Factors are the secret to stock market success, hidden in plain sight. This is a guide to how you can beat the market by identifying stocks that rank highly for the traits of value, quality and momentum.
What drives stock returns? It's a puzzle that most individual investors never seem to figure out. By picking stocks on gut feel or a promising story, we tend to play the market like a lottery. But lottery stocks have lottery outcomes. While some win big, so many lose.
Yet, what works in stock markets is an open secret. A hundred years of research, practice, and academic science have proven that selecting stocks with certain quantifiable characteristics, or ‘factors’, is the surest path to market-beating returns.
Such factors can include measures of company size, profitability, valuation and share price strength. A factor is most useful if you can sort the market by that characteristic (e.g. the P/E Ratio) and find that the stocks at one extreme (cheapest) reliably outperform those at the other (most expensive). If so, you can build a portfolio of stocks that rank best for these kinds of traits, in the hope of market-beating returns.
As Andrew Ang, the Head of Factor Strategies at BlackRock, has put it: "Factors are the language of investing that everyone should be speaking".
As we'll show in this guide, it's easier than you think to speak this language, and measure all your portfolio holdings accordingly. These principles can help you select better stocks, more exposed to proven return drivers, and build a better portfolio. Long-term wealth generation, and preservation, depends on it.
While investment fads come and go, certain factors have outperformed persistently over many decades and across different sectors and regions. And while there is still a little disagreement, in stock markets the following five factors are generally recognised as being most enduring and most investable:
Quality - profitable stocks beat unprofitable stocks.
Value - cheap stocks beat expensive stocks.
Momentum - improving stocks beat deteriorating ones.
Size - small stocks beat large stocks.
Volatility - low-volatility stocks beat high-volatility stocks.
Those factors can be measured using different metrics (for example, a company's price to earnings ratio can be used as a proxy for the value factor) and at Stockopedia we've built a framework for comprehensively analysing stocks using these five key factors. This makes it easy for investors to identify market-beating traits, without having to wade through the data.
The most powerful factor driving any stock is the “market” itself. When the stock market is rising, it creates a rising tide that lifts all boats. As Bill O'Neil once said, "at least 50% of the whole game is the general market". Of course, if you are happy to earn average returns, you can just go and buy the entire market using passive index-tracker funds. This is adequate for many investors.
But as you've got this far, you may well be interested in earning more than the market return. And as the following chart shows, you can find that by picking stocks that rank well for factors. Over the three decades since 1990, the returns to the top 10% of US stocks ranked for quality, value and momentum factors have significantly outperformed the market.
Learning to assess shares across these dimensions is one of the most powerful things you can do to improve your sixth sense as an investor.
To cut a long story short, profitable, cheap, strong stocks tend to beat the market. Let's find out how we can identify them.