The combination of value and momentum has been shown to be a winning formula in stock investing, and quantitative guru James O’Shaughnessy’s firm says the data shows it’s a recipe that works particularly well in the Canadian market.
In a new research report on O’Shaughnessy Asset Management’s site, Travis Fairchild says that the concentrated nature of the S&P/TSX Composite Canadian benchmark makes for some good opportunities for disciplined, systematic investors. The index contains only about 300 stocks and the top ten components usually make up 30% to 35% of the index’s market cap weighting, Fairchild notes. In addition, right now about three-quarters of the index’s weight comes from just three sectors, financials, materials, and energy. The concentrations have made it hard for passive and active investors alike to beat the market — over the past five years, only 30.4% of active managers have outperformed the S&P/TSX, Fairchild says.
“We feel the most effective way to invest in Canadian equity markets is to use a disciplined and consistent approach, similar to how the benchmark is constructed but replacing market cap as the sole criteria for selecting and weighting stocks,” Fairchild says. One of those other criteria is a composite of value factors — which, interestingly, does not include the price/book ratio, which Fairchild shows has a dicey history of predicting future returns in both Canada and the U.S.
OSAM also uses a momentum composite as another criterion, combining relative strength scores over different periods rather than just using one. Like the value composite, the momentum composite has a track record of beating the market on its own, but because the two factors are uncorrelated they work even better in tandem, Fairchild says, helping boost risk-adjusted returns while also providing diversification and protection benefits.
To consistently beat a benchmark, OSAM believes, you need to be different from the benchmark, and studies have supported that idea, Fairchild says. “All this also makes sense in a market with such imbalances in sector weights,” he adds. “If precious metals, oil companies, or banks become overly expensive relative to the market, then a manager able and willing to build a portfolio largely underweighted to that sector will be better equipped to outperform.”