Factors are Not Commodities
(Part 1 of 2)
“A man with two watches is never sure [what time it is].”
—Segal’s Law excerpt (see below)
The narrative put forth by “smart beta” products is that factors are becoming an investment commodity. Factors are not commodities — rather, they are unique expressions of investment themes. The uniqueness of one Value strategy from another can lead to very different results, and there are many places that factor-based portfolios can diverge. So the difficulty for asset allocators is identifying exactly where and how these factor strategies differ one from another, even when they all claim to use the same themes of Value, Momentum, and Quality.
Over the past couple of years, several multi-factor funds that combine Value, Momentum, and Quality were launched. As these products compete to garner assets, price competition has started among rivals. In December, Blackrock cut fees to its smart beta ETFs1 to compete with Goldman Sachs, which has staked out a cost leadership position in that market space. Michael Porter, the expert in competitive strategy, wrote in 1980 that there are three generic strategies that can be applied to any business for identifying a competitive advantage: cost leadership, differentiation, or focus.2 Cost leadership can be an effective strategy, but the key to any price war is for the products to be near-perfect substitutes for one another, just like commodities. This article focuses on how quantitative asset managers can have significant differences — in factor definitions, in combining factors into investment themes, and in portfolio construction techniques — leading to a wide range of investment experiences in multi-factor investment products.
Factor Definition Discrepancies
Value investing through ratios seems to be very straightforward. Price-to-earnings ratios (P/E) are widely accepted as a common metric for gauging the relative cheapness of one stock versus another. Asquith, Mikhail, and Au’s “Information Content of Equity Analyst Reports” found that 99% of equity analyst reports use earnings multiples in analyzing a company. P/E ratio is used widely because it’s straightforward and makes intuitive sense: as an equity owner you are entitled to the residual earnings of the company after expenses, interest, and taxes. Simply put, P/E tells you how much you’re paying for every dollar of earnings.
Getting a P/E ratio is easy as opening up a web browser and typing in a search. But if you’ve ever compared P/E ratios from multiple sources, you can get a variety different numbers for the same company. For example, take a look at Allergan (NYSE: AGN). As of January 12, 2017, Yahoo! Finance gave AGN a P/E of 6.06. But Google Finance gave it 15.84. And if you have access to a Bloomberg terminal, Bloomberg cranked up AGN’s P/E to a whopping 734. Meanwhile, FactSet doesn’t even have P/E ratios in its database. Given all the latter nuances, you might feel like you’re stuck in Segal’s Law: “A man with a watch knows what time it is. A man with two watches is never sure.”3
These discrepancies happen because there are many different ways to put together a P/E ratio. One way could use earnings per share divided by the price of the stock. If so, should “basic” or “diluted” EPS be used? There’s a difference if you switch to the LTM Net Income divided by the total Market Cap of the company, as shares can change over a given quarter. But the reason for Allergan’s different ratios is that some financial information providers use bottom-line earnings while others take Income before Extraordinaries and Discontinued Operations. In August 2016, Teva (NYSE: TEVA) acquired Allergan’s generics business “Actavis Generics” for $33.4 billion in cash plus 100 million Teva shares, generating earnings of $16 billion from Discontinued Operations. After unwinding this, the company actually lost $1.7 billion in 3Q16 — hence no P/E ratio. Depending on whether or not an adjustment is made on this, Allergan would be positioned either as a cheapest percentile stock based on its Earnings Yield (inverse of the P/E ratio) or all the way down into the 94th percentile.
Accounting adjustments for Extraordinaries and Discontinued Operations aren’t the only item affecting an earnings ratio. When considering earnings, you really want to measure the available economic surplus that flows to the holder of the common equity. If preferred stock exists, it supersedes the claims of common shareholders. Fannie Mae (OTC: FNMA) is a great example of how preferred dividends can absorb earnings from common shareholders. During the 2008 crisis, Fannie Mae issued a senior tranche of preferred stock that is owned by the U.S. Treasury, and is paying a $9.7 billion dividend of the company’s $9.8 billion in earnings. There is a junior preferred tranche held by investors like Pershing Square and Fairholme Funds — they are currently not receiving dividends and are submitting legal challenges to receive some portion of the earnings. This leaves common shareholders behind a long line of investors with prioritized claims on earnings. But some methodologies’ adjusted earnings take preferred dividends after earnings, while others do not, creating a difference in having a P/E of 2.3 (an Earnings Yield of 43%) or a P/E of 185 (Earnings Yield of 0.5%).
These comments are not about the cheapness of Allergan or Fannie Mae. Instead, it shows the importance of your definition of “earnings” and the adjustments you apply. If these considerations sound like fundamental investing, it’s because they are. Fundamental analysts consider these adjustments in the analysis of a company. Factor investors work through the same accounting issues as fundamental investors, with the additional burden of trying to make systematic adjustments to create a stronger metric that acknowledges the accounting differences across thousands of companies. Investing results can vary greatly based on these adjustments. In the U.S. Large Stocks Universe,4 there is a +38bps improvement on the highest decile of Earnings Yield if you adjust for Discontinued Items, Extraordinaries, and Preferred Dividends. To set some comparative scale using eVestment’s peer analysis, the difference between a median manager and a top quartile manager is +60bps a year.
Price-to-Earnings — Cheapest Decile
(Excess Return vs. Large Stocks)
Adjustments to Value signals are not limited to price-to-earnings. Book Value can be adjusted for the accounting of Goodwill and Intangibles. Dividend yield can be calculated using the dividends paid over the trailing 12-months, or annualizing the most recent payment. In 2004, Microsoft paid out $32 billion of its $50 billion in cash in a one-time $3 per share dividend when the stock was trading at around $29. Knowing that future investors won’t receive similar dividend streams, should that dividend get included in calculating yield?
Differences in signal construction are not limited to Value factors. Momentum investors know that there are actually three phenomena observed in past price movement: short-term reversals in the first month, medium-term momentum over the next 12 months, and long-term reversals over a 3- to 5-year period. Put two Momentum investors in a room and they will disagree over whether to delay the momentum signal by one month to avoid reversals, the 12-months minus one-month. Quality investors argue the use of non-current balance sheet items, or the loss of effectiveness in investing on changes in analyst estimates. Volatility can be measured using raw volatility, beta, or idiosyncratic vol, to name just a few methods.
Factors are constructed as “unique expressions of an investment idea” and are not the same for everyone. Small differences can have large impact on which stocks make it into the portfolios. These effects are even more significant when using an optimizer (potentially maximizing errors) or when concentrating portfolios (thereby giving more weight to individual names).
There is skill in constructing factors — far beyond simply grabbing a P/E ratio from a Bloomberg data feed.
Next, having established the importance of ironing out factor definition discrepancies, we’ll explore how to build stronger portfolios using the signals.
Go to Part 2…
- See https://www.bloomberg.com/news/articles/2016-12-19/blackrock-cuts-fees-on-etfs-as-price-war-moves-to-smart-beta
- See Competitive Strategy, Free Press, New York. The book was voted the 9th most influential management book of the 20th century in a poll of the Fellows of the Academy of Management.
- From Arthur Bloch’s Murphy’s Law (2003).
- The universe of Large Stocks consists of all securities with inflation-adjusted market cap greater than the universe average. The stocks are equally-weighted and rebalanced periodically.