What Kind of Stocks Have The Highest Returns? The 4 Factor Model
When financial economists (like me) do research into stock returns we start by trying to determine what characteristics predict future stock returns. In this article I'm going to explain what those characteristics are and how you can use them to improve your investing performance.
This is the first article in a series that will explain how to use common characteristics of stocks to predict which ones will have the highest returns. This article is an overview of the four most important stock characteristics that predict performance. Each of the articles over the next four weeks will focus on one of the four stock characteristics telling you how to use that characteristic and what average returns have been like historically.
First though, it's important to understand what kind of return we are talking about when we examine the returns on individual stocks. In particular, we need to distinguish between a stock that goes up because the market is going up, and a stock that goes up even if the market is staying flat. We call this return for an individual stock over and above the market, the excess return. If an investor can consistently pick stocks that go up more than the market, he is said to be "generating alpha" (which of course is where the name for this site comes from). In contrast, the return from just buying and holding the market is termed beta.
The First Factor that Predicts Stock Returns: Beta
When a stock goes up on average by the same amount as the market, we say that it has a beta of 1.0. When a stock goes up by twice as much as the market on average, we say that it has a beta of 2.0. Betas tend to be fairly persistent over time. That means that a stock with a beta of 2 this year, will probably have a beta of 2 next year also. It may be 1.9, or 2.1, but it will be close to 2 usually. What this means is that if the stock market as a whole returns 5% on average, then stocks with a beta of 2, should return 10% on average.
So beta, or the covariance between the market and a given stock, is the first factor that predicts stock returns. Higher betas mean higher returns on average.
How can you earn larger returns with this? If you are willing to take on more risk, then buy stocks with higher betas. Just remember though, higher betas also mean more volatility in the stock price. Indeed, if you want to really amp up your returns and risks, an easy way to do this is to go long high beta stocks, and short low beta stocks. I will talk more about how to use this strategy others surrounding the 4 factor model in future articles, and how to use statistics to forecast those returns.
The Second Factor that Predicts Stock Returns: Size
The second factor that predicts stock returns is called the size factor. Basically, financial economists have shown that stocks with a higher market capitalization (big stocks) have lower returns on average than stocks with a lower market capitalization (small stocks). Over the last 80 years smaller stocks have returned an average of about 13% per year versus about 10% for large stocks. Again though, smaller stocks are riskier and tend to go bankrupt during recessions in larger numbers.
If you want to earn higher returns you should buy small stocks rather than big stocks. To really increase this return again, you can short big stocks, and go long small stocks using the cash received from shorting (or some of it anyway) to fund the long position. But wait… what's a big stock and what's a small stock? Well the way academics define them is a little bit complicated so I will go over it in the article focused on the size factor next week. However for now, a safe way to think about it is a market cap below $2B is small, while a market cap over $10B is large.
The Third Factor that Predicts Stock Returns: Valuation
This factor is where financial economists and other investors sometime disagree. Most investors look at valuation from the perspective of P/E ratios or PE-to-Growth (PEG). What financial economists have found however is that a more predictive measure of valuation is Book Value-to-Market Capitalization. This is often called Book-to-Market for short.
Numerous studies have shown that low book-to-market companies outperform high book-to-market companies. And the best part… there is no additional risk associated with low book-to-market companies vs. their high book-to-market counter parts. Risk in both groups of stocks is statistically identical for most time horizons. As a result, investors should always invest more in firms with low valuations rather than high valuations.
But wait… if there have been lots of studies done showing this result, why do so many investors still choose high book-to-market firms? Well, that is a source of debate among financial economists, but one common explanation that some researchers have found is that low book-to-market firms seem riskier than they really are. Firms with a low valuation are usually the ones where market sentiment is worst and where most investors are afraid to invest. Yet that's exactly what you should be doing.
In the article focused on the valuation factor, I will talk more about this and how to determine which firms have "low" valuations and which ones have "high" valuations. Do NOT just go out and buy firms that seem to have low valuations - some of them are dogs and it is important to have a thorough understanding of value investing from a statistical standpoint. It will vastly improve your returns.
The Fourth Factor that Predicts Stock Returns: Momentum
Finally, the fourth factor and frankly the most misunderstood factor is momentum. Momentum is statistically the factor with the largest returns associated with it, but it is also the trickiest one. Stocks with historical momentum only tend to do well for a limited time period (about a year), and then the trend reverses and they underperform the markets for up to 5 years.
Measuring momentum is very tricky and to do it right you need to use the other three factors, but if you do it well it is enormously profitable. There are multiple large hedge funds that make most of their returns trading based on momentum. I know because I worked for a $15B fund that did exactly that before I got my PhD. Just like with the valuation factor, stocks with high levels of momentum don't have any more risk than other stocks that have low levels of momentum.
Again, I can't emphasize enough how tricky it is to try and do statistical momentum based investing without a complete understanding of the strategy. Most investors who say they are momentum traders take on more risk than they need to and earn lower returns because they don't measure the momentum properly. That's not my opinion - it's a fact borne out by several major research studies in the last decade. Stay tuned for my future article on statistical momentum trading in a few weeks and I will walk you through everything you need to know.
Anyway, those are the four factors: beta, size, value and momentum. You can use each of these factors to increase your returns (or at least if the last 80 years of history is any guide you can). Beta is very easy and any investor can trade using it, but it involves taking on more risk. Size is a little more complicated, and involves a little bit more risk particularly during recessions. Measuring valuation of a stock correctly relative to other stocks is fairly complex, but the strategy doesn't involve any additional risk. And finally, momentum is the most complicated factor to use, but it involves no additional risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.