Why does does factor investing work over some time periods, but not others? What causes the market to correct? We can find the answers by decomposing the drivers of value and momentum performance over time. Its really a simple analytical exercise, but not many people have done it. Investors who take this step are about to find a massive new opportunity set opening up.
How Factors Work
The basic reason why the value factor and the momentum factor can both lead to successful investments makes intuitive sense. The market tends to overshoot on both the upside and the downside. O’Shaughnessy Asset Management summarized it this way in Factors From Scratch :
The excess returns associated with Value and Momentum result from convergent and divergent processes, respectively. Value stocks are systematically underpriced and gradually converge on their fair value over time. Momentum stocks start out fairly valued or slightly overvalued, and go on to become more overvalued in the short-term, before reverting back. Both styles represent a market mistake that can be captured as alpha.
To capture this alpha we need to zoom in on the individual drivers of stock prices.
Decomposing Factor Returns
The price of any security can be decomposed into changes in corporate performance and changes in the valuation multiple placed by the market on that measure.
For example, the most popular measurement is the price/earnings ratio:
P= P/E * E
With a little further math you can back out additional sub components from the income statement. All it takes is a bit of Standard CFA Level 1 work.
Similar logic applies regardless of what metric you prefer. In some industries it might make more sense to use Enterprise value(Market Cap+Market value of debt – Cash), and compare it to other measures such as EBIT, EBITDA, or revenue. For example real estate investors might use funds from operations(FFO).
By tracking the changes in multiples and earnings(or other performance metrics) for value and momentum stocks its possible to see what drives investor returns over time. More importantly, decomposing factor returns makes it possible to see when the market might be missing something.
Value has worked historically because the market overestimates future deterioration of earnings for “cheap” stocks. The market overreacts to negative news. However, over time earnings decline less than expected and as a result P/E multiples expand. QMA finds this is the standard path for value stocks over time.
QMA and the Value Factor Opportunity
In a provocative recent paper: Value Vs. Growth: The New bubble, QMA looked at the data for Russell 1000 stocks and showed mathematically just how weird the market has been acting lately. In the past two years, value stocks have had earnings expand andmultiples contract. This is the exact opposite of historical norms for value factor investing.
Historically, overreactions like this have led to massive corrections. Following the Tech Bubble and GFC, corrections were in excess of +30% for value factors!
In the paper, QMA outlined some possible catalysts that could lead to a value rebound. However timing is uncertain. And markets are never in equilibrium, so there are always situations like this somewhere. Value stocks will overshoot in the other direction eventually setting up the opposite opportunity. Separating out the value drivers makes these opportunities easier to find.
Furthermore, the analytical skill sets necessary to forecast the different drivers of factor investing returns can be quite different. Correctly forecasting either value driver one can be lucrative. Yet sometimes these value drivers cancel each other out. In this quantamental age, investors are able to use alternative data tools to zoom in to ever more granular insights.
Investors need to find the right derivatives trade to profit and protect capital under all possible scenarios. The right tools make it possible to achieve outsized returns from focusing on individual drivers of factor returns.
If your research process gives you a very specific edge, shouldn’t you invest accordingly?
Earnings As an Asset Class
Earnings Derivatives® turn earnings into an investable asset class.The same tool works for other individual metrics such as Revenue, EBITDA and Operating income. This makes it possible to invest in value drivers individually, and hedge stock portfolios that are heavily exposed to one factor. BLX Global Indexes extend this idea to industries, sectors, and themes.
For more information about how Earnings Derivatives® open up new frontiers for factor investing, sign up below: