Key Takeaways:
- Our Factor Investing Model will be based on 5 common factors (value, quality, low volatility, momentum and size). During 3Q 2021, momentum did well while the other factors were flat to down. Over the past year, the size premium (small-cap stocks over large-cap stocks) led the way.
- In this report we will be covering the first 2 factors, value and quality. The value factor focuses on typical valuation ratios such as Price-to-Book (P/B), Price-to-Sales (P/S) and Price-to-Earnings (P/E). Quality, which always will be somewhat subjective, is determined using metrics like Return-on-Equity (ROE) and Return-on-Investment (ROI).
- Value and quality are the first two factors we will introduce in a three-part series. The next article will focus on low-volatility, momentum and size. The final piece will explain how we construct a portfolio using these factors.
- Static factor portfolios have struggled over the past 18 months, and have not contributed consistent positive return since about 2013.
- A simple factor timing overlay, however, has performed better, particularly during the recent downturns in the value and low-volatility factors.
Introduction
This will be the first in a series of regular research notes commenting on the performance and general landscape for factor investors. Quant investors, who generally are aware of these issues, can use this first article to get acquainted with value and quality as lenses through which to analyze equities. Fundamental investors can use the article to better understand the risks inherent in their portfolios from the point of view of factor investing.
For this version of the factor monitor, we will use publicly available indices and ETFs to track factor performance. As we continue to build out the Fundstrat quantitative platform, we will include proprietary versions of these factors, and comment on the performance of the Fundstrat factors compared to their publicly available counterparts.
What it means: Think of factors as different dimensions of risk to analyze your portfolio. In the same way that it is very hard to fly a plane without instruments giving you altitude, pitch, and roll it is also very hard to understand the effects various risks and shifts in market sentiment will have on your portfolio if sensitivity to risks are not viewed through multiple lenses, or factors. The earliest quant could be considered the Father of Value Investing and author of The Intelligent Investor Benjamin Graham. The next major stride in the discipline occurred when Harry Markowitz published his revolutionary paper Portfolio Selection in 1952.
General Factor Commentary
Our discussion focuses on five well-known factors:
- Value
- Quality
- Momentum
- Low Volatility
- Size (i.e. the small-cap premium).
This first report will cover only value and quality. The second report will cover momentum, low volatility, and size (small/medium/large cap). The third and final report in this series will explain how to construct a portfolio using the factors introduced in the first two of the series.
These factors have been explored substantially in academic circles, and have been known to quant investors for decades.
For the purposes of these analyses, we consider factor premia, or the excess return of a factor relative to an appropriate benchmark. Absolute factor returns are driven primarily by the overall return of the market, so to separate out the premium of an individual factor, one must consider the excess return. [1] Fig. 1 below shows the performance of these factors over the past 3 and 12 months.
[1] We specifically consider the market-relative return of each factor in our analysis. Another approach to separate out factor-specific return is to compute the beta-adjusted return of the factor. Using excess returns assumes all factors have a beta of one to the market, and produces factor premia which can be implemented as dollar-neutral portfolios.
What it means: Factor premia refers to the premium of one factor versus a benchmark, like the S&P 500. For example, you may hear a lot about continuous shifts between growth and value. Value stocks are those that have a price near or below some measurement of intrinsic value or may enjoy a deep discount compared to peers.
Growth stocks usually have significantly higher rates of revenue and earnings growth relative to the benchmark, many benefitting from exponential increases in business from network effects. However, many investors may interpret these two categories by certain sectors. For example, many folks might think of Energy as a value sector and technology as a growth sector. Growth At a Reasonable Price (GARP) is sometimes used to describe stocks containing characteristics of both classes.
However, this is a shortcut and can be incorrect. In the words of legendary value investor Bill Miller “any stock trading below intrinsic value can be a value stock.” Similarly, as our head of research Tom Lee has pointed out cyclical is the new growth. In our extraordinary times, pent-up demand and pricing power, earnings and revenue growth at old-guard companies has been much higher than the rest of the market at times. The different factors we will analyze help us look at the market strictly through systematically defined risk dimensions to assist us in leaving our pre-disposed notions about asset classes behind.
Fig. 1 Recent performance of factors
Individual Factor Commentary
Factor 1: Value Factor
The value factor (which we define as the spread between the S&P 500 Value (IVE 0.24% ) and S&P 500 Growth (IVW) indices) has produced little in the way of excess return over the past 25 years (see Fig. 2). Deterioration in the returns to value has accelerated over the past 5 years, with value underperforming by nearly 40% since the start of 2020.
Fig. 2 – Value Factor Cumulative Performance
This level of value underperformance only occurred one other time in the history studied here – during the tech bubble of the late 1990s. Even if we exclude the pronounced underperformance of value during these periods, the factor has generally seen a slow bleed down in performance for the past 15 years.
Myriad explanations have been put forth for the underperformance of value (i.e. flattening of the yield curve, suppression of rates, a premium placed on high-growth companies in a low-growth world) but the fact remains that value has experienced a continued downturn in performance with occasional large relative losses. Recently, value’s underperformance has continued, as it has underperformed by 3.3% during the third quarter of 2021.
What it means: We described the difference between value and growth and how preconceived notions can affect how investors group stocks into those categories. We want to give you an example of one stock for each factor category so you can look into the characteristics that place it there. Marathon Oil (MRO) is a great example of a stock that currently scores high across value factors. Of course, MRO’s scores (like any stock) can change with time.
Factor 2: Quality Factor
The quality factor (measured as the spread between the S&P 500 Quality index[2] (SPHQ 0.30% ) and the S&P 500 index (SPY 0.60% )) was essentially flat over the past quarter and has lost a little over 2% over the past year. Over the past decade, its performance has been mainly flat (see Fig. 3).
Quality experienced a rapid run-up in performance following the tech bubble, and then continued to churn higher over the first decade of the 2000s, but has produced little return over the past decade. As can be seen from the chart, quality tends to do best in and around periods of economic upheaval.
[2] The S&P 500 Quality Index includes stocks that have high ROE, low financial leverage, and low accruals. More information can be found here.
Fig. 3 – Quality Factor Performance
Unlike value, there is no “consensus” definition of quality. The index we use here defines high-quality stocks as having a high return-on-equity, low financial leverage, and low earnings accruals (i.e. the difference between earnings and cash flows). Other definitions for quality include stocks with low earnings volatility. We will explore the definition of quality in a future research note.
What it means: Wal Mart (WMT 1.06% ) is an example of a stock that currently scores high on the quality factor. Since there is no consensus on the investment definition of quality, using another factor like low earnings volatility might generate different names. Generally, quality will capture established companies that have a demonstrated track record of consistent earnings relative to peers and other stocks in our analyzed universe.
