Chapter 1

Counting on Factor Investing

IN THIS CHAPTER

Understanding what factor investing is

How factor investing can benefit you

Identifying the various factors used

In recent years, the strategy approach of factor investing has been catching on and it may be something that could boost your personal approach in the financial markets. Factor investing takes into account decades of portfolio experience and market research regarding effective approaches to portfolio management that can remove the guesswork about which types of securities are best able to meet a particular investor's needs.

Perhaps the simplest explanation for factors is that they can act like guard rails in your portfolio management choices. The growth in factor investing's popularity is evident in the world of portfolio management. Financial assets managed under the mantle of factor investing grew from under $400 billion in 2013 to exceeding US $1.2 trillion in 2021. In this chapter, you see what the appeal is.

The Essentials of Factor Investing

Factor investing is an investment portfolio general strategy that favors a systematic approach utilizing factors or "shared characteristics" of individual stocks (and other assets such as bonds) that have a historical record of superior risk and return performance.

These factors can range from individual characteristics such as the company's sales (revenue indicated on the company's income statement) or debt (total liabilities indicated on their balance sheet) to their performance in macro environments such as inflation or economic growth. A factor is a trait or characteristic that can explain the performance of a given group of stocks during various market conditions.

There are two main categories of factors: style and macroeconomic factors. (Both of these are covered later in the section "Introducing the Factor Groups.")

• Style factors seek to identify the relevant characteristics of the individual securities (sometimes referred to as microeconomic traits or characteristics). Examples are the stock's volatility, market size, and valuation.
• Macroeconomic factors refer to the general market's environmental and economic aspects. Examples are GDP (Gross Domestic Product) growth and inflation (for more details, see chapter 11).

Introducing the Factor Groups

There are two main category types of factors: style (sometimes referred to as microeconomic) and macroeconomic. Style factors are associated with the company (or investment vehicle) itself while macroeconomic factors are about the company's economic environment. In both cases, the factors act as drivers for the returns (for the company's stock appreciation, for example) for that particular asset.

Style factors

Style factors take into account characteristics of the individual asset such as its market size, value and industry/sector, volatility, and growth versus value stocks. Style factors help to explain or identify characteristics that drive that asset's price performance in the marketplace.

These factors are also referred to as microeconomic because they are an individual security or asset that drives its performance as a singular member or participant of the overall market and economy.

Value

Looking at value means typically looking at the company's fundamentals. The fundamentals are the most important financial data of the company such as the company's sales and net profits, balance sheet (assets and liabilities), and important ratios such as the price-earnings (P/E) ratio.

Looking at public companies (as through their common stock) through the lens of value factors is one of the most important factors because value investing has survived and thrived ever since they were initially codified by the work of Benjamin Graham during the Great Depression years. (For more details, see Chapter 6.)

Value investing is a very important discipline for those seeking a safer, long-term approach to stock investing success. Many aspects of it are covered in Stock Investing For Dummies (written by one of the co-authors of this book) because value investing strategies (and their relevant factors) should be a prime consideration for long-term investors. The Intelligent Investor: The Definitive Book on Value Investing by Benjamin Graham - known as the "father of value investing" - is well worth reading, too.

One of the most important reasons to embrace value as a primary factor (especially for beginning investors) is the emphasis on stocks that are undervalued, which makes them safer than other stocks. Undervalued means that all the key fundamental financial aspects of the company (such as book value or the price-earnings ratio) generally indicate that the price of the stock is not overpriced, meaning that you will not pay an excessive stock price versus the value of the underlying company and its intrinsic worth. The reason becomes obvious in market data; overpriced stocks are more apt to decline more sharply in a correction or bear market versus reasonably priced stocks.

The bottom line is the fundamentals of a stock mean a safer bet and a better chance at long-term price appreciation.

Size

The size of the asset, in this case public company, is a reference to its market size based on market cap or capitalization (total number of shares outstanding times the price per share). The most common cap sizes used are small cap and large cap. If you're seeking growth, lean toward the small-cap factor.

Large-cap assets may be safer but typically don't exhibit the same growth or price appreciation relative to the small-cap stocks. The historical data generally bears this out.

Quality

Quality is certainly joined at the hip with value. This factor should definitely be among your top three considerations - especially if you're more risk-adverse as a long-term investor.

Quality is a reference to the financial strength of the company and you would see this through factors such as low debt-to-asset ratios, a high return on equity, and stable earnings growth.

Dividend

Dividends are payouts to shareholders from the company. They are typically paid quarterly and are a sign of long-term financial health when the company has been paying dividends over an extended period of time (years and decades), and these dividends are paid reliably and are increased over time.

Dividends should be among the prime factors considered, especially if you seek income and also want to reduce risk and volatility. Dividend payouts are typically seen as a tangible expression of financial strength and during times of market decline and stress, dividend-paying stocks tend to rebound well.

Additionally, the long-term market studies strongly point out that dividends over an extended period of time tend to match or exceed the rate of inflation so this factor tends to add the bonus feature of dealing with inflation (a macroeconomic factor).

Growth

The growth factor highlights the measure of change in sales and earnings by the company in relation to its group (such as in individual industries or sectors). Is the stock growing better than its peers? If so, this factor should be considered.

As the historical market data suggests, companies with growing sales and revenue show stronger relative stock price appreciation, since investors notice the growth and buy up the stock.

Volatility

Market research over an extended period of time suggests that low-volatility stocks tend to earn a better return over the long term compared to high-volatility stocks. Given that, this factor will be beneficial.

A useful indicator to look at is beta, which is listed at many popular financial websites for a given stock. The beta indicates how much more (or less) a given stock is volatile versus the general market (based on recent market trading data).

For beta, the stock market itself is assigned a value of 1. A stock with a beta that is less than 1 is less volatile than the general stock market while a stock with a beta greater than 1 is more volatile than the general stock market. A stock with a beta of 1.2, for example, is considered 20 percent more volatile than the general stock market. A stock with a beta of, say, .9 is 10 percent less volatile than the general stock market.

A good example of a stock that has low volatility would be a large-cap public utilities company. A good example of a high-volatility stock would be a small-cap technology firm. If you're a retiree, you would most likely benefit from this factor to ensure getting low-volatility stocks.

Momentum

This type of factor is a better consideration if you're an experienced investor and/or speculator seeking short-term results.

Momentum is the reference to how well the stock's price has moved upward in a given period of time (such as six months or a year) versus its peers in that particular category. Some short-term focused investors and speculators believe that if a stock is performing much better in a bullish trend (stock market prices are trending upward) that it will continue to do so in the near term. In that case, it would provide superior short-term gains versus its...