OSAM Guide to Factor AlphaSM
BACKGROUND: We invest deeply in our in-house research, trading, and technology platforms and 100% of the research feeding our investment process is conducted internally. In most cases, our exhaustive study of fundamental investment characteristics leads us to redefine industry-standard metrics at the most granular level in order to boost the accuracy and strength of the signal. We’re fortunate to have a core team of Researchers & Technologists who all share a passion for, and background in, factor-based investing (visit our Blog archives for more background). As a result, OSAM is a living, breathing, evolving, team-based research project. This Guide is an overview of our findings.
Put simply: as factor investing experts, our mission is to help our clients build better portfolios. We believe that successful investing should meet these two criteria:
- Carefully researched & designed factor-based investment strategies in sync with investors’ objectives
- Steadfast discipline to stick with those strategies across market cycles and regimes
For almost 3 decades, our team’s research has been dedicated to identifying the characteristics that are most indicative of consistently strong total returns and risk-adjusted returns. Our bottom-up investment philosophy is rooted in the concept of Factor Alpha, which is characterized by the following fundamental beliefs:
- Factors drive returns. We study global market history, with an emphasis on individual stocks, to identify common themes among the most successful companies. Our unique application of Quality, Value, Momentum, and Yield factors results in unique portfolios and returns.
- What you don’t own matters. Factors should be applied from the bottom-up to build more concentrated portfolios, rather than “smart” indexes.
- Discipline wins. The investment process must be consistent and repeatable.
- Risk matters. We calculate stock positions with a mindfulness of risk groups.
- Continuous research improves results. Grounded in our research of the U.S. market dating back to 1927, and global market back to 1970, we seek innovative ways to continually improve our factor expertise.
We believe a multi-factor, hybrid themes approach, using historically proven factors, leads to long-term outperformance in equity markets. We use our factor expertise to identify and exploit market inefficiencies, enabling us to capture opportunities missed by other active managers and overlooked by passive investments.
Market Capitalization is a Weak Investment Factor
In the years following the financial crisis of 2008, passive investing has gained in popularity.1 Though passive investing might work okay in certain portfolios, we believe this conventional approach to indexing is gravely flawed.
If you believe in the power of exposure to robust investment factors other than just size, as we do, then indexing a portfolio based solely on market cap is philosophically challenging. In the chart below, we‘ve built hypothetical portfolios grouped by market cap, using S&P Compustat data. In this article, we’ll use an equally-weighted selection universe, which we call All Stocks.2 For comparison purposes, the All Stocks Universe — albeit equal-weighted — would be analogous to the Russell 3000® Index.3
Market Cap as a Factor — Excess Return vs. All Stocks
As it turns out, the majority of passive equity investments are focused on the two lowest-performing deciles shown above, which also happen to be the larger-cap stocks (deciles 9 and 10). What’s more, in rolling 5-year observations, those larger-cap stocks tend to underperform our All Stocks Universe more than half the time.4 Indeed, the odds of success are stacked against passive investors who choose passive, cap-weighted indexes.
OUR FACTOR-BASED INVESTING FRAMEWORK
Factors are often thought of in singular terms. Price-to-earnings is a single factor for identifying undervalued stocks; return on equity is a singular factor for identifying profitable firms. Reasonable investors selecting stocks would refuse to rely on these metrics in isolation because they know each characteristic has a unique set of strengths and weaknesses. Whereas much of the investment management industry has vigorously pursued naïve single-theme “smart beta” products, our themes get used within a robust framework for selecting stocks with a 360º view of a firm. Below, we discuss the theoretical underpinnings, nuances, and supporting empirical evidence for each of these themes.
Our multi-factor Value theme is the centerpiece of our investment framework. It’s a building block in every one of our strategies — even growth-oriented strategies. We believe that the price you pay for an investment is one of the most predictive characteristics of future alpha and is therefore the most deeply researched. Five underlying constituents comprise our Value theme, measuring the price paid relative to sales, operating cash flow, earnings, and free cash flow. We also include a metric for shareholder orientation called Shareholder Yield, which is the combination of dividends and buybacks.
As above, we’ll use a decile chart to summarize our research on the Value theme. It divides the All Stocks Universe into 10 groups of stocks based on valuation, ranging from cheapest (decile 1) to most expensive (decile 10). We evaluate each group on the basis of total return relative to our All Stocks Universe (excess return), risk-adjusted return (Sharpe Ratio), and consistency (Base Rates). Sure enough, the cheapest stocks outperform by 6.3% annually over the 53-year study. They also outperform on a risk-adjusted basis with a Sharpe ratio more than double the All Stocks Universe (0.74 vs. 0.33). Finally, the cheapest stocks are consistent outperformers. Over 636 rolling 3-year periods, the group outperforms 94% of the time. On the other end of the spectrum, the most expensive stocks (decile 10) underperform by 10.4%, have a worse Sharpe Ratio and only outperform the market in 14% of all rolling 3-year periods.
OSAM Value vs. All Stocks (1964–2016)
We believe that a firm’s orientation towards shareholders is extremely important. Management teams serve in two capacities for their shareholders: (1) generate profits and (2) allocate those profits as efficiently as possible for shareholder’s long-term benefit. In an analysis of corporate allocation over the past several decades, we have found that the most rewarding way to allocate capital is often to return it to shareholders. “Shareholder Yield” represents the two most tangible ways that management teams can align their interests with shareholders: (1) writing them a check in the form of dividends, or repurchasing their shares in the open market as buybacks. Shareholder Yield is the sum of a stock’s dividend yield and (2) the percentage of share buybacks over the prior 12 months.
Despite periodic bouts of negative press, share buybacks are a major component of corporate allocation policy that seems unlikely to disappear anytime soon. The popularity of buybacks has gradually increased ever since a 1982 SEC ruling which provided “safe harbor” for a corporate manager’s liability arising from lawsuits involving share price manipulation. In 2016, $743B in gross buybacks were executed by U.S. companies. For comparative purposes, dividend payments totaled $771B. Net of share issuance, buyback activity comes to $432B. As compared with the total U.S. market cap of $34.2 trillion, these amounts represent “yields” of 2.2% for gross buybacks, 1.3% for net buybacks, and 2.3% for dividends. Buybacks have even become structural components of management’s capital allocation tool kit.
From the perspective of an executive in the C-Suite, buybacks offer three key advantages not available through dividend payments alone:
- Share repurchases are non-taxable transactions. The ability to return capital without double-taxation on dividends accrues significant gains to shareholders.
- Buyback programs are flexible in magnitude, duration, and frequency. While stocks cutting their dividends are substantially penalized by investors, buyback programs are generally allowed to run their course without future expectation for distributions.
- Buyback programs, when executed under certain conditions, are accretive to shareholder wealth.
Combining the traditional dividend yield factor with buybacks (Shareholder Yield), we have found its signal to be effective regardless of cap ranges and geographies. It is especially effective as a stock selection factor in the large cap value space, and we commonly use it as a stand-alone factor there. Dividend Yield is also used as a stand-alone factor in equity income portfolios — and when paired with valuation and then applied globally, we’ve found its signal to be particularly effective.
Shareholder Yield vs. All Stocks (1964–2016)
The chart above summarizes our research on the theme of Shareholder Yield. Decile 1 represents the group of stocks rewarding shareholders with higher levels of dividends and buybacks; decile 10 shows companies that are generally not paying dividends and issuing shares.5
Markets are aggregators of information. Stocks with strong momentum (those that have recently appreciated the most) tend to continue to appreciate. Another interpretation would be that the market has recognized improving fundamentals of a particular stock and reward it accordingly. Conversely, stocks with poor momentum tend to continue to depreciate over time.
The challenge with momentum investing is that the “raw” momentum (e.g., 6-month or 12-month momentum) typically presented in academic literature can exhibit elevated levels of volatility relative to the market. The chart here is a handy illustration of that signal. The two stocks below have the same 9-month momentum but they’ve taken markedly different paths to get to their ultimate destination — one path resembles an EKG monitor, the other a purposeful walk up the stairs.
Volatility of Momentum6 (For illustrative purposes only.)
Investing based on raw momentum does not differentiate between these two stocks. We have found that by including in our momentum theme a metric that penalizes overly-volatile names, we can tame the raw momentum factor. Volatility is measured as the standard deviation of return over the prior 12 months. Historically, we have found that companies with volatile returns in the past tend to remain volatile in the future. Companies that have been stable performers tend to remain stable moving forward.
OSAM Momentum vs. All Stocks (1964–2016)
The chart above summarizes our research on the multi-factor theme of Momentum. Decile 1 is stocks with strong momentum; decile 10 is companies with weak momentum. As we did with the Value and Shareholder Yield themes, each group is evaluated on the basis of total return relative to our All Stocks Universe (excess return), risk-adjusted return (Sharpe Ratio) and consistency (Base Rates).7
Although the three themes above are exceptional methods with which to select stocks, risk-adjusted returns can be improved even more by incorporating an evaluation of stocks based on their quality. Far from esoteric minutiae, the quality characteristics we’ve chosen are fundamentally rooted in key management decision making about how capital is put to work, conservatism of accounting policies, and overall profitability. In our research, three themes have proven their efficacy: Financial Strength, Earnings Quality, and Earnings Growth. We use these themes to avoid stocks from eligibility in portfolio construction.
Our Financial Strength theme incorporates four factors which help to screen out companies that are improperly levered and/or overly reliant on outside sources of capital. Leverage is a double-edged sword — it provides additional capital for investment purposes, but it also places a burden on a firm’s ongoing operations. We have generally found that overly-levered firms and under-levered firms both tend to underperform. There is an “optimal” amount of leverage that characterizes stable firms. We pair our analysis of leverage with the overall direction of debt levels — rising or falling over the prior 12 months — and the level of debt in relation to cash flow. Finally, External Financing seeks to shy away from firms that rely on outside sources of capital (debt and equity issuance) to support their core business.
The Earnings Quality theme identifies companies where a divergence exists between cash flows and earnings. We seek to stay away from firms where management is using “creative accounting” methods to manufacture earnings. For example, depreciation would be expected to roughly match actual capital expenditures over the long term. Large deviations between the two could signal a significant write-down, or an earnings miss in the future when the imbalance is corrected — neither of which are good for shareholders. This theme is a forensic analysis of the ratios between balance sheets and income statements, avoiding companies that appear to use questionable accounting practices. Other examples of earnings manipulation could include revenue recognition, shifting of expenses, and/or improper inventory adjustments.
Switching from balance sheet strength and accounting choices, the Earnings Growth theme measures the trend in earnings and overall profitability relative to capital invested. This theme seeks to avoid firms with declining earnings that exhibit unexpected downside surprises, and poor profitability. Return on equity would be a more traditional metric to measure profitability . However, equity is not likely the best base from which to assess profitability. Companies that employ robust share buyback programs can sometimes exhibit super-normal profitability through the lens of ROE. To level the playing field across firms, we’ve instead chosen return on invested capital, which includes total firm capital — not just equity — to be a more representative metric.
Folding these three multi-factor “quality” composites into our strategies is intuitive because they improve stock selection based on Value, Momentum, and Yield. Some companies are cheap for a reason. Some companies initiate buybacks when their stock is expensive. And some momentum names are based on headlines and stories rather than the underlying fundamentals of the company. Imagine a choice between two cheaply-valued companies: the first one has declining debt, rising earnings, and a solid balance sheet whereas the second one has burgeoning debt, declining earnings, and fishy-looking financial statements. Common sense dictates that you should avoid the second one, which our quality overlay helps to accomplish.
The trio of tables below helps illustrate the payoff for the elimination of poor quality relative to each of our primary Value, Momentum, and Yield selection themes. From a group of stocks (top quintile) that rank highly on each of our selection themes, we then split out the group based on Financial Strength, Earnings Quality, and Earnings Growth. In every case, poor-quality stocks underperform their higher-quality counterparts.8 Suffice it to say, incorporating quality into constructing portfolios is compelling.
Bivariate Analysis — Interaction of Quality & Selection Themes
% Annualized Return (1964–2016)
HELPING TO BUILD BETTER PORTFOLIOS
We use our customized themes as the building blocks of our investment strategies, consistently aligning them with attractive factor profiles. As stated above, what you don’t own matters. Screening out firms using the quality themes, and then focusing in on stocks with the highest scores, historically delivers substantial alpha.
We believe a hybrid of our multi-factor quality and selection themes can greatly contribute to long-term outperformance. We’re active investors — so we meticulously research our models from the most granular level, set them, and remain faithful to the process through good and bad times. As such, we often see investments generate strong live-time results despite running contrary to the market’s narrative.
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- Conventional indexes are designed to capture the performance of the market. As such, the weighting of individual stocks within the index is by market capitalization. The larger the stock, the greater its weight in the index, also implying the greatest influence on the return of the overall index. In other words, traditional passive investing is “a bet on market capitalization as an investment factor.”
- The All Stocks Universe consists of stocks listed on U.S. exchanges with a market cap greater than an inflation-adjusted $200 million, excluding Utilities and REITs. Every stock under consideration receives the same weight. This selection universe serves as the benchmark for our themes’ excess returns.
- The Russell 3000® measures the performance of the largest 3,000 U.S. companies, representing approximately 98% of the investable U.S. equity market.
- The largest-cap stocks (decile 10) underperform the All Stocks Universe 60% of the time. The second-largest (decile 9) underperforms 52% of the time.
- As we did with the Value theme, we evaluate each decile group on the basis of excess return vs. our All Stocks Universe, risk-adjusted return (Sharpe Ratio), and consistency (Base Rates). The chart shows that the stocks with high Shareholder Yield outperform over the study by 3.8% annually. They also outperform on a risk-adjusted basis with a Sharpe Ratio double the All Stocks Universe (0.64 vs. 0.32). Lastly, they are consistent outperformers. Over 636 rolling 3-year periods, the group outperforms 80% of the time. On the other end of the spectrum, the lowest-yielding stocks (decile 10) underperform by 7.7%, have a worse Sharpe Ratio, and only beat the universe in 10% of the rolling 3-year periods.
- Source: Bloomberg
- Stocks with strong momentum (decile 1) outperform the All Stocks Universe over the study by 4.6% annually. They also outperform on a risk-adjusted basis with a 0.58 Sharpe Ratio — double the universe’s 0.26. Finally, they are consistent outperformers. Over 636 rolling 3-year periods, the top group outperforms 91% of the time. On the other end of the spectrum, stocks in decile 10 underperform by 8.7%, have a worse Sharpe Ratio, and only outperform the market in 10% of the rolling 3-year periods.
- Generally, the spread between what we consider high and low quality in our 5-decade study is anything greater than 3%.