valued then your investment returns will be higher (i.e. if you buy lower your immediate dividend yield will be higher, and your long term capital appreciation will also be greater). "Neglected" shares tend to outperform shares that are widely followed by brokers - regardless of company size.
In practice "neglected" shares and "smaller" company shares are usually very similar - but "neglected" and "out of favour" large company shares will generally be a better investment than the "popular", widely followed shares of a smaller company.
Shares "neglected" by institutional investors also tend to perform better than companies that are widely owned. No one has shown why this is so, but the reason is probably that institutions are potential buyers in the former case and potential sellers in the latter case. Shares that are widely owned by institutions tend to be "fairly valued", while shares that institutions have yet to "discover" are probably relatively under-valued.
Once again, low institutional ownership of a company's shares is highly correlated with broker "neglect" and "smaller" company size.
On the other hand, companies where directors and management have large shareholdings tend to perform best. When management has a large stake in the company their interests are closely linked to those of the public shareholders and the company is more likely to be run to maximise shareholder wealth.
When management doesn't have a large shareholding in the company, their personal financial interests (i.e. salaries, bonuses and job security) can conflict directly with the interests of shareholders (i.e. cost reductions, sensible risk taking).
Over the years, numerous studies have shown that "under-valued" shares (i.e. those with low Price/Sales ratios, low Price/Earnings ratios and/or high Dividend Yields) outperform the market average, while "over-valued" shares (i.e. with high P/S ratios, high P/E ratios and/or low Dividend Yields) have under-performed the market.
Other studies have shown that "insiders" (i.e. directors and senior management) have an uncanny ability to buy or sell at the right time. Shares where "insiders" have been buyers, tend to outperform the market over the next 12-18 months, while shares where "insiders" have been sellers tend to under-perform.
Unfortunately, NZ company directors do not need to regularly disclose their buying and selling - as is required in the US, UK and Australia.
"Technical Analysis" covers a range of popular share selection methods - but usually these require subjective ability and/or the benefit of hindsight.
One of the few "technical" methods that does work well is "Relative Strength". Shares with high "relative strength" (i.e. that have risen the most) have historically tended to continue to rise at a slower, but still above average rate in the future. Similarly, the "weakest" shares continue to languish and under-perform.
Another important "technical" factor is that shares with high "volatility" will rise the most during a general sharemarket advance and fall the most during a general sharemarket decline. So volatile shares can be the best investment at least half of the time (and during a general sharemarket decline you are best to be out of the market, earning interest in a bank deposit).
Furthermore, as the loss on any single share investment is limited to a maximum of 100% (if it becomes worthless) while there is no limit to the maximum gain, a diversified portfolio of high volatility shares can perform well in all but a sharply falling market. As a simple example, if you own two volatile shares and one doubles over a year (i.e. rises 100%) and one halves (i.e. falls 50%) then your average portfolio gain is +25%. (If you expect these shares to either double or halve in value the next year you will need to re-balance your portfolio so you have equal dollar amounts in each.)
There are many successful methods for selecting the
"best" shares to buy and own. Unfortunately, combining
all of these methods into a single, comprehensive share selection
criteria - and then formulating a portfolio management strategy
based upon that selection criteria - is not a simple task and
does require a large input of subjective analysis.
Next month that will be the subject of the second part of this article.