Factors of Returns | AWM Insights #118

Investing in index funds or ETFs is a great place to start, but can you do better?

 

There are segments of the stock market that have proven over time to deliver better results than the averages. This is backed by almost one hundred years of data and research across time periods and found in markets globally.

 

Exposure to these parts of the market, known as factors, in a cost-effective way can provide higher expected returns rather than just settling for market returns. The caveat is that you have to be a long-term investor to capture these premiums and the patience required for most investors is maybe the hardest part. If it was easy every investor would be doing it. 

 

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EPISODE HIGHLIGHTS:

(1:17) What are the actual drivers of returns in the public stock market? Why is there compensation for putting your money at risk?(2:25) If you want to get into the details and go deeper on investing, text 602-704-5574 for a longer conversation.(2:55)) An index approach is the epitome of letting the markets work for you.(3:13) A broad index market approach is a good place to start. However, there is evidence in the research of other factors that drive returns.(3:55) When you analyze the data there are groups of companies that perform differently than the whole.(4:08) The data shows there are parts of the market that underperform the general index and parts of the market that outperform the index. These are well researched and acknowledged factors in finance. (4:51) Company size is one factor measured by big companies versus small companies.(4:57) Valuation or relative value is another factor and is based on paying less money today for future earnings. If you pay a substantial premium for future earnings the evidence shows your returns could be better if you instead bought at a discount (lower relative price).(5:09) Profitability is another factor that is intuitive. Companies with higher profits tend to outperform companies that have lower or negative profits.   (6:10) These groupings of similar stocks continue to show up in the data in a persistent way. Meaning they show up across time periods, across the world’s stock markets (not just the US), and across the different market cycles. For a factor to be valid, it has to be sensible and backed by the data. It can’t be an opinion and it has to be cost-effective to implement.(6:36) These factors also have to be cost-effective to capture. If the taxes generated eliminate any benefit then the factor isn’t valid for the investor. Trading costs can also eliminate the benefits of other researched factors. (7:38) Small companies are defined as having a smaller market capitalization. Market capitalization is the number of shares multiplied by market price. This is the size of the company or what the market determines is the fair market value of what a company is worth. (8:39) If you rank the smaller companies (smallest 10%) versus the biggest companies since 1928, they have outperformed by almost 2% per year. An extra 2% compounded per year for that many years delivers staggering differences in wealth.(10:23) The price of a stock comes down to what you pay for the future earnings of a company. If you pay a lower relative price you are considered a value company. A higher relative price is a growth company. Relative price always relates to their expected future earnings.(11:27) Early-stage technology companies tend to fall into the growth category.(12:18) Do these factors show up over shorter time periods? (12:35) There will be periods where the factors underperform and that can be thought of as the cost to pay for higher expected returns than the index.(13:05) If you can generate between around 2% for small caps and 3% for relative price, that is 5% of additional performance, why don’t we go fully into small-cap value?(13:23) Comparing it to baseball and hitting. You can’t expect the factors to hit every year but you do want to give them more at-bats so the odds over time are in your favor. (14:31) The third factor is profitability. The group of profitable companies have higher rates of return over long periods of time when compared to the group of less profitable companies. (15:40) Multi-generational investing allows for these factor premiums to be captured because of the long time periods and patience that can be assumed.(16:15) These factors also provide diversification when implemented together. When one factor is underperforming another factor may be outperforming. This reduces dispersion of returns and lowers volatility.(16:50) These factors implemented in your portfolio can target higher expected returns than just settling for what the market index will give you.(17:07) Don’t run out and buy the first small value fund you find. Make sure you choose a good manager that uses a systematic approach index like approach.(17:45) You don’t have to play the game of which sector of the market will do well. Rather you can own a well-diversified portfolio that over time has proven to provide statistically better returns. This is a great investing experience that lowers uncertainty and increases your chances of achieving your priorities.