Why Factor-Based Investing Works

Summary

Factor-Based Investing (FBI) is widely misunderstood.

FBI is NOT the same as Smart Beta.

You are probably using FBI right now.

High-performing investors are skilled at finding and exploiting high-performing factors.

Even passive, buy & hold indexers are using a type of FBI.

Factor-Based Investing (hereafter FBI) is all the rage today. Which I find amusing, since almost every investor on the planet is already using it. It's just that they don't know it.

FBI is as old as the stock market itself. What's new is the fancy name, and the stampede by Wall Street to monetize a strategy that has been in common use since brokers first met under the Buttonwood Tree on Wall Street.

That's what Wall Street is good at. Recycling old ideas, giving them a new name, and then marketing them as the latest cutting-edge way to beat the market. Let me illustrate what I mean.

As the old saying goes, there's nothing new under the sun. What is new is that ordinary investors are now able to participate in a tried-and-true strategy that until about 1990 was only available to Wall Street firms and their high-net-worth clients.

The arrival of the internet, combined with cheap access to powerful computers, changed the game.

What is Factor-Based Investing?

FBI is just a fancy term for a specific stock picking methodology. Each investor has his/her own criteria for picking one stock instead of another. For argument’s sake, let’s assume that there are 20 recognized stock picking methodologies that we can evaluate in terms of how much alpha they capture over the course of 20 years. That time frame should include two complete market cycles, so we will be able to evaluate their performance in both up and down markets.

We can then rank these 20 different strategies in order of alpha efficiency.

At the low end of the spectrum would be ad hoc stock picking. This is as close as one can get to throwing darts at the Wall Street Journal, but it is a methodology. It’s nearly random; it’s seat-of-the-pants; it’s picking stocks that are trendy, or have a certain product that they have fallen in love with.

Ad hoc investors don't know or care which characteristics these companies have in common with other companies. They choose them because they see them as "good companies." The only factor at play here is saliency. And it’s a very ineffective way to approach investing.

At the high end of the spectrum is picking stocks based on insider information. Illegal, yes, but it is a fact of life. Always has been, always will be. Not recommended for anyone who fears incarceration.

At the center of the spectrum is the buy and hold, low-cost index fund strategy. Guaranteed to match the market before costs. But even this strategy is factor-based. How? Because most indexes are cap-weighted, which means their primary factor is size – and the bigger the better.

Every strategy from the low end to the middle (indexing) is alpha-negative. These strategies supply the above-market returns to the strategies that lie to the right of center on the spectrum.

What is a factor?

A factor is simply a common characteristic or trait that is shared by a group of companies. The simplest examples are Beta, Size, and Value. Beta is a measure of how volatile a stock is, when compared to the entire market. Size is self-explanatory. You can limit your portfolio to just small stocks, or large stocks, or anything in between.

Value is a measure of how cheap or expensive a stock is when compared to its intrinsic value.

If, for example, you only buy stocks that are high beta, small size, and close to fair value, you are using a clearly defined FBI strategy.

Another common factor is momentum. If you are attracted to stocks that are rising in price faster than the rest of the market, and only buy companies that have this characteristic, you are using an FBI strategy.

Why does FBI work?

You have to go all the way back to 1934 to read about the discovery of one of the most profitable and durable of all factors - value. Graham & Dodd published their seminal book "Security Analysis" that year. It was then, and still is today, considered the bible of value investing. Warren Buffett is a disciple of Graham and Dodd.

The reason why the value factor has worked for so long is that it's based on sound reasoning. A stock is a good investment only if you buy it at the right price. If you pay too much for a great stock, your future returns will suffer. Graham and Dodd showed investors how to calculate the right price.

The Fama-French FBI models

After Graham and Dodd proved that the value factor was an important characteristic for stock selection, along came Eugene Fama. Together with Kenneth French, they wrote a paper in 1992 titled, "The Cross-Section of Expected Stock Returns."

This paper eventually led to the widespread adoption of what is now called "The Fama-French three-factor model." The three factors were value, size, and market beta. This idea of combining different factors into a single screening algorithm became the foundation of what we now call FBI.

In 2013, Fama and French updated their model to include two more factors, thereby establishing the Fama-French 5-Factor Model.

How to design an FBI strategy

Anyone who has enough time, interest, and discipline to do the research can come up with a winning FBI strategy. I have been doing just that since 2005. Over the years, I have developed 5 different strategies, with each strategy designed for a specific type of investor.

I use all 5 of these strategies with my clients. All 5 strategies have produced significant alpha, and one of them – the Top 7 - is available on the SeekingAlpha Marketplace.

The Top 7

In 2004-2005, I began to develop specific trading strategies based on factors that had demonstrated an ability to capture alpha over consecutive 20-year periods. I wanted to give each strategy a distinct set of characteristics that would appeal to the different types of clients I was advising.

The Top 7 combines two categories of factors: solid fundamentals like increasing earnings and modest valuations, and technical strength, like positive price momentum and positive on-balance volume. This strategy is beating the S&P 500 by 7.5% year-to-date.

There have been seven completed cycles this year, and a total of 86 trades. Out of seven cycles, five beat the market and two lagged.

How the Top 7 strategy works

Every four weeks I run the screening algorithm (details below) that generates a model portfolio of the seven stocks that have made it through all twelve of the filters. The model remains intact for the next four weeks, when I run the algorithm again and rebalance the portfolio by selling stocks that no longer qualify, and replacing them with new picks.

Starting with a universe of 8,000 stocks, it first eliminates those trading at less than $2 per share. Next it excludes stocks with insufficient daily trading volume.

Once these filters are completed, the algorithm turns to fundamental factors. Earnings must be positive for each of the prior 4 quarters. Earnings growth for the prior 4 quarters must be above the median growth rate for the relevant industry. Analyst earnings estimate revisions must be positive (>0) for the current quarter, the current year, and the following year.

The algorithm eliminates stocks that have been downgraded by analysts during the past 4 weeks. (It is not required that passing stocks have been recently upgraded.)

On the valuation front, price-to-sales, price-to-book, and price-to-free cash flow must be at or below the median for the relevant industry group.

Next the algorithm turns to technical factors. Price momentum must be positive over the prior 3 months. The current price must be above the 50- and 200- day moving averages. Volume must be higher on up days than it is on down days.

As a final screening hurdle, the algorithm tallies up the scores for each of the companies that have passed, and selects the top 7 best overall scores for inclusion in the model portfolio. Depending on market conditions, there may only be 5 stocks that pass, or as many as 12. I limit the model to no more than 7 names to keep the trading (and trading costs) at a manageable level. Here is the most recently completed Top 7 Model Portfolio:

Here are the stocks that passed the latest screen and are in the current model:

In-sample and out-of-sample performance

In July alone, the Marketplace portfolio gained 3.4% vs. 2% for the S&P. This strategy, as well as the other four that I use with clients, don't beat the market every month, or even every year. But they have been very successful all the way back to the year 2000. The performance from 2000-2005 is in-sample, the result of backtesting. The performance from 2005-today is out-of-sample, based on real-time data.

Since 2000, the Marketplace model has outperformed the market by an average of 14.09% per year. If we exclude the backtested results from 2000-2005, the actual returns to clients bested the market by 13.15% per year. See the table below for the complete track record.

Final thoughts

Almost everyone is using factors in their investment process, whether they know it or not. Which factors are you using? Or are you an ad hoc investor?

You might be wondering, if everybody is using factors, why does FBI still work? That's a fair question. It comes down to which factors you use. Most investors use only the factors that appeal to them, like saliency. Some are attracted only to penny stocks. Day traders like momentum stocks.

The factors I use in my work are carefully researched, and then combined in ways that are logical, and can be tested. Of the 600 or so factors that have been identified by academic research, only a handful have proven to deliver alpha persistently.

If Wall Street some day manages to capture a large enough portion of the money available for investing, and they direct that money into FBI strategies, then we might see a decline in the amount of alpha these factors capture. But I don't believe that the alpha will completely disappear.

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Thanks for reading my article. If you have any factor-based approaches you want to share below, I'd love to hear them. And if you're interested in checking out The ZenInvestor Top 7, check it out here.

Disclosure: I am/we are long HTHIY LAKE LGIH OZM PJT WF XGTI. 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.

Additional disclosure: All information in this article is based on sources believed to be accurate. The ZenInvestor Top 7 is a model portfolio presented in newsletter format. Nothing in this premium service is personal financial advice. Always do your own research before buying or selling any security.