By Juergen Buettner
Pro-cyclical investment strategies, unlike advice often preached by supporters of , show that it can be financially rewarding to swim with the current. Here’s how this approach works, and which U.S. stocks allow it to put it into practice.
Buy low, sell high
That is the mantra, fundamentally, of anti-cyclical-oriented investors. It sounds like a plausible approach, but investors who trust only in that “rule” risk never getting the chance to invest in some of the world’s top shares. This means those winning stocks, which apart from some temporary exceptions have risen continuously for several years or even decades.
These marathon runners are seldom really cheap, but their upward drive seems nearly unstoppable. Basically, these are precisely the stocks every long-term investor should own, since, after all, these are the real stocks that can make you rich – at least when it comes to sustainably earning money with shares. This investment philosophy is underpinned by historical data. Analysts at the French bank Société Générale examined the development of so-called trend-following CTA hedge funds from 1990 to 2016. The results show that the average annual performance of 9.5 percent was clearly better than that of the MSCI World Index and slightly better than that of the S&P Total Return Index. At the same time, volatility and setbacks were lower.
Price trends more helpful than ego
Calculations from past data, in general, should be treated with some caution because by choosing certain parameters, many desired results can be shown. However, in this case, stocks with decades-long upward trends present credible evidence. Despite that, most investors must first overcome some mental blocks to get ready to conduct a trend-follower strategy. On the one hand, these mental obstacles have to do with the fact that stock market newcomers usually from the very beginning are told repeatedly to invest anti-cyclically.
On the other hand, and perhaps even more difficult, trend followers must overcome their own ego. After all, an investor who bets on a trend follows only the signs created by the market and not his own instincts. Many investors lack a humble attitude, as behavioral psychologists have proved numerous times.
Mensur Pocinci, technical analyst at Swiss bank Julius Bär, says, “The real luxury for investors is to have no ego. Since at the end, often enough investors are their own worst enemy. The fact that our ego is our greatest investing enemy has to do with the problem that we do not want to admit our mistakes. As a consequence, investors hold on to loss-making, unprofitable investments because otherwise they would have to admit a mistake. The best way to overcome these psycho-social traps is to stop trying to predict the future. The risk of dying with such a prognosis is too high compared to the occasional hits.”
Very confident alpha leaders, of which many seem to be active on the stock market, especially should think about this, as well as what Pocinci has to say about the best prevention tactics of expensive investment mistakes:
“In order to not invest against an established trend, we are not allowed to listen to ourselves. One way to escape our personal inclinations is to refer to graphs or to classify the financial markets by historical performance.” The Julius Baer analyst demonstrates how well this can work by referring to a back-test, in which on the basis of 52-week highs the performance of the top regions was compared with that of the bottom regions. From 1998 to 2015, the stock market with the top rating achieved an increase of 11 percent per year compared to an increase of 6 percent per year for a buy-and-hold-strategy, and an increase of 2 percent for the worst-rated stock market.
Combine technical and fundamental considerations
Investors who consider the trend-following approach plausible should focus on stocks with an intact upward trend when they search for potential candidates to buy. Preference should be given to shares where those upward trends exist for years or, even better, decades. Also suitable are stocks that have broken out of a temporary sideways trend and have thus confirmed the long-term uptrend as intact. It sounds simple, but putting it into practice is difficult, since only a relatively limited number of shares fulfill that condition. Especially, if on top of that, fundamental factors are also taken into consideration. Simply by doing this, the circle of potential buy-candidates gets even smaller. This in turn has to do with the fact that many long-distance runners are no longer bargains after all the price gains they posted.
At the same time, winning shares only attain this status permanently if the business model is robust and the ability to make money has proved sustainable. Therefore, demanding valuations are reasonable as long as the business path to success holds on.
Companies with a functioning business model have the following characteristics: Strong brands with high customer loyalty, high barriers to entry, high switching costs for customers, high sustainable returns on capital invested, highly sustainable free cash flow, protective network effects, good chance of stable growth, responsible management, pricing power, economies of scale, a solid balance sheet and low investment costs to ensure the ongoing operation.
But even for long-distance runner shares with a proven business model, not every price should be paid. This has to be considered, especially in the current environment where the valuation of many safe-haven stocks has been driven to high levels by the abundance of liquidity and the strong safety thinking among the investors. This applies especially to consumer staples, utilities and defensive dividend payers. U.S. utility stocks, for example, on average now have an even higher average price-earnings ratio than those in the technology sector.
Cut losses and let profits run
It should be emphasized, despite all the advantages, that the trend-follower strategy is not a free ticket for share price gains. Such a flawless working investment strategy simply does not exist. However, the chances that the trend-follower approach will work can be considered good, whether the markets fall or rise, since trend-following strategies under these circumstances have worked out well in the past, according to Société Générale. However, no real protection exists if it comes to a sharp sudden market slump of more than 10 percent.
In such an event, even stop-loss limits do not really help, but since even previously winning stocks can get derailed someday, the use of this hedging technique should not be abandoned.
Ultimately, all of this is about implementing a philosophy the British economist David Ricardo relied on some 200 years ago. His motto was simply, “cut losses and let profits run.” This advice still carries weight, since Ricardo is considered one of the richest economists in history.
It is quite possible that the wise man would these days like the U.S. stocks Johnson & Johnson (pharma), Travelers Companies (insurance), UnitedHealth Group (health insurance), Raytheon (defense tech) and Southern Co. (utility), since they all have a long-term upward trend and an estimated price-earnings ratio of less than 20.