Something that fund managers tend to do often is highlighting their investment styles. Investment strategies can be divided roughly into two categories: macro forecasting and stock selection, with the latter often categorised further into value investing, momentum investing, and quality investing. On top of these, there are funds that put their emphasis on small-cap stocks.
Value investors target primarily stocks with low price-to-earnings ratios, price-to-book ratios, and high dividend yields; and momentum investors tend to chase after companies with ample liquidity and whose share prices have been on the rise in the past 6 to 12 months. Meanwhile, quality investors focus their attention largely on companies with higher returns on equity, lower volatility in earnings growth, and lower debt ratios.
The question, therefore, lies in which one of these stock selection strategies are more resilient to the test of time, and are able to deliver higher returns to long-term investors. Let’s begin by looking at US stocks, and make our way to Chinese equities.
In fact, MSCI’s full-fledged Factor Indexes can help us find the answer. Looking back on the 15 years before the end of May this year, the global stock markets fell twice into bear and prolonged bull market, respectively, while the Chinese stock market swung more frequently between the bear and bull territory; the performance of indexes that had been tracking these markets, then, could to some extent reflect how each of the various investment styles fared under different market conditions.
What we found is that, the quality strategy posted the best performance in the US, with the MSCI USA Quality Index outperforming the broader MSCI USA Index by 2.2% in annual return rates. The momentum strategy, on the other hand, surpassed the main index by a mere 0.4% in return rates. Being the worst performer, the value index underperformed the benchmark by an annual rate of 2.4%. Also underperforming the benchmark was the MSCI USA Small Cap Index, which fell short by 0.8% on average annually over the past 15 years.
What about Chinese equities, then? The MSCI China All Shares Quality Index charted a 7.1% annual rate of return in the past 12 and a half years as of May’s end, outperforming the MSCI China All Shares Index by 4.1%, a margin that surpassed the 2.2% that the MSCI USA Quality Index posted in excess of the MSCI USA Index.
If we were to look just at the MSCI China A Quality Index, we would find that its annual rate of return outperformed the broader MSCI China A Index by a significant 5.3% in the past 13 and a half years as of May’s end.
The MSCI China All Shares Momentum Index, in contrast, only eked out an outperformance of 0.1% against the MSCI China All Shares Index in the past 13.5 years as of May’s end, with most of the former’s returns contributed by gains from 2017 and 2020. In 2020, particularly, the momentum index outstripped the benchmark by a whopping 47%, which led to its return rate being much more volatile than that of the MSCI China All Shares Quality Index.
The performance of the MSCI China Value Index and the MSCI China Small Cap Index resembled largely that of their US equivalents, lagging the main China index by 1% and 2% respectively in the past 15 years, which we think is due to the fact that a lot of the small cap stocks are, at the same time, also value stocks.
Clearly, opting for quality stocks makes for a superb strategy to beating the market whether or not you are investing in US or Chinese stocks. The momentum investment style proved to produce returns inferior to that of the quality strategy in the US market; meanwhile, it appeared overly volatile in the Chinese market. We also think investors targeting value and small cap stocks should take a cautious approach – unless dividend yields are a top priority, cheap stocks could turn out to be nothing more than a “value trap”.
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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