1. Size matters

Small cap stocks usually perform better than large cap stocks, because they have higher growth rates and longer time frames during which they can grow.

Small caps have outperformed large caps, on average, by 3.6% per annum between 1927 and 2009.

But beware, there are periods where large caps outperform, such as the period we are in now. Over the past few years, big companies have outperformed small companies because they are well positioned to capture the market with new technologies.

2. Valuation matters

The cheaper you can buy a good stock, the better.

A study showed that buying the cheapest stocks based on a price-to-sales ratio outperformed the market by 3% per annum.

This is a bit simplistic, so don’t just go out and buy cheap companies.

What this really means is the return on a stock is composed of two parts, the growth in company earnings and the change in the multiple that the market will pay. The growth in earnings stays the same irrespective of the price you pay for the company. But the change in multiple can be higher for a stock that is cheaper.

The trick is to buy good companies at reasonable prices.

3. Dividends matter

Companies that sustainably pay dividends are often great investments. These companies can be old companies. They often have global reach and dominate their market segments. This is what gives them the ability to pay dividends and keep increasing them over time.

Although, dividends may seem small, they matter. In the US dividends have been shown to contribute:

• 49% of the return over 10 years

• 83% of the return over 20 years

• 91% of the return over 100 years

Beware - don’t look for stocks paying the highest dividend, because this may not be sustainable. Look for good companies that can keep paying dividends over time. For example, companies in the Dividend Aristocrats index have been paying dividends for more than 25 years.

4. Free cash flow matters

There is a saying in business…

The reality is that cash pays the bills and is used to grow businesses. So invest in companies that earn good free cash flows and can grow them in future.

5. A healthy balance sheet matters

Most companies have debt. A healthy company has a manageable amount of debt. Manageable means that it either uses little debt or it generates high cash flows in relation to debt.

The reason for wanting a healthy balance sheet is obvious – even good companies take a knock now and then. When that happens you want to be invested in a company that can weather the storm.

In a study, companies with the highest cash flow to debt ratio outperformed companies with the lowest ratio by 8.0% per annum.

6. Momentum matters

In the short term, what goes up tends to keep going up and what goes down tends to keep going down.

In other words, stocks that are going up tend to keep going up (until they don’t). This trend can last much longer than you think. So don’t be impatient to sell your winners and bank the profits. If you want to sell, do your analysis and then sell slowly.

In a study, a momentum-based strategy outperformed the market by 3.6% per annum.

7. Insider ownership matters

Companies that are run by insiders with significant stakes tend to outperform those run by managers without significant stakes.

The reason is governance. A large shareholder running a company, will focus on long-term performance and will keep manager self-enrichment under control.

8. Consistency matters

There is a persistent gap between the returns investors obtain and the total returns reported by funds. Morningstar does a report on this every year, called Mind the Gap.

The main cause of the gap is investor behaviour. When the market goes up, investors buy in and when the market goes down, they sell out.

This is the proverbial buy-high, sell-low strategy. It doesn’t work in business and it doesn’t work in investing.

As an investor, you are better off sticking with your investments, even through a bumpy patch, rather than trying to time market entry and exit.

Conclusion

Our Extraordinary Companies portfolio has a return of 49% over the past year. That places it an astounding 28% ahead of the index.

When you see those kinds of numbers, it is tempting to think that outperforming the market is easy. It is not.

To outperform, you will need an edge, a strategy and a bit of luck. Use the factors discussed here to give you an edge with your investment strategy.

As for the luck, I’m wishing you lots of it 🍀.

I would like to hear what you’re up to.

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