How to pick winning styles of shares for your portfolio

Warren Buffett once said that “Investing is simple, but it’s not easy”. I guess he finds it hard, like me because he binge-watches Netflix or scrolls 300 feet of social media daily instead of doing investment research. Yes, it’s hard to be a good investor these days.

We live in an information-overloaded age. Do you know what the brain does to cope with too much information? It classifies, and groups everything as a shortcut. We develop buckets for everything - from people to animals, to brands to stocks. It makes coping with the world so much easier.

The problem in the stock market is that the groups we use can be extremely narrative-driven. We think “it’s an innovative stock”, rather than empirically knowing “it’s a low odds stock”. As a solution to this, we created a classification system that separates the real winners from the losers in the stock market based on data-driven principles.

A map for the stock market - to help you avoid sucker stocks

Each classification (or style) depends on a stock's relative ranking for Quality, Value, and Momentum - which we compute daily. Combining all the possible variations of strong/weak, quality/value/momentum pairings creates eight unique style combinations, as seen below.

If you look at?Greencore, which shot up on Tuesday by 18% after an ahead of expectations announcement, - its high Quality, Value and Momentum Ranks led it to being classified as a “Super Stock” in the Styles schema. It's not been unusual lately to see Super Stocks announcing "ahead of" expectations announcements, normally because expectations are very low for these styles of shares.

How to use these classifications

You really can use these classifications to save time and pick better stocks. Here's a study on the relative annualised performance of each style in UK markets since inception in 2013. “Winning” styles have outperformed “losing” styles by a significant margin.

Ultimately, returns on average accrue to good, cheap, strong stocks - i.e. stocks that show strong relative quality, value and momentum. These "factors" have been proven by market-beating practitioners over many decades, and more recently by academics like Eugene Fama and Josef Lakonishok. "Winning" style shares have these traits, so the odds of beating the market are higher if your portfolio is skewed towards them.

While the average returns to “losing” styles may be negative, that doesn’t mean you can’t pick winners from within them. If you are a good stock picker, you may have a research edge, and that can swing the odds of picking the minority winners from majority losers from within those sets.

You may also find that good stocks temporarily swing into losing stocks styles. For example, the “Falling Stars” of the market are often high-quality companies that are suffering from temporary setbacks. Their high valuations often need to normalise before the share price can return to winning ways. While there may be an opportunity cost while he waits, I can almost guarantee that Warren Buffett owns a few Falling Stars right now.

Nonetheless, there's no point in fighting a headwind, and the easiest way to do this is to avoid losing style shares.

If you want to check out the styles for a few of the shares you own - go to this link and search a few stocks.