Combining ‘value investing’ and ‘trend following’ strategies to beat market returns?

AS STOCK investors, we are often told to just go for “buy-and-hold” market portfolios such as a low-cost index fund for the long run.

In return, we should be able to reap market returns but we will have to bear huge market losses along the way.

Are there any ways that investors can reap – or even beat – market returns but with much lower market losses?

How about value investing? How about trend following? Can we use a combination of both value investing and trend following to help us?

The focus here, by the way, is on index funds such as the S&P 500 index fund and not stock-picking (quantitative or otherwise).

First, value investing. Empirical evidence shows that buying cheap stocks tends to beat expensive stocks in the long term. Investors can deploy valuation metrics such as price-earnings (PE) ratio, price-to-book ratio, price-to-sales ratio or cyclically adjusted price-earnings (Cape) ratio to gauge if stocks are cheap or expensive.

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Let us take the Cape ratio as an example. The Cape ratio is the index price divided by the average of 10 years’ earnings adjusted for inflation. This ratio helps to smooth out the earnings and provides a more accurate valuation measure. The Cape value is also known as Shiller PE ratio. The long-term historical average of the Cape ratio is about 17 times.

Stock valuation is a good predictor of long-term returns over, say, 10 years. It is, however, a poor market timing indicator.

Generally, if the valuations (ie the Cape ratio) are rising or becoming more expensive, the 10-year-forward average annualised returns tend to decrease. In other words, overvalued stocks would imply poor long-term forward returns and undervalued stocks point to good long-term forward returns. 

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Trend following versus Buy-and-hold

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Next, let us turn to trend following. It simply means buying when prices are moving higher and above the trend and selling when prices are below the trend. 

Investors can use the 10-month simple moving average (SMA), which is the average of a market’s closing prices over a year, to define a trend. The 10-month simple moving average is used instead of the commonly known 200-day moving average to smooth out noises.

Trend following may or may not enhance returns. However, it certainly helps to mitigate market losses.

What if we combine both value investing and trend following?

Numerous studies have confirmed the efficacy of combining both value and trend or momentum.

For example, John Hussman of Hussman Funds examined the annualised real return of US stocks across trend and valuation from 1940 till 2013.  

Stocks are considered to be in an uptrend when their prices are above their 10-month moving average, and in a downtrend when the stock prices are below their 10-month moving average. Cheap or expensive is defined when the Cape is below or above 17. 

The finding is that the best time to invest is when stocks are both cheap and in an uptrend.

Here are the details:

• Buying expensive stocks in a downtrend: annualised real return of -5.84 per cent
• Buying cheap stocks in a downtrend: annualised real return of 6.17 per cent
• Buying expensive stocks in an uptrend: annualised real return of 12.68 per cent
• Buying cheap stocks in an uptrend: annualised real return of 14.03 per cent

By the way, the annualised real returns for US stocks are about 7 per cent from 1928 to 2021, according to Prof Aswath Damodaran of New York University. 

Here are some thoughts on applying the research insights to the investment process:

Expensive stocks in a downtrend

When stocks are expensive and in a downtrend, it is time to sell them as they tend to produce negative returns.

However, the prevailing narrative is often unequivocally bullish at that time. It goes something like this: the fundamentals are still sound as revenues and earnings are still growing. Though the stocks spot expensive valuations, they will continue to grow strongly in the coming years and thereby cheaper valuations. 

Do not buy the narratives. Just follow the trend.

Action: Sell stocks

Cheap stocks in a downtrend

Value investors often tend to buy cheap stocks too early. However, stocks that are cheap can become cheaper as their prices continue to decline.

Cheap stocks also exist for a reason and some of them are very vulnerable to insolvency risks.

Benjamin Graham, the father of value investing and the guru to Warren Buffett, was once asked why the market catches up with value. This was what he said : “That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realises it in one way or another.”

Sure, cheap stocks may eventually go up in price, but we just don’t know when.

I think the rule of thumb is that it is better to avoid cheap stocks in a downtrend lest one ends up catching a falling knife.

Action: Do not buy stocks 

Expensive stocks in an uptrend

We often think that if stocks are expensive, they always produce poor returns going forward. That is not necessarily the case. This is because when stocks are in an uptrend, they can still produce above-market returns though they are expensive. For instance, US stocks were awfully expensive from 1995 to 2000 and from 2014 to 2021, but they produced good returns as they were mostly in an uptrend.

Also, investors often sell their stocks when they are expensive. They move into cash hoping to buy the stocks back when they become cheap again. However, investors may have to wait for quite a long time for the stocks to become cheap again. Meanwhile, expensive stocks continue to outperform.

Action: Hold stocks

Cheap stocks in an uptrend

This is the best time to buy stocks and investors should probably back up the truck and buy stocks massively.

For instance, stocks were cheap in late 2008 and early 2009 as many investors thought that the global financial system was on the verge of collapse. Warren Buffett, being a contrarian, bought stocks massively in late 2008. 

Back then, he wrote an op-ed “Buy American. I Am.” published in The New York Times on Oct 16, 2008.

Here’s the background. In October 2008, stocks had already declined by about 40 per cent from their peak in October 2007, which made the period one of the worst in post-war records.

In terms of investor sentiment, the Volatility Index (VIX), or widely known as investors’ fear gauge, hit 70 on a weekly basis in October 2008 and the daily VIX was about 90. These readings were some of the highest readings on record since 1986 and were signalling extreme fear on the part of investors.

Stocks were fairly cheap, with a Cape ratio of about 16 at that time. At the market peak in October 2007, the CAPE ratio was around 27.

Buffett bought stocks in October 2008, and the stock market bottomed only in March 2009 as equities declined by another 30 per cent on average. How many stock investors can stomach that kind of decline?

During the six-month period, the Cape ratio declined from around 16 to about 13 at the market bottom. 

Unless you are Warren Buffet and have his patience and tenacity, most investors are better off buying stocks when they are in an uptrend. By the way, by about mid-2009, stocks were trending up again.

Action: Buy stocks

Conclusion

The takeaway is that combining both trend and value can help investors to achieve good market returns with substantially lower losses. It might even beat market returns if the strategy is implemented well and the market environment is cooperative. 

However, investors need to understand that no strategy is perfect, and each strategy has its own drawbacks. For instance, investors are likely to be subjected to whipsaws. This strategy also does not purport to buy at a market bottom or sell at a market top.

Finally, we often heard of the investing axiom, “buy cheap, sell dear”. Perhaps we should modify it to “buy cheap in an uptrend, sell dear in a downtrend”?

The writer is a private investor. He was previously a researcher at an international business school in Europe, and an Asia-Pacific director at multinational corporations.