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Every investor is looking for an edge to beat the market.
Factor investing offers just that kind of edge.
It’s the investment “free lunch” that promises the holy grail of investing… beating the stock market with less risk.
So just what is a “factor”?
Factors explain why specific investment strategies outperform the market over time.
If you’ve heard the terms “value” or “momentum investing,” then you’ll already be familiar with two of the most important factors.
Today, I’ll give you a quick overview of the “big five” most persistent investment factors – value, momentum, quality, size and low volatility.
The idea behind value is both familiar and straightforward: Cheaper stocks outperform more expensive stocks over the long run.
Expensive growth stocks rarely meet their lofty expectations. Conversely, cheaper value stocks tend to surprise on the upside.
Published in 1934 in the middle of the Great Depression, Columbia Business School professor Benjamin Graham’s Security Analysis is the bible of value investing.
Graham recommends that investors buy stocks at a discount to their intrinsic values.
Graham taught that you can calculate a stock’s intrinsic value by using measures like price-to-book (P/B) and price-to-earnings (P/E) ratios.
Research by Fidelity Investments shows that between 1985 and 2015, stocks with a low average P/B or P/E outperformed a broader market cap-weighted index by 2% and 3% per year, respectively.
Momentum investing is based on the observation that once a stock starts to rise, it tends to keep going.
Put another way… “The trend is your friend.”
Academics and die-hard value investors cringe when they hear the word “momentum.” After all, the success of momentum investing is an insult to their hyper-rational approach.
But it’s no surprise to technical analysts. They know that investors tend to pile into a stock once it starts going up.
Momentum investing is less about abstract theory than real-world investor behavior. Unlike the perfectly rational “homo economicus” (economic man) you find only in finance textbooks, most investors are driven by FOMO – the fear of missing out.
Again, between 1985 and 2015, momentum stocks that outperformed over the prior 12 months beat a broader market cap-weighted index by an average of 1.5% per year.
It seems like common sense: Invest in high-quality companies and you generate higher returns.
Not surprisingly, research has confirmed that stocks of high-quality companies beat the market over time.
A strong balance sheet, stable earnings, increasing dividends and reasonable leverage are all hallmarks of quality companies.
Most importantly, high-quality companies have “wide moats” – sustainable competitive advantages – that allow them to earn higher profits than their competitors.
Think of what it would take to launch a rival to Visa (NYSE: V) or The Coca-Cola Company (NYSE: KO) and you’ll understand the power of a wide moat.
Investing in a portfolio of quality companies between 1985 and 2015 outperformed the market cap-weighted index by an average of 1.6% per year.
The “small cap effect” is the market anomaly that small cap stocks consistently outperform large cap stocks over the long run.
Eugene Fama, a 2013 Nobel Prize winner in economics, and his colleague Ken French found that small cap stocks outperformed for three significant reasons.
First, small caps are riskier than large caps. And higher returns compensate for that higher risk.
Second, analysts don’t cover small caps as thoroughly as large caps. So the small cap market is less efficient and offers more mispriced stocks.
Finally, smaller companies are nimbler than their large cap counterparts. They adjust better to changing market conditions.
Between 1985 and 2015, small caps outperformed large caps by an average of 0.7% per year.
5. Low Volatility
The investment case for low-volatility stocks is harder to get your head around.
The original reason for investing in low-volatility stocks was to offer investors a smoother ride.
Surprisingly, research has shown that low-volatility portfolios not only are less volatile but also offer higher returns.
That’s because low-volatility stocks hold up better during market pullbacks.
“Dividend Aristocrats” are low-volatility stocks that have increased dividends for at least 25 years in a row.
During the financial crisis of 2008, the overall market dropped 37%. In contrast, the Dividend Aristocrats tumbled only 22%.
Between 1985 and 2015, low-volatility stocks outperformed large cap stocks by an average of 0.8% per year.
There Is No Holy Grail
Over time, each of these factors outperforms the overall market.
Yet no single factor works all the time.
Value stocks fell out of favor during the dot-com boom. But they more than managed to earn back their losses in the years that followed.
Momentum stocks got crushed following the dot-com bust in 2000 and after the financial crisis of 2008. But momentum has trounced the S&P 500 over the past five years.
High-quality stocks may lag during momentum-driven market rallies. Yet their wide moats ensure these are the investment turtles that beat the hare.
Small caps can underperform large caps for many years, as they did during the tech bubble in the late 1990s and the financial crisis in 2008. But over the long term, they crush the S&P 500.
Finally, low-volatility stocks tend to underperform during market rallies following bear markets – such as in 2009. But they are the best way to preserve your capital in the midst of market crises.
I’ll examine each of these factors in more detail over the coming weeks…
And I’ll provide you with specific exchange-traded fund recommendations on how to profit from them.