Why do most investors ignore the biggest driver of returns?

When something sounds too good to be true, it usually is. So if I told you most fund managers could boost long-term returns by paying more attention to a single metric, your reaction would likely be one of scepticism. 

However, if I told you all that was standing in the way of making this change was their ego and instinct for self-preservation – well, you might just detect a ring of truth to the statement.  

The importance of estimate revisions 

Our SmartGARP (Smart Growth at a Reasonable Price) stock-screening tool rates companies on the eight factors that ultimately drive returns: growth, value, estimate revisions, share price momentum, accruals, ESG, macro and investor sentiment. But only one of these – estimate revisions – is double weighted.  

The reason should be obvious. What type of stock would you rather own – one where the fundamentals are improving or deteriorating? Where profit growth is speeding up or slowing down?  

Whether you call yourself a growth or value investor, the aim is to buy a stock for a price that underestimates the amount of profit it will eventually generate. This is more likely in a company whose earnings forecasts are being upgraded than downgraded, which is why SmartGARP closely follows any changes in analyst recommendations.  

So why don’t more fund managers do the same?  

When to admit you were wrong 

As we mentioned at the start, we think it partly comes down to ego and a lack of humility. You want to own more stocks receiving upgrades than downgrades. But what does this actually involve? Higher trading costs as you buy and sell more frequently. But most importantly, it means admitting you were wrong. A lot. 

Think about it. You make a presentation to a room full of clients where one of them asks you to name a recent investment. Maybe the fund house has invited a journalist along to boost your profile and they quote you in their weekly share-tip column.  

Whether you call yourself a growth or value investor, the aim is to buy a stock for a price that underestimates the amount of profit it will eventually generate

A few days later the stock misses its guidance and analysts trim their profit forecasts for next year. The earnings miss is not a bad one, but you suspect it won’t be the last, undermining your bull case. Do you admit your rationale for owning the stock may be flawed and sell out at a loss? Or do you re-assert faith in your process, imply you have spotted something the market has overlooked and reassure investors the position will come good in the long run? 

Don’t prioritise self-preservation over performance

Self-preservation is another factor to consider. The average fund manager tenure is about five years¹. If you have to frequently announce you got an investment decision wrong, you will draw attention to yourself and your employer. If this coincides with a period of underperformance – which every fund manager will experience at some point – even that five-year tenure may begin to look optimistic. 

This is why funds often have more of a bias to momentum in share prices and less of an anchor to valuations and momentum in the underlying business. Even when they suspect the good times may be coming to an end, they cannot bring themselves to sell out of what has worked so well in the past. 

The difficulty of going against the crowd 

So, the ‘herd mentality’ remains in place. All active managers want to beat the market, but standing out from the crowd can be uncomfortable, especially when your view is the opposite of the consensus.  

For much of the decade to 2020, ‘growth’ stocks seemed to perpetually outperform. Sure, they were expensive, but profit growth was good and share prices strong. It got to the stage where the majority of active funds had low weightings to ‘value’ stocks compared with index funds. As a result, they missed the violent re-rating in value over the past few years and the super-normal returns it generated. We didn’t.  

The herd is not quite so anti-value as it used to be, but it is still quite negative despite strong profit and share price growth in this area. 

Why investors should work backwards 

At a portfolio level today, Artemis SmartGARP European Equity has a slightly lower return on equity than the market average (13.3% versus 14.4%), yet our P/E ratio is close to one-third cheaper (10.0x versus 14.4x), with a higher dividend (4.4% versus 3.3%) and free cashflow yield (6.1% versus 4.6%).  

Crucially, companies in the portfolio are more than twice as likely to have received recent upgrades to their profit forecasts than the market average. 

All active managers want to beat the market, but standing out from the crowd can be uncomfortable, especially when your view is the opposite of the consensus

As a result, we believe we are well placed for further outperformance. Our process of working backwards – looking at the metrics that drive returns, then screening for the companies with the best exposure to these factors – means we frequently have to sell stocks we only recently purchased, often at a loss. 

Viewed in isolation, such trades could make us look fickle. But as part of a strategy that increases our exposure to companies with improving fundamentals, it ultimately drives outperformance. If we own companies that keep growing and are lowly priced, the chances are that our investors will receive good returns.