The Investment Scientist

Not Without Risk: Factors Driving Stock Returns

Posted on: October 22, 2007

Academics have found out that stock returns are driven by several factors: size, valuation, fundamental, seasonal and momentum. I’ve covered the seasonal factor quite extensively in previous communications. At some point I will talk about the momentum factor as well. In this article, I will primarily talk about three very important factors: size, value and fundamental. Our investment strategy MDVFS is designed to take advantage of these three factors. These three factors are risk factors, meaning that they have their own risk/reward characteristics. By understanding these factors, you will come to grasp the risk/reward characteristics of MDVFS.

Size Factor

“Size matters” – we heard that a lot. Usually that means ” the bigger the better.” In the arena of investment however, it could mean “small is beautiful.” Based on the data in professor Kenneth French’s online library, between 1963 and 2006, small cap stocks on average outperformed large cap stocks by 3.76% a year. However, small cap stocks don’t always outperform. Out of those sample years, small caps stocks outperformed 57% of the time and large cap stocks outperformed 43% of the time. As a matter of fact, we are in a period of small cap underperforming now. In the past 12 months, small cap stocks have underperformed by about 3.61%.

Value Factor

Stocks’ valuations have very strong predictive power regarding their prospective returns as well. Though Wall Street prefers P/E as a valuation measure, academics have found P/B to have the most predictive power. Value stocks are defined to be stocks with the bottom 30% P/Bs and growth stocks are defined to be stocks with the top 30% P/Bs. Between 1963 and 2006, value stocks on average outperformed growth stocks by 6.51% a year. Value stocks don’t always outperform though. Out of the sample years, value stocks outperformed growth stocks 70% of the time and growth stocks outperformed value stocks only 30% of the time. As a matter of fact, we are not just in a period of small cap underperforming, we are also in a period of value underperforming now. In the past three months alone, value stocks have underperformed growths stocks by 7.29%.

Fundamental Factor

Fundamental factor is the strongest of all. According to professor Piotroski’s research, fundamentally strong stocks on average outperformed fundamentally weak stocks by an astonishing 18.3% a year. Despite overwhelming historical evidence, it should not be taken as axiomatic that strong stocks always outperform weak stocks. Strong stocks only outperform to the extent the market is surprised by their strengths and weak stocks only underperform to the extent the market is surprised by their weaknesses. Because large cap and domestic stocks tend to be better covered by analysts relative to small cap stocks and foreign ADRs, the fundamental factor has the best predictive power among small cap stocks and foreign ADRs.

Even the fundamental factor is not without risk. Historically, one out of seven years, fundamentally weak stocks actually outperformed fundamentally strong stocks! It is helpful to recall that during the height of the internet bubble in 98/99, people shunned solid brick and mortar stocks in favor of .com stocks without any sales. Warren Buffet was laughed at because he did not subscribe to the idea that profits don’t count any more for .com stocks. He suffered ridicules for two long years and now it’s clear to us that his patience and discipline paid off.

Conclusion

MDVFS picks fundamentally strong stocks among deep value stocks, it is therefore exposed to the value and fundamental factors by design. In portfolio composition, MDVFS assigns equal weighting to large cap stocks and small caps stocks, the resulting portfolio is also exposed to the size factor.

MDVFS is most appropriate for patient investors who do not care to follow the market, since over the long run, we almost surely will benefit from exposure to the size, value and fundamental factors. In any given moment however, these factors may not necessarily work to our favor.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

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