An investing expert’s ways to pick the right shares (and beat the market)

Over the decades, finance experts have uncovered good evidence that there are a handful of investment styles that beat the market. The commonsense lessons from this number crunching can act as an excellent guide for private investors hunting for winning shares. 

Over 10 years from 2011, I screened the UK market for stocks inspired by four of these well-recognised styles – quality, momentum, value, and low-volatility investing. The success left me stunned. 

Stock screens select shares based on predetermined financial characteristics. The ones I ran were reassessed yearly and published in the Investors Chronicle magazine. Over a decade they outperformed by between 242 and 388 percentage points on a total return (where dividends are reinvested) basis. 

These are some of the most valuable things I learned.

Quality

Beat the market by 388 percentage points

The secret of quality investing’s success is rooted in the idea of compounding, something Albert Einstein is said to have called “the eighth wonder of the world”. 

Take the example of a new company that has £1m to invest and can generate a 20pc return on that investment in a year. It will make £200,000 in year one. If it reinvests this profit, in year two it will generate 20pc on £1.2m, or £240,000. If reinvestment in growth continues, the original £1m investment will snowball to be worth an incredible £1bn (1,000 times the original amount) in about 38 years.

The power of compounding is hard to appreciate in the moment, but it creates huge wealth over long time periods. This means incredible opportunities are often hidden in plain sight for investors, even when shares look superficially expensive. The type of quality characteristics my quality screen looked for were persistently strong profitability along with a sound balance sheet.

Quality investing is most likely to underperform when markets are recovering from a fall; quality companies have less to recover from. 

Momentum

Beat the market by 262 percentage points

When a share price has risen strongly it can feel like we’ve missed the boat. However, it is more often a sign of good things happening that will cause more investors to jump aboard and push the price even higher.

There is often hype around momentum stocks, and this investment style can blow up if there is an abrupt reversal in sentiment. It is possible, though, to try to avoid the worst of the hype by looking for companies displaying both share-price and profit momentum. Upgrades to brokers’ forecasts can be a particularly valuable indicator. 

But there is no antidote to momentum investing’s vulnerability to swings in sentiment. During the 10 years in which my momentum screen outperformed so strongly, it also experienced a gargantuan 54pc maximum “peak to trough” fall versus 35pc from the market. This illustrates why my advice is to only use screens as a source of ideas rather than for off-the-shelf portfolios.

Momentum usually does best late in bull markets. Downturns and recoveries can both be tricky.

Value

Beat the market by 242 percentage points

Using low valuations to identify shares that have been oversold has historically been very effective. But more recently, there’s been growing reason to think traditional valuation measures, which compare share prices to companies’ profits or net asset values, have become ineffective.

An alternative approach to valuation that my screen employed was to look for companies that appeared cheap compared with sales and which also had historically displayed decent profit margins; suggesting sales could be a source of healthy profits even for a company currently misfiring. 

Shares become oversold because it’s very hard for us to imagine sunny uplands when a company is struggling. In reality, though, companies and shares often bounce back. This is part of a widespread natural phenomenon known by statisticians as “reversion to the mean”. 

Value strategies tend to suffer during bear markets but rocket during recoveries. Like momentum investing, this is a high-risk style.

Low-Volatility

Beat the market by 267 percentage points

Counterintuitively, investors do not get rewarded for taking more risk, according to my research. Less volatile, low-risk shares tend to outperform. This can be explained by our weakness for the excitement of high-risk, high-reward longshots while overlooking the delight of dull, conservatively run businesses. 

A feature of conservative companies is that they tend to hand back more money to shareholders and invest less in glory projects. That makes screening for both good dividend payers and less-volatile shares a great combination.

Shares in these kinds of companies tend to underperform during hot markets but more than make up for this when markets fall.

Appreciating how, why, and when these four strategies work can help to make private investors far more effective in hunting for winning shares.

My new book Four Ways to Beat the Market: A practical guide to stock screening strategies to help you pick winning shares offers a deeper exploration of these approaches and the curious stories that underpin them, as well as providing all the building blocks needed to identify winning shares and to screen for them.