Factor Investing. Factor investing is in vogue right now because of institutional and retail investor preferences for smart beta investing strategies. The approach selects stocks for investment based on factors or attributes correlated with higher returns. There are two main types of factors: macroeconomic and style factors, more on both below.
In reality, most investors have been employing factor investing in some form or another for many years in practice. For example, do you prefer value stocks over momentum stocks? Both are style factors. You are doing this to enhance your returns and minimize your risk. From a personal perspective, I realized that I practice a type of factor investing. I prefer value stocks but add in some momentum tech stocks, and I tend to emphasize low volatility stocks.
History of Factor Investing
Factor investing traces its founding back to the 1960s, when the capital asset pricing model (CAPM) was introduced in a series of papers.
- Lintner, John (1965). “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics 47: 13–37.
- Mossin, Jan (1966). “Equilibrium in a Capital Asset Market.” Econometrica 34: 768–783.
- Sharpe, William F. (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance 19: 425–442.
- Treynor, Jack (1961). “Market Value, Time and Risk.” Unpublished manuscript: 95–209.
According to an overview, The CAPM suggested that stocks were sensitive to the movement of the broader market, measured as beta. Thus, the most crucial factor was the market factor as measured by a beta for driving the risk and return of a stock. The remainder of a specific stock’s return was due to company-specific attributes such as quarterly earnings beats or misses, CEO change, new products or services, etc.
Further research, a paper by Stephen Ross, extended the CAPM and suggested that more than one factor can better explain stock returns.
- Ross, Stephen A. (1976). “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory 13: 341–360
Finally, Fama and French developed the three-factor model in 1992. The authors added the size and value factors to the market risk factor in developing this model.
- Fama, Eugene F., and Kenneth R. French (1992). “The Cross-Section of Expected Stock Returns.” Journal of Finance 47: 427–465
The primary innovation here was the Fama and French Three-Factor Model considers the fact that value and small-cap stocks regularly outperform the broader market. Hence, the Fama and French 3-Factor Model includes the volatility, size, and value factors.
The authors updated their model in 2014 to add two more factors forming the Fama and French Five-Factor Model. The two additional factors were probability and investment. The probability factor captured the fact that companies reporting higher future earnings have higher returns. In contrast, the investment factor captured the idea that companies directing profit to major growth projects are likely to have underperformance in the stock market.
Macroeconomic factors capture broader fiscal, natural, or geopolitical risks. They are applicable across asset classes and generally affect national economies. Macroeconomic factors are economic growth, unemployment, real interest rates, inflation, credit, emerging markets, and liquidity. These factors affect the whole or significant part of the stock market. For instance, a fiscal macroeconomic risk is rising interest rates, which tends to adversely impact the revenue and growth of companies. An example of a natural risk is a hurricane that affects a large region of a country. An example of geopolitical risk is a regional conflict that limits trade or access to markets.
Style factors are risks within asset classes. Examples of style factors are value, momentum, volatility, quality, and market size.
The value factor attempts to capture excess returns from stocks priced low compared to their fundamentals, e.g., low price-to-earnings (P/E) ratio relative to a trailing average. Investors tend to have an overly optimistic view of expensive stocks and excessively negative views of inexpensive stocks.
The momentum factor accounts for the fact that stocks outperforming in the recent past tend to have strong forward returns. Investors tend to use recent returns to make their investment decisions.
The volatility factor captures research illustrating that low volatility stocks have greater risk-adjusted returns.
Low debt, stable earnings, consistent cash flow, high margins, and good credit ratings define the quality factor. This fact is often a result of a wide moat or competitive advantage.
The market size factor captures the fact that small-cap stocks have historically outperformed large-cap stocks. Small-cap stocks are riskier and more volatile, and investors expect higher returns.
Is Dividend Growth a Factor?
Dividend growth may or may not be a factor. However, Ned Davis and Hartford Funds research suggest that dividend growers tend to have higher returns with lower beta over more extended periods. You can read my discussion about it in my article on Why Dividends Matter to Investors. The main issue, though, is the research is not as rigorous and back-tested as the factors mentioned above. Therefore, if dividend growth is not a factor, then, in my opinion, it is a company-specific driver.
A Factor Investing Approach
Factors are cyclical. Macroeconomic factors may have a long cycle, while style factors may be more short-term. Most factors are not highly correlated. For example, the value and momentum factors are direct opposites.
For instance, momentum stocks outperformed during the dot-com boom, but value stocks outperformed during the dot-com bust. Large-cap stocks outperformed during the dot-com boom, while small-cap stocks outperformed during the dot-com bust. Rapid changes in market direction tend to cause momentum stocks to plunge. Low-quality stocks sometimes perform well, while high-quality stocks muddle along.
Asset managers are offering exchange-traded funds (ETFs) with a focus on factor investing. It is possible to pick different factor investing ETFs and build a diversified portfolio with low volatility. But does it work? In theory, yes, as seen by the chart below. However, some research has indicated that costs may eat into returns eliminating any benefits.
Final Thoughts on Factor Investing
Factor investing is increasingly popular, especially smart beta strategies. However, factor investing may not be for everyone. Factor investing contradicts the efficient market hypothesis, which postulates that investors cannot beat the market over time because stock prices immediately reflect all available information. Nevertheless, a factor investing approach is something to consider since it focuses on maximizing risk-adjusted returns.
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Chart or Table of the Week
Today I highlight Dividend Contenders that have negative year-to-date returns. Dividend Contenders are stocks that have increased their dividends for 10 – 24 years in a row. Stocks on this list are facing company-specific issues for the most part. Nevertheless, it is a good starting place to look for stocks to invest in. The screenshot below is from Stock Rover*.
Dividend Increases and Reinstatements
I have created a searchable list of dividend increases and reinstatements. I update this list weekly. In addition, you can search for your stocks by company name, ticker, and date.
Dividend Cuts and Suspensions List
I updated my dividend cuts and suspensions list at the end of September 2021. The number of companies on the list has risen to 538. Thus, we are well over 10% of companies that pay dividends, having cut or suspended them since the start of the COVID-19 pandemic.
There were seven new companies added to the list this past month. The seven companies were International Paper (IP), CatchMark (CTT), Permian Basin Royalty Trust (PBT), Permianville Royalty Trust (PVL), San Juan Basin Royalty Trust (SJT), PermRock Royalty Trust (PRT), and Sprague Resources (SRLP).
Dow Jones Industrial Averages (DJIA): 35,820 (+0.40%)
NASDAQ: 15,498 (+2.70%)
S&P 500: 4,605 (+1.33%)
The S&P 500 is trading at a price-to-earnings ratio of 29.0X, and the Schiller P/E Ratio is about 39.2X. These two metrics were down the past three weeks. Note that the long-term means of these two ratios are 15.9X and 16.8X, respectively.
I continue to believe that the market is overvalued at this point. I view anything over 30X as overvalued based on historical data. The S&P 500’s valuation came down as the index companies reported solid earnings for the second consecutive quarter.
S&P 500 PE Ratio History
Shiller PE Ratio History
Stock Market Volatility – CBOE VIX
The CBOE VIX measuring volatility was up almost one point this past week to 16.26. The long-term average is approximately 19 to 20. The CBOE VIX measures the stock market’s expectation of volatility based on S&P 500 index options. It is commonly referred to as the fear index.
Fear & Greed Index
I also track the Fear & Greed Index. The Index is now in Greed at a value of 72. The Index is up five points this past week. This Index is a tool to track market sentiment. There are seven indicators in the Index that are measured on a scale of 0 to 100. The Index is calculated by taking the equally-weighted average of each indicator.
These seven indicators in the Index are Put and Call Options, Junk Bond Demand, Market Momentum, Market Volatility, Stock Price Strength, Stock Price Breadth, and Safe Haven Demand.
Safe Haven Demand is in Extreme Greed.
Market Momentum indicates Extreme Greed.
Put and Call Options are signaling Extreme Greed.
Junk Bond Demand indicates Extreme Greed.
Stock Price Breadth indicates Greed.
Market Volatility is set at Neutral.
Stock Price Strength is signaling Fear.
The Conference Board’s Consumer Confidence Index increased this month to 113.8 and followed a 109.8 value for September. “Consumer confidence improved in October, reversing a three-month downward trend as concerns about the spread of the Delta variant eased.” The Present Situation Index, based on consumers’ sentiment of current business conditions and the labor market, increased to 147.4 from 144.3 in September. The proportion of consumers planning to purchase homes, automobiles, and major appliances all increased. In addition, about 47.6% of respondents said they intend to take a vacation within the next six months.
The U.S Census Bureau reported that new orders for durable goods decreased 0.4% to a seasonally adjusted $261.3 billion in September. The decrease follows four consecutive monthly increases and is the second decline in the last 17-months. Total durable-goods orders are up 20.7% percent YoY.
The Bureau of Economic Analysis’ first estimate on third-quarter gross domestic product (GDP) growth reported an economy expanding at a seasonally adjusted annual growth rate of 2%, well below the 6.7% pace set in the second quarter. This value was the slowest GDP gain since the second quarter of 2020. The deceleration in real GDP was driven primarily by a slowdown in consumer spending. Consumer spending grew at an annual rate of 1.6% in the third quarter versus 12% in the second quarter.
Thanks for reading Factor Investing – Week in Review!
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.