Factors are an important investing idea. Like many important ideas, many people don’t pay attention. For investors, that can prove costly.
Academic researchers started finding factors in 1992. That year, Nobel Prize-winning economist Eugene Fama partnered with Kenneth French to explain why some stocks outperform the market.
They showed that the stock’s volatility, size and value mattered. The biggest winners were volatile small-cap stocks with low price-to-book ratios.
Many investors nod in agreement when they hear that. They think they understand value. They’ve been told for decades that small caps beat large caps. But that’s not what the paper revealed…
Fama and French showed that a large group of small-cap stocks outperformed on average compared to a large group of large-cap stocks. The same idea applies to value. But their work doesn’t say anything about an individual stock.
The truth is that an individual investor can’t apply factors like Fama and French did. Duplicating that research requires buying hundreds of stocks and, at the same time, selling short hundreds of other stocks.
Shorting stocks is risky. Many professionals who try to short a stock end up with large losses. Bill Ackman famously lost about $1 billion shorting Herbalife Ltd. (NYSE: HLF) even though his thesis was right in the long run.
Without shorting, there’s no way to re-create those studies.
But the fact that we can’t re-create the market-beating strategies in academic papers doesn’t mean we can’t benefit from them. We just have to work harder to find what works.
Identify the Right Factors
That effort starts with finding factors. Even though we can’t follow the research exactly, we can use the papers to start our own research. So reading could be the first step toward beating the market.
I’ve read hundreds of papers over the years. Many are low quality, which is unfortunate. But we can’t know it’s low quality until we actually read it. And hidden among all that poor-quality work are a few gems.
The next step after finding one of these gems is to develop a test plan. Even the highest quality research isn’t valuable to me if I can’t apply it.
Over the years, I’ve learned that combining factors often makes them useful for individual investors. This process can be as simple as ranking all stocks by size and value. Then you can look for the few stocks that are highly rated in both categories.
Diversifying factors can also help reduce risk. You probably already heard that diversified portfolios perform better than nondiversified portfolios. That’s not always true, but we’ll talk about that another day.
Diversification with factors can improve performance. Different factors perform well under different market conditions. Combining them can help you weather various economic storms.
That’s true because factors often have low correlations with each other. That’s a little more technical than I want to get into today … but I want you to see that there’s a mathematical logic at the core of this idea.
Few stocks will rank high on uncorrelated factors, and that makes the strategies tradable by individuals. I apply this approach in my Apex Alert strategy with seasonals and a variety of other factors.
It utilizes the same system created by my colleague, Adam O’Dell, called Green Zone Power Ratings, that focuses on six combined factors (Momentum, Size, Volatility, Value, Quality and Growth) to give stocks a rating between 0 and 100. Higher rated stocks are worth investing in and low ratings are ones to steer clear of.
To see how he uses factors to help find some of his highest-conviction stock recommendations for his premium Green Zone Fortunes research service (and avoid the worst), click here.
Until next time,
Chief Market Technician