Factors are a critical concept for investors who want to consistently beat the market.
Yet despite decades of proven outperformance, it’s easy to overlook the power of factors … a mistake that can cost a fortune — especially in turbulent markets like these.
Academic researchers first started finding investing 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. Paid-up Green Zone Fortunes readers will know that these are three of our six key factor categories. The biggest winners from Fama and French’s research 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 … and they’ve been told for decades that small caps beat large caps. But that’s not what the paper revealed…
We Can’t Replicate Fama and French
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 we 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 the tactic end up with significant losses. Bill Ackman famously lost about $1 billion shorting Herbalife Ltd. (HLF) even though his thesis was correct in the long run.
Without shorting, there’s no way to directly recreate the results of those studies.
Fortunately, there’s a practical alternative for cashing in on the advantages of factor investing.
Using Factor Investing to Pinpoint the Market’s BIGGEST Breakouts
Over the years, I’ve learned that combining different investing factors is incredibly useful. 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 non-diversified 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.
My Green Zone Power Ratings identifies top stock investments based 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 stocks with low ratings are ones to steer clear of.
Using this straightforward system, my team has identified some of the market’s hottest investments long before their share prices started to soar.
Longtime Money & Markets Daily readers will recall Matt Clark used the system to highlight Celsius (CELH) back in April 2021 before it became one of the decade’s best-performing stocks.
With volatility on track to continue swaying markets throughout the year, you can count on a systematic approach like Green Zone Power Ratings to help sort the market’s best investments from the ones you’d rather avoid.
To good profits,
Adam O’Dell
Chief Investment Strategist, Money & Markets
