2 Timeless Pieces Of Academic Research For Your 2012 Equity Strategy

by: Simon Moore, CFA

Investors are fortunate in that the stock market gets a significant amount of academic attention, often with thoughtful, rigorous thinking. Below are two key, broadly cited, pieces of research that should help inform investor's equity portfolios for 2012.

---

Fama and French - The Cross Section Of Expected Stock Returns (1992) [source]

This is a seminal article, showing that historically small cap and value tend to outperform over long time horizons. The research was done over the 1963-1990 period in the US, but has subsequently been validated internationally and over different time periods. It is important to note that this method doesn't work uniformly each year, and there are sometimes periods of several years where it doesn't work at all.

Recommended Action: Buy stocks that are in the smallest 10% of the NYSE and/or are in the 10% lowest price/book ratios in the NYSE. Note the effects are independent, you don't need to buy both the smallest and the lowest price/book in the same stock.

Decision rule for January 2012:

  • Stocks with a market cap of under $70M
  • Price to book ratio below 0.81

Potential Outperformance

Fama and French found outperformance vs. the market of 0.65% per month for the low price/book strategy and 0.15% per month for the small stock strategy (note: not including trading costs). Of course, these returns are inconsistent each year and because the source of the outperformance is not known with any certainty it could simply cease to work, nonetheless these strategies do appear to have worked historically over long time periods based on academic testing.

---

Jegadeesh and Titman - Returns to Buying Winers and Selling Losers - Implications for Stock Market Efficiency (1993) [source]

Jegadeesh and Titman show that holding the top 10% stocks in terms of price performance over the previous 6 months for the next 6 months outperforms the market by about 0.8% per month. However, importantly, this strategy tends to be negative in January, but positive in all other months. Therefore, February is the ideal time to implement this strategy.

Decision rule for January 2012:

  • Wait for February before implementation
  • On current numbers, buy stocks with >12% price performance in past 6 months

Potential Outperformance

Jegadeesh and Titman found outperformance vs. the market of 0.8% per month across all months including February. This does not include trading costs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.