How rapid returns can transform your portfolio

It’s hard to remember a time when investors have been subject to as much white noise about where they should park their capital. You could argue this is a partial consequence of our reliance on digital media. People and organisations with vested interests now find it much easier to reach a broad – and, in some cases, susceptible – audience, so the line between dispassionate analysis and what realistically amounts to marketing can easily become blurred.

The reality is that much of the unsolicited advice one can become exposed to through digital channels is little more than tub-thumping (online chat rooms are a particular bugbear on this score). Establishing an online presence is about as difficult as falling out of bed, yet for some wide-eyed investors it still somehow confers a degree of legitimacy.

There may be a generational element at play. According to Nasdaq, a high proportion of active Gen Z investors regularly seek financial advice from social media. It is little wonder we have witnessed the rise of commission-free trading apps as platforms seek to exploit what amounts to the most tech-savvy demographic in history. Unfortunately, an unrivalled familiarity with a mode of communication doesn’t necessarily help you separate the wheat from the chaff where investment advice is concerned.

A struggle to discern where analysis ends and marketing begins could give rise to a get-rich-quick mentality, but this shouldn’t be conflated with investors who are simply interested in maximising returns over shorter timeframes. Indeed, most people are quite relaxed with the notion that you can take on a greater degree of risk when you’re an early-stage investor. It’s a point that should provide a degree of solace for those at the younger end of the spectrum.

One key factor is liquidity. Superior short-term investments generally have strong secondary markets, enabling you to access your invested capital quickly. For an example of what happens when liquidity considerations take a back seat, see the transcript of the Financial Conduct Authority’s recent findings on the collapse of the Woodford Equity Income Fund.

Rapid returns and received wisdom

Though there are various avenues to drive rapid returns, some means are obviously less fraught than others. Disregard the relationship between risk and reward at your peril. Still, some may consider it heterodox to even suggest it’s possible to build wealth over the long term by targeting rapid returns.

Study after study has shown that stocks have outperformed other liquid asset classes over time, but the extent to which this is apparent depends on the timeframe and, by extension, individual investors’ investment horizons. Comparative investment returns are bound to be more erratic the shorter the timeframe on which they’re based, hence the view that frequent trading patterns often correlate with inferior returns. It’s little wonder then that we push the mantra that the best way to capture superior returns is to invest for the long term.

Be that as it may, it doesn’t mean a process favouring tactical asset allocations is somehow invalid. There are investors who are simply more open to speculative positions, while others are in search of more immediate sources of income as part of a growth strategy. These approaches do not negate the benefits that can accrue through simple compounding, but pursuing them does call for a more active approach to portfolio management.

This style of investing isn’t for the faint hearted. If you’re chasing short-term liquidity, it usually entails a higher degree of volatility and an increased risk of losses. 

Equally, there is no doubt that many investors are quite content with passive strategies, but you will only get so far by simply weighing up benchmark indices against the risk-free rate of return. Opportunity cost extends beyond comparisons on that basis.

Mean reversion and spreads

For those uneasy with the idea of having to regularly tailor their portfolios, there are other options, including a variety of different assets (such as cash and bonds) that allow you to take more risk in the rest of your portfolio. But perhaps the least complicated way to generate rapid returns when markets are faltering is through simple mean reversion – the assumption that an asset’s price will tend to converge to the average price over time.

The prominence of mean reversion may have faded over time, but it remains a well-worn method employed by investors and traders alike, so it doesn’t necessarily necessitate a more active trading approach. But it is possible to book short-term gains if you become familiar with the relative volatility of a given stock. That entails an appreciation of how spread out a company’s share prices have become and their variance – the standard deviation in regular terminology. Put simply, noting the peak-to-trough decline of a stock during a specific period can help investors determine how the stock price can deviate from the underlying trend in the short term.

Sophisticated traders often utilise mean-reversion pair trades – essentially a form of arbitrage. These trades involve identifying a pair of correlated assets that tend to move in tandem. When prices deviate, it's possible to profit by either buying the asset which is undervalued relative to the other, or by selling the one that is overvalued.

Even more insight can be gained as to the likely trajectory of a given share price through comparing its moving averages over 50- and 200-day trading periods. Some investors employ this method to take account of companies whose share price performance is strongly correlated to the price of an underlying asset, as in the case of natural resource companies.

Another commonly used relative comparison centres on the relationship between growth and value indices. Among other characteristics, value stocks trade at low prices relative to earnings, while growth stocks usually derive a larger portion of their value from future cash flows. Those two factors are worth keeping in mind when you're plotting the standard deviation.  A debate is now intensifying, ahead of a prospective base rate cut, about the extent of the anticipated market rotation into small-caps – we can probably expect a few long positions in response.

Naturally, these reversions are not quite as straightforward as they may seem. Investors still need to take account of fundamental analysis, together with any factors that make it less likely a mean reversion will occur. It clearly isn’t all about numeric relationships, advocates of the efficient market hypothesis would probably tell you that it’s a load of bunkum, but the widespread adoption of these techniques suggests otherwise. The bottom line is that you should always look at assets/stocks which exhibit strong underlying trends. 

Capital appreciation vs expected returns

If you’re in search of rapid returns, it makes sense to assess the extent to which a given company prioritises dividends, retained earnings, and buyback programmes, although as ever this shouldn’t be viewed in isolation.

Expectations as to prospective rates of capital appreciation (based on earnings upgrades) versus expected cash returns (from dividends) also form part of your deliberations. For established enterprises, capital appreciation tends to be a long-run affair, whereas the benefits of cash returns are obviously more immediate, although that should be reflected in the asset price – at least theoretically. It may seem obvious, but understanding how returns are generated, what those returns are and how to maximise them for your individual circumstances is central to deciding on your investment strategy. 

This comes into stark relief when the US and UK markets are compared. Though it’s true that the mature industries which dominate the domestic index – financials, energy, and healthcare – are unlikely to match the tech-heavy US indices in terms of capital appreciation, there are more immediate and tangible returns on offer.

Dividend yields and growth rates have historically had an outsize impact on investor returns, with changes in valuation playing a less influential role. The performance of the UK benchmark moves much closer to that of the much-vaunted S&P 500 over the past three years once cash returns are taken into consideration, although it’s worth noting that in the US the dollar value of share repurchases has outstripped that of cash dividends since 1997.

The FTSE 100 offers a forward dividend yield of 3.9 per cent complete with a solid coverage ratio, a point worth mulling over amid the clamour surrounding the handful of high-profile stocks across the pond. It may also be valid to suggest that there are more assumptions baked into the valuations for US tech than other less fashionable corners of the market. If so, this inherent vulnerability helps to explain the recent slump in the Nasdaq Composite: there is little margin for error when shares are priced for protection.

A 'smash and grab' approach to dividends

If you’re analysing yields and growth rates, you will apply the same criteria whether you’re targeting short- or long-term positions. We would venture, however, that anomalies do arise periodically, and they aren’t even necessarily at odds with the efficient markets hypothesis.

If you wanted to generate rapid returns through what might be described as a “smash and grab” approach, you could have done worse than to actively trade in tobacco stocks over the past decade or so. It may seem fanciful to describe the likes of Imperial Brands (IMB) and British American Tobacco (BATS) as “bond proxies”, but there is now an effective ceiling on capital appreciation for “Big Tobacco”. This is due to environmental, social, and governance mandates, together with the widespread acceptance that their core market is in secular decline. Regulatory risk is also a defining feature of the tobacco market; a point brought home in the recent King’s Speech to Parliament. It means that the two big UK tobacco companies have seen their market valuation contract by 2.6 and 16 per cent respectively over the past five years.

Though these stocks have faltering institutional support, they still generate oodles of cash, so they have been able to adequately fund their near-term obligations and returns to shareholders, although Imperial’s current ratio (a measure of its ability to meet those short-term obligations) isn’t overly reassuring. The companies’ respective dividend yields have sat within the range of 6.3 to 12.3 per cent over the past five years, which arguably represents an opportunity if you’re confident that the core business isn’t going to wither away overnight.

Average dividend yield is a function of aggregate share price performance. So, it may be possible to drive significant short-term gains in response to changes in the moving average share price for these types of stocks, but diligence is certainly required. If you were to apply the Rule of 72 (an estimate of how quickly your money will double: divide 72 by your estimated rate of return) to Imperial’s median yield through the period, you might expect to double your initial investment in as little as 8-9 years, although there are other variables at play (it’s a notoriously woolly metric). There is an element of “timing the market” in all of this; something we normally advise against. But we use the example of the tobacco companies to illustrate that it’s possible to adopt short-term bespoke strategies to income generation.

This active approach to portfolio management also extends to share buybacks, although again it depends on the ability to identify anomalous pricing. Share repurchases return cash to shareholders who want to exit the investment, but they also increase a stock’s potential upside for those who want to remain owners. It could make sense for investors to hive off a proportion of their holdings, banking immediate gains while taking advantage of the prospective increase in earnings per share.

The dollar value of global share buybacks has soared over the past decade and is now broadly in line with the total dividend payout. Part of the attraction is their tax-efficient status, but there is a somewhat sobering caveat in that buybacks can destroy value as well as create it. Any increase in earnings per share from share repurchases is essentially functional and unrelated to underlying value creation. In theory, the market will adjust valuations to reflect the reductions in both cash and shares, but that doesn’t always play out.

Some sectors are more dynamic than others

Although it is advisable to review any potential investment based on its total return characteristics, it's still worth examining which sector indices have exhibited the highest short-term rates of appreciation. According to analysis published by Charles Schwab, six- and twelve-month trailing returns (based on standard global sector classifications) shows that communication services, financials, and information technology were the standout performers at the end of June, although the rankings change somewhat according to the total return index.

That probably wouldn’t surprise too many market watchers, but any broad classification doesn’t tell you why a given company or specific sub-sector might grow based on diverse factors ranging from the size of the addressable market (and its long-term prospects) to the impact of innovation

This catalyst is doubly significant given the accelerated spread of disruptive market technologies. Seemingly unassailable technical applications can be rapidly overhauled — think of the speculation surrounding AI and the potential for it to make the existing search engine function obsolete. That’s one example of many.

It would be disingenuous to suggest that innovation is wholly synonymous with market success. But it should be quite possible to capture short-term gains from companies which might be termed “disruptors” in a given market; the likes of Rightmove (RMV), Telecom Plus (TEP), or perhaps even Fevertree Drinks (FEVR) spring to mind.

History shows that the greatest proportional increase in terms of the market valuation often occurs when these types of companies are establishing a foothold in their given markets, rather than at the point of the initial public offering or when they have matured.

Identifying such companies involves a certain degree of intuition, but it can often amount to a more prosaic value judgement if you’re weighing up potential additions to your equity portfolio based on metrics such as share price momentum, forecast revenue expansion, and upgrades to revenue per share expectations.

Unfortunately, the trouble is that many start-ups do not have the financial performance indicators necessary for standard approaches to valuation. This presents something of a challenge for venture capitalists and industry analysts alike, who will often employ discounted cashflow and “cost-to duplicate” models to try and gauge the intrinsic value of early-stage companies. But there is always a certain 'blue-sky' element where these types of companies are concerned.

Whether you concentrate on cash returns, tactical allocations, and/or anomalous pricing to drive short-term gains, the risk/reward trade-off should be a key consideration. The first thing that any investor needs to ask themselves is what they’re trying to achieve and the level of risk they’re willing to accommodate to that end. Essentially, you need to set out your stall before you do anything else, otherwise, you risk losing perspective and focus.

Invariably, if you’re weighing up risk you will need to factor timeframes into the equation. The conventional view is that risk appetite diminishes in line with the age of an investment portfolio. By extension, it should also apply to the ability to generate alpha returns. But it doesn’t have to be that way.

It should also be quite possible to pursue rapid returns alongside a more conventional value-based investment strategy – it’s not a question of either/or. But whether that pursuit relies on capturing the early-stage development of a company or the cash returns of certain dynamic sectors, you will still need to return to first principles.

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