A series of expert studies and analyses over a period measured in decades shines light on the path to successful stock market investing.
Well-known among value investors is the collection of studies from US fund management firm Tweedy, Browne. These statistical studies demonstrate winning strategies that have thrashed the market. The company's publication 'What Has Worked in Investing' (link to pdf file) contains details of 50 successful stock-selection strategies.
Here are four techniques that have been shown to win around the world.
1. Buy companies with a low P/E ratio
Companies with a low price-earnings ratio (P/E) make more profit for every dollar you invest than more expensive, high P/E stocks. The market rewards companies it expects strong profit growth from with a high P/E, while it punishes the shares it expects to lag behind by giving them a lower rating.
So far, so sensible. The problem is 'the market' often gets this calculation massively wrong, bidding up the price of popular growth stocks to stratospheric highs, and writing off solid, successful companies to the point where they become outrageous bargains.
A US study examined the stock market returns investors made from low P/E stocks and high P/E stocks over a multi-decade period. The study shows that investors buying the low P/E stocks between 1951 and 1986 made an annual investment return of 19.08% per annum, while selecting the highest P/E stocks would have made just 14.28% each year.
And you shouldn't think "that's just a few lousy percent a year". Compounded, the difference is massive. Over 35 years at 19%, $1,000 invested in low P/E stocks becomes $370,000, while the high P/E portfolio is worth 'only' $93,500.
Some examples of low P/E ratio stocks are QBE Insurance Limited (ASX: QBE), Washington H. Soul Pattinson & Co Ltd (ASX: SOL), Harvey Norman Holdings Ltd (ASX: HVN), United Overseas Australia Ltd (ASX: UOS), BHP Billiton Limited (ASX: BHP), Collins Foods Limited (ASX: CKF) and Ainsworth Game Technology Ltd (ASX: AGI).
2. Buy shares that pay big dividends
The idea that the way to better investment returns is to simply buy high dividend paying stocks sounds too simple to be true. Isn't there more to successful investing than that?
Another study conducted by the University of Bath in the UK, published in 1989, suggests not – a portfolio of the UK's big dividend payers trounced both the market and companies with a mean payout ratio between 1955 and 1988.
The study constructed ten different portfolios, populated according to the size of dividends that companies were paying. The portfolio with the largest dividend-paying stocks made an average investment return of 19.3% a year. The lowest payout portfolio made 13.8% a year, while the market as a whole was delivering an average 13.0% per annum.
If you want some examples of high yielding companies, then take a look at these: Tatts Group Limited (ASX: TTS), Telstra Limited (ASX: TLS), IMF Australia Limited (ASX: IMF), Platinum Asset Management Limited (ASX: PTM), Metcash Limited (ASX: MTS), Oroton Group Limited (ASX: ORL) and United Overseas Australia Limited (ASX:UOS)
3. Buy companies priced below book value
Investors struggling to work out what a company is worth should always have one helpful pointer — the net asset value reported in the company's accounts. Most listed companies trade above their asset value, but when things go wrong, it can help support a company's share price.
A small percentage of businesses trade at valuations less than their assets, and an investment strategy that seeks out these companies and buys them has been shown to beat shares that trade at a higher rating.
A 1991 study examining the 15-year period between 1974 and 1989 showed investments in the 20% of UK companies with the lowest price-to-book rating outperformed the 20% of companies trading at the highest multiple of their assets. The cheaper stocks made an annual return of 32.7% a year, while the more highly rated portfolio stocks made 24.4%. Those were the days!
The following companies are examples that are currently trading below their book value. Macquarie Group Limited (ASX: MQG), AGL Energy Limited (ASX: AGK), United Overseas Australia Ltd (ASX: UOS), Billabong International Limited (ASX: BBG), Brickworks Limited (ASX: BKW), Premier Investments Limited (ASX: PMV) and Collins Foods Limited (ASX: CKF).
4. Small caps beat blue chips
There's an old stock-market saying popular among small cap investors: 'elephants don't gallop'. In other words, large, blue-chip companies tend to be dominant in industries that have already matured, and the possibility of rapidly advancing profits (and a rapidly advancing share price) has passed. The possibility of finding a winning small company in a developing market draws investors to small companies, but what sort of returns can a small cap investment strategy make compared with a blue-chip portfolio?
A study of the investment returns made between 1958 and 1981 showed the 10% of Australian companies with the smallest market capitalisation made the highest returns (81.05% a year), while the largest 10% of companies made the smallest return at 12.88% per annum.
This means avoiding the big four banks, namely Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank (ASX: NAB) and Westpac Banking Corporation (ASX: WBC) as well as BHP Billiton, Rio Tinto Limited (ASX: RIO), and looking beyond the Top 100 or Top 200 largest companies on the ASX . Here at the Motley Fool, we have written about many small cap companies that deserve a closer look, they shouldn't be hard to find!
The Foolish bottom line
The returns generated by all these strategies may be flattered by the long-term bull market shares enjoyed at the time, but their outperformance over other selection strategies is considerable.
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Editor's note: The original version of this article included ThinkSmart (ASX:TSM) as an example of a company paying big dividends. The inclusion of that company was an error and it has now been removed
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Motley Fool contributor Mike King owns shares in Oroton, QBE Insurance & Soul Pattinson. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.
A version of this article, written by David O'Hara, originally appeared on fool.co.uk. It has been updated by Mike King.
