Secrets of Success: It was the year of the golden tiddlers

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The Independent Online

There are the usual hard and useful lessons to be learnt by investors in the latest annual edition of the ABN-AMRO Global Investment Year Book. The authors, Paul Marsh, Elroy Dimson and Mike Staunton, are London Business School academics whose painstaking research over the past few years has produced the most comprehensive and reliable database of long run global stock market returns around.

Several facts stand out from the latest edition, which includes, for the first time, the year in which the bear market decline in equities reversed and the great bull market in bonds also (so most of us think) ran out of steam. In fact, 2003 was an interesting year for several reasons, not least because it proved to be such a difficult one for investors, amateur and professional, to get right.

To score straight As in the continuous assessment exercise that investment management involves, you had first to identify correctly that the equity bear market had run its course in mid-March, three years almost to the day since the great bull market had peaked. Then you had to know which of many conflicting strategies would pay off best over the balance of the year, and throw in good calls on the bond market's reversal in early summer, the continuing strength of property and house prices and the further strong showing of the pound against the dollar through most of the year.

Such perfect timing is almost impossible to achieve, though the LBS professors point to the coincidence, if such it was, that the bottom of the bear market was marked almost to the day by the yield on shares rising above the yield on bonds for the first time in many years. It was also around that time my colleagues on this paper joined me in starting to make the case for renewed equity investment.

The classic indicator of an oversold market proved to be a short-lived phenomenon, as the stock market returned 42 per cent from its lows in March to the end of the year, while the long-bond index (20-year Government gilts) fell 7.5 per cent from its mid-June high. Over the year, shares returned 21 per cent and gilts an indifferent return of 1.3 per cent, the full-year averages concealing the dramatic nature of the turnaround in performance.

More importantly for anyone trying to maximise returns, you had to recognise that the dominant forces in the market would be two style factors, size and beta. The biggest rewards in the stock market went to those who realised the end of the bear market would be followed by a dramatic period of outperformance by small- and micro-cap shares. This was not a new phenonemon: the relative outperformance by small cap shares has been an observable trend since the market peaked in 2000, reversing the previous period of large cap dominance that market most of the great 1990s bull market.

But the trend bore real fruit in absolute terms last year, with the market minnows index of micro-cap shares rising 81 per cent from the March lows, roughly twice as fast as the market. So strong was this effect, which many investors will have missed through excessive caution, that some of the smaller cap indices have not just recovered from their earlier beating, but hit new all-time highs.

Other notable features of the market revival have been the reversal in fortunes of many sectors, with those that did worst leading up to the market bottom visibly outperforming subsequently. Sectors that had done the worst in the three years of bear market started to outperform strongly on the way back.

Last year was the worst since 2000 for anyone following a simple momentum strategy, because most style and sector trends reversed themselves at or around the March turning point. At such points, the contrarians, those who bet against a trend that has worked recently, who will always do better than momentum investors.

While a strategy of buying high beta stocks has also reaped rich rewards since last March, the most interesting phenomenon concerns so-called value stocks, represented in the academics' research by stocks that have above- average dividend yields. The long-run evidence suggests value stocks will eventually outperform shares with low yields. Value in this sense has certainly been the strategy to follow since the bull market ended, a trend this column did foresee at the time. Yet despite the reversals elsewhere in the market last spring, a strategy of buying only the highest yielding stocks would have continued to outperform right through the market's March turnaround, with the top 20 per cent of dividend-paying shares returning 28 per cent on average in 2003.

The lowest yielding 20 per cent of dividend-paying shares did next-best, rising 22 per cent on average. But shares that paid no dividends did best of all. You are entitled to a beta plus if you managed to outdo the market at all over the past four years, though the professors also note that those who bought only the 20 per cent of highest yielding shares four years ago, and rebalanced their portfolio every year, would have missed the bear market, as that strategy would have returned a handy 28 per cent.

jd@intelligent-investor.co.uk

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