Everything you need to know about Artemis’ Secret Weapon.
SmartGARP is Artemis’ proprietary tool for identifying winners and losers in the stock market. It may come across as a very complex system, but is in fact trying to do something quite simple. It objectively measures the financial characteristics of companies and industries – those with good characteristics tend to outperform the market, those with poor ones tend to lag. For many years we have found it an invaluable help in generating alpha.
This year we’re seeing that attention being focused on the FTSE100 where we’ve already seen two or three big takeovers; Corus, Scottish Power, and I think there are three. And so it’s M&A and strong global earnings. A global phenomenon. Meanwhile, valuations remain relatively attractive, because we have had very strong earnings growth over the last couple of years throughout the G7 economies, with share prices either rising in tandem or, in the case of the UK, actually falling behind leading to a lower P/E.
How and why Artemis’ secret weapon works.
John Maynard Keynes enjoys a reputation not only as one of the greatest economists of the 20th century, but also as a canny investor. Many of his observations, made some 70 years ago, have lost none of their relevance.
He cautioned that “financial markets can remain irrational longer than you can remain solvent” and likened financial markets to a beauty contest where the idea is not to pick the most beautiful contestant, but the one everyone else is going to vote for.
These insights are reflected in our investment strategy. SmartGARP helps us to pick the best stocks for the long run, but recognises that there is a good chance we might be wrong or that even if we are right it may take a long time for the market to reflect this.
Hence, when choosing a stock we also take into consideration whether it has the characteristics that other investors will be attracted to as well. We do this because we think we understand how financial markets ought to work in the long run, but also how investors behave in the short term.
So how do investors behave?
The answer is with a reasonable degree of predictability. For example, if you offer two companies with identical financial characteristics, except their valuations, to a group of investors, they will tend to prefer to buy the stock on the lower valuation. Likewise if the sole difference was the growth rate, they would generally prefer to buy the faster growing company. If the difference was that one of them was seeing upgrades to profit forecasts or was in an industry that was benefiting from helpful macro-economic trends they would pick the upgrade stock or that with the positive industry backdrop.
The difficulty most fund managers face is that the decision making process is far more complex than this yes/no choice. Not only are there many companies to follow but each one has slightly differing characteristics making a yes/no answer all but impossible. The result is that despite starting off with good intentions, most investors end up with a collection of stocks that have, on aggregate, pretty average characteristics and hence pretty average performance.
What do we do?
Our own technique is to use technology to make the task simpler. Each day we electronically collect thousands of bits of data. This information is processed in order to identify the features of thousands of companies. We measure each stock on
seven characteristics (growth value, estimate revisions, momentum, top down, fund manager sentiment and accruals) and assign an overall rank to it where 100 is fantastic and 0 is very poor.
In doing this we are able to build up a picture of the financial DNA of each stock. From there it is a reasonably straightforward job to build a portfolio of stocks that have good overall characteristics (above average growth, below average valuations etc), whilst ensuring it is diversified by industry, style and size.
We won’t have a list of stocks which all have a tick in each box, but we will have a list that on average have all the boxes ticked.
Combining financial theory, investor behaviour and sentiment
Financial theory states that the expected return from investing in a stock is a function of its valuation and its growth rate. Stocks that are cheap compared with their growth rates (so-called GARP stocks, as in Growth-At-a-Reasonable-Price) should thus outperform the market. The problem is that the forecast growth rates may be wrong (not uncommon), and even if right, it may take a long time before investors believe them.
By using revisions and top down factors we identify which stocks have a catalyst that might change the market’s perception of the stock and hence might convert an undervalued situation into a higher stock price. We also take into consideration that changes in sentiment towards individual stocks and sectors can have a dramatic impact on share price movements. We therefore try to find stocks and sectors that investors hate, but where price momentum and sentiment are improving. Finally, we focus on accruals to help identify statements that have been subject to manipulation.
SmartGARP and Fund Manager Judgement
Articulating our quantitative process is reasonably easy. Doing so for our subjective judgements is less so. Nevertheless, it is important to recognise that for us SmartGARP is a means to an end rather than the end in itself. It is a tool that helps us to identify winning stocks. From there we will ask ourselves if we have other information that is sufficiently convincing to disagree with the system. Usually we don’t, but occasionally we do.
We have been running and developing the process for over a decade and that gives us the confidence to trust it year in, year out and to know when to switch the autopilot off.
Why SmartGARP works
Information overload and investment by committee are two of the major problems facing institutional investors. Insight becomes crowded out by noise, decision making becomes difficult and investments become average. As Keynes said “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
At Artemis we would rather succeed. We find that SmartGARP combats information overload by focussing the fund manager’s attention on the few stocks where financial characteristics are extreme. Moreover, it helps police existing holdings by giving unequivocal signs of deteriorating financial characteristics that call for the fund manager’s attention.
Crucially, it also provides an objective framework within which to discuss the attractiveness of stocks. All of this means that investment decisions are more timely and frequently non-consensual.
Conclusion
Investment can be made very complex and difficult. We believe the simple truth is that you just need to buy stocks on low valuations with good growth. SmartGARP helps us to hunt down those companies and to stack the odds of success in our favour.
