The market is made up of thousands of investors, bringing to bear hundreds of different investment systems (even a few naïve amateur investors have no system at all.) In this month's school's article we look at four strategies that have proven successful over several decades.

Of course no two investors apply the same strategy in the same way and there are literally hundreds of different ways each strategy can and is implemented by investors.

At a further level of simplification, all these strategies can be divided into two; a value or fundamentalist approach where the investor is mainly concerned with the quality of the underlying company in relation to its price and the momentum strategy where the investor is mainly concerned with how the price is changing and how it will likely change in the future.

Pick winners
This is one of the easiest stock market strategies to follow. It is based on the observation that in any portfolio, in general, over the long term (typically 10 years or more) one or two companies do spectacularly well, a small minority beat inflation, whilst another minority under perform versus inflation and another one or two lose most of their value (or even go bankrupt.)

The essence of the approach is to rigorously weed out underperforming shares and hold on to the companies that perform well. Of course there are many different ways the strategy is implemented, but in general it is approached in a very mechanical way and investors using the approach have specific hurdles that the stocks have to achieve at the end of each year (or whatever period is chosen for ongoing review) and those that do not achieve it are sold. New stocks are added each period to keep the portfolio balanced, but winners are never sold.

A typical rule might be to sell any company that has remained in the bottom 40% of the portfolio for two years running (or for some investors two quarters.) Another investor might choose to sell any company that has underperformed the index for one, two or three periods in a row.

The reason the method works so well (in our opinion) is that good companies tend to remain good, whilst bad companies remain bad. Warren Buffet put it quite eloquently when he said 'if a company with a reputation for being bad meets up with a management team that has a reputation for being good, only the company will end up with its reputation intact.' The reason for this is that bad companies are frequently bad for structural reasons which are not easily overcome.

For instance in the brewery industry Guinness and NBL have significant economies of scale and brand loyalty which Premier Breweries will struggle to replicate regardless of how hard they try or how smart the managers are.

Or they are bad for internal reasons to do with culture which are also very difficult to change (we recommended John Holt on the belief that the new management will turn it around, we believe this will be an exception that proves the rule.)


Earnings Acceleration
Earnings acceleration is a method that can result in spectacular results. The stock market tends to value companies based on their price to earnings ratio. The PE that it assigns to a company is based on a number of factors including its industry, quality of the company, expectations about the future and of course its growth.

The investor using earnings acceleration is looking for companies whose rate of growth is changing, knowing that if the rate of growth increases, at some point the stock market will revalue the company with a higher PE. (Earnings acceleration differs from ordinary earnings growth in that we are talking about an increase in the rate at which the earnings are growing.)

You might think that a change in growth rate would be clear to all investors, but it is not and in general it can take several quarter or up to a year or more for the market to react fully, over this period the price can frequently double or even triple.

The way to detect earnings acceleration is to carefully analyse the quarterly trading updates of the companies and compare them to previous periods, looking for changes in the rate of growth.

Typically we are looking for big jumps of 30% or more in the rate of change. How do you know that it is not temporary? The method requires you to do further research to understand the reasons for the change and use your own judgement as to its sustainability. Typical causes for sustained changes include new management, new strategy (e.g. UACN now focusing on fast food,) breakthrough new products (as opposed to just ordinary products,) new geographical expansion, and entry into new market segments.

This approach is by no means a passive approach and requires an active investor who spends time researching companies.

Good Business
Investing in good businesses is a mainstay of legendary investor Warren Buffet. It is based on the idea that good quality businesses outperform the market over the long term. It then begs the question what is a good quality business. Here at Smart Investor, we define a good quality business as one that has a high return on capital, a defensible competitive advantage, low/manageable levels of debt and honest and competent management.

Good businesses differ from backing winners in that investing in good Businesses takes a fundamentalist approach, looking at the company itself and again requires an active investor who is prepared to analyse the accounts and investigate the business. Backing winners is more of a momentum approach and just requires the investor to hold the stocks that are doing well.

Value Investing
Value investing is one of the oldest investment disciplines and was first developed by Benjamin Graham, who is often referred to as the father of modern investment practice.

Value investing is based on three ideas:
First is that a company has an intrinsic value that is independent of its share price and that the value can be calculated by an investor (indeed Smart Investor employs several analysts just to do this.)

Secondly that the market price of a share  which is set by short term demand and supply  can be driven above or below its intrinsic value due to emotional, irrational or external reasons.

Thirdly that over time the period of irrationality will end and prices will reflect their true value.

The value investors calculate the intrinsic value and then buy the securities when they are trading at a significant discount to it. They sell when the securities become fully value (or in some cases when they become overvalue.)

In valuing a business most value investors use a combination of:

1. Net asset value (also called book value, or shareholder equity),

2. Discounted cash flow valuation (where the expected future cash flows are discounted at an appropriate discount rate  which is normally the yield on quality corporate bonds.)

3. Earnings yield (which is the reciprocal of price to earnings ratio) again comparing to the yield on quality corporate bonds.

In Graham's seminal book, Securities Analysis, he lists several rules of valuation and of safety. Modern value investors have modified many of the rules to suit the times.

One of Grahams rules was to invest in a company whose earnings yield is at least twice the yield on an equivalent corporate bond, as long as total debt is not larger than shareholder equity. In Nigeria at the moment corporate bond yields are about 18%, so Graham would be looking at earnings yield of 36%, or a price to earnings ratio of just 3.  There are very few companies in Nigeria trading at that value.

Here at Smart Investor where we favour a combination of the good business and the value approach we would look for quality companies that are trading at 20% below our estimated intrinsic value. If the companies quality were only just average then we would look for a higher discount of up to 40%.

Value investing is quite a rigorous approach and requires one spend time analysing the financial statements of many companies in order to choose the few that you plan to invest in.

It is also an approach that works better in a bear market, where investors' fear creates many opportunities, compared to a bull market, where even low quality companies will be selling at high valuations.