The Five Core Investment Factors Explained - Size, Value, Momentum, Profitability and Investment

These are the drivers of your portfolio performance. Choose well.

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I previously wrote about factor investing. Even if you choose to focus on one or two factors, it is instructive to learn what factor investing is and why we should be aware of it when we choose our investments.

The five core investment factors are Size, Value, Momentum, Profitability and Investment. These factors can independently give you an edge in the market. However, recognize that these factors do not all perform at the same time. Therefore a portfolio that blends multiple factors will tend to do better over time than a market portfolio or focusing on just one factor alone.

For even better results, take advantage of the Shannon's Demon.

So What are these Investment Factors Anyway?

Investment factors are characteristics that help explain the differences in returns among various investments. Factor investing is a strategy where you select securities based on these characteristics, with the goal of improving your risk-adjusted returns.

This approach isn’t new; it's rooted in decades of academic research. You may have heard of the famous study by economists Eugene Fama and Kenneth French in 1992. They introduced the "Three-Factor Model," which identified size, value, and market risk as key drivers of returns. Since then, further research has expanded the list of factors to include Momentum, Profitability, and Investment, giving you more tools to refine your investment strategy. Frankly, more than 600 factors have been identified so far, but most are transient. These 5 have stood the test of time.

Factor investing is a practical, evidence-based approach you can use to enhance your own investment returns. By incorporating factors into your strategy, you gain a deeper understanding of why certain stocks perform better than others, allowing you to build a more resilient and potentially more profitable portfolio.

Let's look at each of these 5 factors one at a time.

Factor 1: The Size Factor

You might have heard that smaller companies tend to deliver higher returns over time compared to their larger counterparts. This phenomenon is known as the "small-cap premium," and it’s one of the most well-established investment factors out there.

Small-cap stocks are typically defined as companies with a market capitalization between $300 million and $2 billion. Historically, these smaller firms have outperformed larger ones over the long run. It might seem counterintuitive – after all, wouldn’t big, established companies be safer and more profitable? But smaller companies have greater potential to grow, which is why they can deliver bigger returns.

Why the Size Factor Works

So, why do small-cap stocks tend to do better? Here are a few reasons:

- Higher Growth Potential: Small companies have more room to expand, innovate, and capture new markets. Think of them as young plants with plenty of space to grow.

- Market Inefficiencies: Small-cap stocks are often under the radar of Wall Street analysts and big investment firms. This lack of attention means that their prices can be more inefficiently set, giving savvy investors like you the chance to find hidden gems.

- Risk Premium: Because smaller companies are often riskier, investors demand higher returns for taking on that extra risk. This risk premium is what can lead to those higher long-term gains.

How to Apply the Size Factor to Your Portfolio

If you want to add the size factor to your investment strategy, consider allocating a portion of your portfolio to small-cap stocks. You don’t need to go all-in – even a small allocation can make a noticeable difference in your returns over time. You can start with individual stocks or choose a small-cap-focused ETF, such as the iShares Russell 2000 ETF (IWM), which tracks an index of smaller companies.

Before you dive into small-cap investing, remember that these stocks can be more volatile and prone to bigger swings than large-cap stocks. They may also struggle more during economic downturns, so make sure you’re prepared for a bumpy ride if you decide to add them to your portfolio.

Factor 2: The Value Factor

The value factor involves investing in companies that appear to be undervalued based on fundamental metrics like earnings, cash flow, or assets. In other words, you’re looking for stocks that the market has overlooked or misunderstood, and you’re buying them at a discount. Over time, as the market realizes these stocks are worth more than their current price, their price increases to approach the intrinsic value, and you profit.

Why the Value Factor Works

Why does value investing work? There are a few key reasons:

- Market Overreactions: Investors can be irrational, overreacting to bad news or short-term setbacks. This often pushes the price of a solid company’s stock well below its actual worth, giving you a chance to buy it on sale.

- Behavioral Biases: Many investors chase the latest trends or hype, ignoring fundamentally sound companies that don’t have the same buzz. This creates opportunities to find value in stocks that others have overlooked.

- Mean Reversion: Stock prices tend to revert to their intrinsic value over time, meaning that undervalued stocks often bounce back to reflect their true worth.

How to Apply the Value Factor to Your Portfolio

To take advantage of the value factor, you’ll want to look for stocks that are cheap based on metrics like P/E ratio, P/B ratio, and perhaps a high dividend yield. Typically finding these stocks requires deep research as the market is generally efficient in erasing the price-value gap whenever it exists. Your best bet is to have more specific knowledge about the business or the company than most analysts in the market, and then use this knowledge to find insights that tell you something the market is not properly understanding.

There are value-focused ETFs, such as the Vanguard Value ETF (VTV) or the iShares S&P 500 Value ETF (IVE), that can give you exposure to a diversified basket of value stocks. However, please note that these ETFs work based on the standard valuation metrics and will not give you stocks that are fundamentally misunderstood (these are the stocks that generate highest returns for the investors)

Value investing isn’t a quick win. It often requires patience because it can take time for the market to recognize a stock’s true value. Also, not every cheap stock is a good deal – sometimes they’re undervalued for a reason, such as poor management or declining business prospects. This is often called a "value trap," and it’s something to watch out for.

Factor 3: The Momentum Factor

The law of inertia is alive and well in the stock market. It has been observed that stocks that are going up generally continue to go up. Reverse is also true: declining stocks continue to decline until some significant event occurs that reverses the trend.

The momentum factor focuses on buying stocks that have shown strong performance over the last 6 to 12 months and avoiding (or even selling) those that have been lagging. It’s based on the idea that stocks that have gone up in price tend to keep going up, while those that have dropped often continue their decline. By riding the wave of the market's winners, you can potentially capture some impressive gains.

Why the Momentum Factor Works

You might be wondering why this strategy works. After all, shouldn’t the market be more efficient? Here’s why momentum investing often pays off:

- Behavioral Biases: Investors are human and can be slow to react to new information. When good news about a company comes out, some investors hesitate to buy in right away, which allows momentum to build as more people gradually pile in.

- Herd Mentality: As people notice a stock performing well, they tend to jump on the bandwagon, driving prices even higher. This collective behavior reinforces the momentum effect.

- Underreaction and Overreaction: Investors often underreact to positive news, allowing prices to drift upward over time. Conversely, when a stock starts rising rapidly, others tend to overreact, pushing it even higher.

How to Apply the Momentum Factor to Your Portfolio

To leverage the momentum factor, you should look for stocks that have been performing well over the last 6 to 12 months. Tools like stock screeners can help you identify these top performers, or you can take a more hands-off approach by investing in momentum-focused ETFs such as the iShares MSCI USA Momentum Factor ETF (MTUM).

You can also use momentum as a complement to other factors. For example, combining momentum with the value factor can help you avoid holding onto stocks that are cheap for a reason – those that are simply stuck in a downward trend.

Momentum investing can be a double-edged sword. While it can deliver strong returns, it’s also more prone to sudden reversals, especially in volatile markets. Stocks riding high can come crashing down just as quickly, so you need to be prepared for potential swings. Additionally, momentum investing tends to have higher transaction costs because you’re frequently buying and selling, which can eat into your profits if you’re not careful.

Factor 4: The Profitability Factor

The profitability factor zeroes in on companies with strong earnings, stable cash flow, and efficient use of their assets. It’s all about finding quality businesses that consistently generate profits, which tend to outperform over the long term. These companies are often more resilient, better able to weather economic downturns, and have a competitive edge that allows them to keep growing. Profitability Factor is also referred to as the Quality Factor.

Why the Profitability Factor Works

You might be wondering why profitable companies tend to do better. Here’s why this factor is so powerful:

- Financial Strength: Companies with high profitability are usually more stable and have better access to capital, allowing them to invest in growth, pay dividends, or buy back shares.

- Competitive Advantage: Profitable companies often have something special – whether it’s a well-known brand, a unique product, or an efficient operation – that allows them to stay ahead of the competition.

- Investor Preference: Investors are naturally drawn to companies that make money. This consistent demand helps drive up the stock prices of profitable firms over time.

How to Apply Profitability Factor to Your Portfolio

To identify profitable companies, you’ll want to look at metrics that measure how efficiently a business generates profits. Some of the key indicators include Return on Equity, Gross Profit Margin and Return on Assets. Please note that many of these metrics are also important in identifying great value stocks.

For a simple way to invest in profitable companies, consider an ETF that focuses on profitability, such as the iShares MSCI USA Quality Factor ETF (QUAL), which targets companies with high ROE, stable earnings growth, and low financial leverage.

While profitability is a sign of a healthy business, it’s not a guarantee of future success. Profitable companies can still face challenges, such as increased competition or shifts in consumer demand, that can affect their earnings. Additionally, highly profitable companies often have higher stock prices, which means they can be more vulnerable to price drops if they miss earnings expectations or face setbacks.

Warren Buffett famously moved from strict value criteria to buying stock in quality companies. One way to control the risk of eroding profitability over time is to insist on the presence of an economic moat - for example, a strong brand, monopoly powers, or powerful executing or strong barriers to entry. This moat ensures that the company continues to earn outsize profits in the future so the stock will continue to trade at a premium.

Factor 5: The Investment Factor

Rapid growth is a potent killer. Investors in the tech IPOs are wary of the cash burn and other red flags. This malaise can affect established companies as well.

The investment factor targets companies that invest their resources wisely, particularly those that exhibit low asset growth. In simple terms, it’s about favoring businesses that are cautious about how they reinvest their profits, expand their operations, or acquire new assets. Studies have shown that companies with more disciplined, lower levels of investment tend to outperform those that aggressively pour money into expansion or acquisitions.

Why the Investment Factor Works

Here’s why the investment factor has proven to be a valuable strategy:

- Efficient Use of Capital: Companies that invest conservatively tend to be more disciplined and selective, focusing only on projects with high returns. This careful approach often leads to better profitability and shareholder returns.

- Avoiding Overexpansion: Companies that aggressively invest in new projects or acquisitions often end up overextending themselves, diluting their returns or taking on too much risk. In contrast, companies that invest wisely avoid this trap and maintain a stronger financial position.

- Market Underestimation: Investors often overlook the benefits of conservative investment practices, which can lead to undervalued stocks with solid long-term potential.

How to Apply the Investment Factor to Your Portfolio

To capitalize on the investment factor, look for companies that show steady, controlled growth. You can identify these companies by focusing on metrics such as asset growth, Capex relative to revenue, and free cash flow growth.

If you want to incorporate this factor into your investment strategy without manually analyzing individual companies, consider investing in ETFs that focus on this approach, such as the Invesco S&P 500 Quality ETF (SPHQ), which includes companies with strong balance sheets and prudent investment practices.

While the investment factor can help you find companies that are efficient with their capital, it’s not a foolproof strategy. Sometimes, companies with low investment levels might miss out on growth opportunities, or they could be struggling to find profitable ways to reinvest their profits. Additionally, this factor might underperform during periods when aggressive growth strategies are in favor, such as during economic booms.

Combining the 5 Factors

Since most factors perform in cycles and these cycles do not always match up, investing in a single-factor portfolio is not always the best idea. The real power of factor investing comes from blending these factors into a well-rounded, diversified strategy that leverages their unique strengths while minimizing their weaknesses.

Why Use Multiple Factors?

No single factor works perfectly all the time. Markets change, investor behavior shifts, and what works in one year might underperform the next. By combining multiple factors, you can smooth out your returns and reduce the impact of any one factor's downturn. Think of it like building a balanced diet for your portfolio—each factor provides something different that helps you stay healthy as an investor.

Building a Multi-Factor Portfolio

Certain factors work exceptionally well together. For example, combining Value and Momentum can help you avoid buying "cheap for a reason" stocks by ensuring that they’re not just undervalued but also on an upward trend. Meanwhile, combining Profitability with the Investment factor helps you zero in on high-quality companies that allocate their capital wisely.

If you want an easy way to implement a multi-factor strategy, consider investing in ETFs that are specifically designed to capture multiple factors. Funds like the iShares Edge MSCI Multifactor USA ETF (LRGF) offer exposure to a blend of factors, giving you a balanced approach without the hassle of picking individual stocks.

If you invest in individual factors yourself, decide how much weight to allocate to each factor. You can spread your investments evenly across the factors, or you can adjust based on your risk tolerance and market outlook. For instance, if you’re more risk-averse, you might want to lean more heavily on Profitability and Investment factors for their stability, while more aggressive investors might prefer a larger allocation to Size and Momentum.

Monitoring and Adjusting Your Multi-Factor Portfolio

Once you’ve built your multi-factor portfolio, it’s crucial to monitor it regularly. Factors go through cycles, and your portfolio’s exposure might drift over time. Consider rebalancing periodically (e.g., annually or semi-annually) to make sure you’re maintaining the right mix and staying true to your strategy.

Here at Astute Investor's Calculus, we keep different factors in mind when constructing our portfolio. We primarily target small cap and value but we are not averse to taking a position in momentum if the opportunity exists (please note that value and momentum tend to negatively correlate - when value is in vogue, momentum is not and vice versa). As a result, we build a small concentrated portfolio that is high on performance and low on volatility.