Super Stocks: Why multi-factor stock selection offers higher returns at lower risk

Regardless of what the marketing departments at some major fund management firms might like you to think, the concept of ‘factor’ investing has been around for decades. The characteristics of Quality, Value and Momentum have long been credited as a source of some of the strongest returns in the stock market - it’s an open secret. But despite evidence from academics and high profile investors who have successfully used these factors, most individual investors fail to do the same. Part of the problem is that despite making so much sense, there are strong behavioural and risk based reasons why many of us struggle to apply them properly.

To understand how and why Quality, Value and Momentum work so well together, it’s worth exploring some of the history of these factors. The case for buying good quality stocks that are undervalued dates back at least as far as Benjamin Graham’s 1934 book, Security Analysis. He’d witnessed at first hand the consequences of chasing stocks on stretched valuations and then watching them tumble as confidence evaporated in the 1929 crash. The young Graham nearly lost everything and so built a new Value philosophy that aimed to buy assets as cheaply as possible.

Fast forward nearly 80 years and Graham still has a following that boasts some of the most respected and successful investors around. The likes of Warren Buffett, Seth Klarman and a multitude of fund managers subscribe to the power of buying stocks when they’re underpriced. In turn, each of them applies different standards of Quality to the stocks they assess.

But while value investing has a rich heritage, most agree that it’s a strategy at odds with the behavioural preferences of most investors. Buying unloved, potentially broken businesses that no-one else wants is difficult to stomach and prone to periods of underperformance - even if they are good quality firms. Yet, with patience, Graham’s principles remain just as powerful as they ever were. Buffett observed precisely this in his now legendary paper, The Superinvestors of Graham and Doddsville^[1]. So while buying exciting growth shares might seem to be much more palatable, it’s nowhere near as profitable, if at all.

Next, there’s the self-perpetuating nature of positive price momentum. This has been a much more recent observation, and one that’s largely been driven by quants. Over the past 20 years, finance professors and hedge fund practitioners have explored the phenomenon that stock prices that have risen the most have a tendency to maintain momentum - continuing on the same trajectory typically for up to 12 months, and sometimes longer.

Historically, momentum has suffered short, sharp periods of reversal, particularly in bear markets. But in terms of investor behaviour, the biggest barrier to trading on momentum is that it  means buying stocks that may have already risen sharply in price - an idea that most investors hate. Ironically, this psychological hurdle is one of the reasons why momentum works. Investors in a stock that’s already risen in price, can be slow at pricing-in further good news about it. This leads to a share price that drifts upwards over time, much slower than it might do otherwise.

Josef Lakonishok, one of the key figures in momentum research (and a fund manager in his own right) credits the behavioural errors of investors as a reason why momentum works so well. He believes investors have ‘a tendency to extrapolate the past too far into the future, to wrongly equate a good company with a good investment irrespective of price, to ignore statistical evidence and to develop a “mindset” about a company.’

So, to summarise, investors have a tendency to see value stocks as risky, quality stocks as boring and momentum stocks as scary. Who on Earth would want to buy stocks with this type of profile?

Modern day multi-factor strategies

Blending factors to figure out the most influential drivers of success in the stock market is nothing new. One of the most famous is the Fama-French^[2] three-factor model, which was published in 1993. That pinpointed stock size, value and market risk as the most important factors. Since then, though, a huge amount of research has been done to assess every conceivable variable that might influence returns and prove that markets are not efficient at pricing shares.

A giant in this field was the late Robert Haugen. As a critic of efficient market theory, Haugen spent years studying market data to model the profile of the ideal stock. In his book, The Inefficient Stock Market - What Pays Off and Why^[3], he introduced Super Stocks.

Haugen’s detailed modelling had uncovered some quite staggering results^[4]. He found that the 10 percent of stocks with highest expected return, in aggregate, were low risk and highly profitable, with positive trends in profitability. They were cheap relative to current earnings, cash flow, sales, and dividends. They had relatively large market capitalisation and positive price momentum over the previous year.  He wrote, “this is a dream profile, the profile of a stock you would love to own.”

By contrast, the 10 percent of stocks with the lowest expected return had exactly the opposite profile to Super Stocks. These low quality, expensively priced, deteriorating shares he christened Stupid Stocks. Our own research at Stockopedia has highlighted how attractive this profile of “stupid” stock is to individual investors.  We believe the attraction comes down to the fact that we’re hard wired to empathise with the optimistic stories that surround these companies.  As a result in the Stockopedia lexicon we have rechristened this poor profile as Sucker Stocks.

Haugen’s work was part of a new generation of research into the power of multi-factor models. Routinely, these studies have concluded that Quality, Value and Momentum used together can be highly effective.

What the experts say

Value and Momentum have long been paired as powerful, uncorrelated drivers of stock market returns. Research by a quant team lead by Cliff Asness (formerly of Goldman Sachs, now at AQR Capital) explored this theme in a 2012 paper called Value and Momentum Everywhere^[5]. It showed how the two factors can very effectively smooth returns over time. In a later study, AQR showed how the addition of Quality could produce superior returns when combined with Value and Momentum. They noted:

We have found that three styles are particularly useful in actively managed long-only equity portfolios: value, momentum and profitability. Ample evidence shows that each of these styles can generate long-term excess returns on its own — and go a long way toward explaining why some portfolio managers excel — but research suggests that these styles work even better when united.

In 2012, US finance professor Robert Novy-Marx published a paper taking a detailed look at the interplay between Quality and Value in investing. His research considered the essence of what is meant by Quality and how it influences Value investing strategies. He concluded that a combination of factors was preferable:

Over time, tilts towards value, momentum and profitability have outperformed the market, and due to the diversification benefits, a combined portfolio of these three has provided much higher reward per unit of risk and a significant reduction in extreme risk or losses.

Financial academics and quant statisticians continue to argue in favour of blending Quality, Value and Momentum factors. Among them, the equity research teams at investment banks like Credit Suisse and Societe Generale, among others, have modelled investment strategies based on very similar multi-factor approaches.

Digging into QVM

In general terms, a Quality company is one that is highly profitable (ROCE, ROE, GPA) with high industry leading margins, stable, growing and ideally accelerating sales and earnings, with a strong and improving fundamental trend (F-Score), a good shareholder payout (Yield, Buybacks) without having any risky red flags (e.g. Bankruptcy risk, Earnings Manipulation Risk or Share price volatility).

When it comes to valuing a stock, the most common measures focus on what a company earns or what it owns. Therefore, the most frequently used valuation ratios compare the share price to earnings, book value, cashflow or sales. Alternatively, it may look at the earnings yield or even the dividend yield.

A Momentum stock is one whose share price is up or above its 52 week highest price, is within the top 20% of share price percentage winners for the last 6 or 12 months (using Relative or Absolute Price Strength), is beating broker estimates (earnings surprise) and seeing estimate upgrades and recommendation changes.

What we can learn from Super Stocks

A compelling reason for looking closer at Quality, Value and Momentum in stock market investing is that decades of research shows that stocks with high exposure to these factors are often overlooked. Investors are generally predisposed to stories, good news, popularity, and excitement. They veer away from shares that appear to be troubled, staid or have seen their prices rise in the recent past. Yet it’s precisely this profile of stock that tends to win in the stock market.

Perhaps it’s best to leave you pondering this point with a marvellous quote from Teddy Roosevelt:

Nothing in the world is worth having or worth doing unless it means effort, pain, difficulty… I have never in my life envied a human being who led an easy life. I have envied a great many people who led difficult lives and led them well.