Investing can seem complex and intimidating, especially if you’re just dipping your toe in the pool of financial jargon and seemingly endless data. Today, we’ll try to simplify some of this complexity and make investing more accessible by focusing on four key factors: value, size, profitability, and market beta. These factors have been researched extensively and validated by some of the most renowned names in the field of financial economics, including Eugene Fama and Kenneth French.
The core purpose of this article is to explore these investment factors in a simple, easy-to-understand manner. These factors form the backbone of the investment philosophy espoused by Dimensional Fund Advisors, an investment firm whose beliefs are deeply rooted in empirical and academic research, particularly the work of Fama and French.
To set the stage, let’s first understand what “factors” are. In investing, a factor refers to a characteristic or trait that influences the risk and return behavior of a security or group of securities. Value, size, profitability, and market beta are four such factors that can be used to sort and classify stocks. The goal is to gain an edge, or a “factor premium,” by targeting stocks with these characteristics. If you’ve heard of index fund investing, consider this as a potentially more sophisticated approach that aims to yield better returns over time.
Let’s dive into the value factor.
The Value Factor
Think about when you’re shopping for groceries. If you see an item that you feel is priced lower than it’s worth, you’d be inclined to buy it, right? You’re recognizing that item’s “value.” In the world of investing, the same principle applies. The value factor is based on the concept that undervalued stocks – those priced lower than their intrinsic value – tend to yield better returns over time compared to similar companies with more expensive or overvalued stock prices.
But how do we determine whether a stock is undervalued? One common method is to look at the company’s book-to-market ratio. This ratio compares a company’s book value (what’s left if you sell off all assets and pay off all debts) to its market capitalization (how much the market thinks the company is worth). A high book-to-market ratio often indicates an undervalued stock.
The value factor has been a subject of financial research for decades. It was notably put into the spotlight by Fama and French in their groundbreaking research demonstrating that over the long term, portfolios constructed with high book-to-market ratios (value stocks) tended to outperform those with lower ratios (growth stocks) over long time periods.
In the next section, we’ll explore the size factor, which relates to the impact of a company’s size on its expected returns.
The Size Factor
As we continue our investing journey, let’s think about size. Size in this context refers to a company’s market capitalization, or the total market value of a company’s outstanding shares of stock. Just as with the value factor, the size of a company can influence its stock performance, which is the principle behind the size factor.
Remember the story of David and Goliath? In the world of investing, small-cap (capitalization) companies are often called “Davids,” while large-cap companies are “Goliaths. The size factor posits that small-cap stocks outperform large-cap stocks over the long term.
Why might this be? It’s often because smaller companies, while carrying more risk due to less stability and resources, have a greater potential for growth. Imagine a small tech startup versus a giant multinational corporation. The startup might have the potential to double or even triple its size in a brief period, whereas the giant corporation is less likely to experience such rapid growth due to its already massive size. At some point, there are only so many more customers for a company to market its products to.
You can incorporate the size factor into your investing approach by tilting portfolios toward small-cap stocks. However, it’s important to remember that this doesn’t mean exclusively investing in small companies. Rather, it’s about strategically balancing the portfolio to harness the potential higher returns from these companies while mitigating risk with investments in larger, more stable companies. This is one of the core philosophies underpinning Dimensional Fund Advisors‘ investment approach.
Now that we have an understanding of the value and size factors, we’ll move on to examining how a company’s profitability can influence long-term returns.
The Profitability Factor
When we talk about profitability in investing, we’re referring to a company’s ability to generate earnings or profits. As an investor, it may seem obvious to prefer more profitable companies over less profitable ones, but it wasn’t until recent years that profitability was empirically confirmed as a factor that could consistently explain differences in stock returns.
Fama and French, in their later research, expanded their original model to include profitability as an additional driver of long-term returns. Their study showed that companies with higher profitability tend to have higher stock returns, relative to their peers, than those with lower levels of profitability. This makes intuitive sense. Companies that generate higher profits can reinvest in their growth, pay dividends to shareholders, or buy back their own shares, all actions that can positively influence stock prices.
A common place to see the profitability factor exhibited is in the selection of large-cap growth stocks. To create a portfolio that captures all segments of the investment landscape, you would have to include larger, more growth-oriented companies within your portfolio. This would seem to violate the ideas of both the size and value premiums we just finished discussing. For that reason, firms like Dimensional Fund Advisors design some of their large-cap growth funds to emphasize the profitability factor instead. They use robust measures of profitability to ensure they’re selecting companies with genuinely strong financial health, not just those that might look good due to accounting gimmicks, temporary market conditions, or being in the new “hot sector.”
We have now covered the value, size, and profitability factors and how they can impact investment returns. Finally, we will look at market beta and how those factors can come together to improve returns relative to index fund investing.
Beyond value, size, and profitability, another factor that plays a crucial role in investment decisions is market beta. Beta is a measure of a stock’s sensitivity to market movements. All investments have a beta which is measured relative to an underlying index. When it comes to market beta, the most common index for comparison is the S&P 500. An investment with a beta greater than one indicates that it is more volatile than the S&P 500, while a beta less than one signifies that the stock is less volatile and has less dramatic price move movements relative to the S&P 500.
Now, you might be wondering: How does this relate to the three factors we’ve discussed? Here’s where it gets interesting. Research has shown that the value, size, and profitability factors have low correlations to market beta. In simpler terms, the returns from these factors don’t move in lockstep with the overall market.
This is great news for diversification, which is often said to be the only “free lunch” in investing. When you spread your investments across factors that don’t move together, you can potentially achieve smoother, more stable returns over time. It’s like not putting all your eggs in one basket – if one factor underperforms, the others might offset this underperformance. As one factor’s performance zigs, another factor often zags, helping reduce the overall volatility in your investment portfolio.
So, when you add the value, size, and profitability factors to your investment strategy, not only are you potentially positioning yourself for higher returns, but you’re also adding another layer of diversification by investing in factors with low correlations to the market. It’s an approach that leverages the power of academic research to enhance both the return potential and risk management of your portfolio.
Beyond Index Funds: Improving Returns with Factor Investing
Now that we’ve understood the value, size, profitability, and market beta factors, let’s tie it all together and see how we can use this knowledge to potentially improve investment returns compared to traditional index fund investing.
Index funds have gained popularity due to their low costs, diversification benefits, and the general difficulty of consistently outperforming the market. They offer a passive investment strategy where the fund’s portfolio mirrors a market index, like the S&P 500, and therefore captures the market beta premium.
Factor investing, on the other hand, is a more targeted strategy. By understanding and harnessing the power of factors like value, size, and profitability, investors can potentially outperform the market over long time periods and achieve higher returns over the long term. Here’s how:
Instead of simply replicating an index, factor investing allows for a more refined selection process. Investors can overweight their portfolio with stocks that exhibit drivers of long-term expected returns – such as undervalued, small-cap or highly profitable stocks. Dimensional Fund Advisors use such an approach to tilt portfolios toward these types of stocks, hoping to capture the higher returns factors have historically offered.
While index funds provide broad market exposure at relatively low cost, they can still leave you exposed to market swings. Factor investing maintains a similar level of broad market diversification while offering yet another layer of diversification by spreading investments across several factors that each respond differently to various market conditions. This additional layer can help smooth out the ride during turbulent markets.
Greater Potential for Outperformance:
While it’s true that most active funds struggle to beat the market consistently, a low-cost, factor-based approach can be different. It’s not about chasing hot stocks or trying to time the market – strategies that are often destined to fail. Instead, factor investing is about structuring portfolios based on decades of empirical research and staying disciplined over the long term. This approach can offer a greater potential for outperformance over standard index funds.
That said, it’s important to remember that all investing involves risk, and that past performance is no guarantee of future results. While factors like value, size, and profitability have been shown to offer premium returns historically, there’s no certainty they will do so in the future. Moreover, a factor-based approach can underperform an indexed-based approach for extended periods.
So, should you dive right into factor investing? That depends on your personal circumstances, including your financial goals, risk tolerance, and investment horizon. Consulting with a financial advisor can be helpful to determine the right investment strategy for you.
In the dynamic world of investing, knowledge truly is power. We’ve traversed the landscape of investment factors, delving into the nuances of value, size, profitability, and market beta. While the realm of investing may initially seem daunting, particularly when you venture beyond the simplicity of index investing, the potential for improved returns and increased diversification makes this philosophy on investing worthwhile for many individuals.
Index investing offers a straightforward approach, mirroring the performance of market indices and inherently capturing the market beta factor. However, this strategy leaves investors exposed to the fluctuations of the entire market. By integrating an understanding of other factors, such as value, size, and profitability, into your investment strategy, you can enhance your portfolio’s overall diversification.
These three factors have demonstrated low correlations with the market beta, meaning that they don’t move strictly in line with the overall market. So even when the market is turbulent, these factors could perform differently, potentially smoothing out your investment journey. This approach allows investors to avoid putting all their eggs in the market-beta basket, instead spreading them across various baskets that each respond differently to market conditions.
Investing is a fascinating, complex field, and there’s always more to learn. But hopefully, this exploration of the value, size, profitability, and market beta factors has simplified some of the complexity and provided you with some valuable insights. Here’s to your continued learning journey and success in your investing endeavors. Happy investing!