Don’t follow the trend – hunt for value

All stockmarket investing boils down to one of two strategies: you either follow momentum, or you hunt down value. At any given time, one strategy or the other tends to have the upper hand so which should you be following now?

Momentum investing

Momentum investors don't worry about detailed analysis of individual stocks. Their strategy is based more on human behaviour. Investors, goes the thinking, are prone to act in herds. In a bull market, they chase stocks way above any rational fair value; in a bear market they dump them as mass panic takes hold.

So, as long as you can spot a rising or falling trend in a stock price (or a currency or a commodity), the trick is to buy early enough and enjoy the ride. In short, make the trend your friend. Once a promising chart pattern forms, you just set up a position and wait for the pattern to complete. It sounds so easy that anyone should be able to do it. And that's one of the weaknesses of the strategy.

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Momentum investing buying rising stocks and selling falling ones over a holding period of three to 12 months worked well in the US market in the 1990s, according to papers by Narasim Jagadeesh of the Anderson Graduate School of Management and Sheridan Titman of the Hong Kong University of Science and Technology. However, between 1999 and 2010, any momentum effect disappeared. Indeed, for the American market, a momentum strategy would have lost money over the last five years, according to a paper by M Scott Wilson of the University of Texas. Why?

It's all down to improving market efficiency, according to a study (Momentum Loses Its Momentum) by Debarati Bhattacharya, Raman Kumar and Gokhan Sonaer from Virginia Tech's Pamplin College of Business. Put simply, once a sufficient number of investors are looking out for a promising pattern or trend, it becomes unreliable as a guide to what other' investors will do next, because now everyone is trying to pile in to take advantage of it. It's perhaps no coincidence that the evaporation of momentum gains has come alongside the rise of hedge funds. They seek to spot and then arbitrage away (often tiny) pricing anomalies as fast as possible.

How to find value

So what about the other key strategy value investing? This approach is based on the idea that individual stocks, or groups of them, can trade at more or less than they are intrinsically worth. Your job as an investor is to decide what that intrinsic value is, then buy stocks that are trading below it and dump the ones that trade above it. There's only one way to work out a stock's true' value to conduct detailed financial analysis using ratios.

But how can you be sure that the market will eventually recognise this true' value? Another key plank of the value approach is mean reversion' this is the tendency of most things, including share prices, to move towards a long-term average level. For example, if an investment trust is trading at a whopping discount to the value of its underlying net assets (NAV), a value investor would prick up their ears. You may be able to buy it below even its minimum potential liquidation value (in other words, you could in theory buy up all the shares, sell all the assets, and still make a profit). And assuming the trust doesn't go bust, mean reversion will ensure the gap between the share price and the NAV eventually closes.

Waiting for the mean

The good news for value investors is that mean reversion definitely happens, according to a paper produced for

De Nederlandsche Bank that looked at stockmarkets from 1900 to 2008 over 17 countries. The bad news is that it can take ages. The authors found that stocks could take anything from 2.1 years to 23.8 years to revert to a value lying on a long-term average trend line, with an average of about 13 years. While most of us can wait a few years, 24 is an investing lifetime.

So does anything speed up mean reversion? This is where it gets interesting. The authors found that it happens more rapidly "in periods of high economic uncertainty, caused by major economic and political events". Examples include the Great Depression and the early years of the Cold War. Today's post-credit-crunch environment is another good example. That suggests we should all be on the hunt for mean-reverting bargains. But where should you start looking?

Buy small, buy Japan

As the Psy-Fi blog puts it, "a value strategy that doesn't involve detailed analysis of the individual companies involved is flawed". You can't rely on simplistic, lone measures such as price-to-book ratios to reveal groups of apparently mispriced stocks, then sit back and wait for mean reversion to work its magic. Instead, "investors who spend time digging the dirt on small value stocks" (which are often ignored by bigger investors, and so mispriced) are likely to have the most success.

The drawback is that this takes hard work. If you'd rather delegate the effort, one option is to look for a promising fund in a cheap market Japan fits the bill nicely. Indeed, as Mark Dampier at Hargreaves Lansdown notes, on a price-to-book, price/earnings or dividend-yield basis, Japan's equity market "has never looked so cheap". The Baillie Gifford Japan Trust (LSE: BGFD) invests in mid to small cap Japanese stocks, and trades on a near-12% discount to NAV.