How to Pick Winning Stocks With Factor Investing

Warning:  Dense material.  I’m about to attempt to simplify and compress over forty years of academic research into a few short pages.  Sorry in advance.

In investment accounts above $250,000, I’ll implement my best thinking by purchasing individual stocks (rather than mutual funds or ETFs).  To achieve adequate diversification, I’ll normally purchase at least 25 stocks from different sectors.  Of course, I aim to purchase stocks which I believe could rise in value and outperform others over the long term.

A Brief Description of Factor Investing

The method which I use to identify these potentially strong stocks is called “factor investing.”  Factor investing identifies one or more specific “factors” of companies or stocks which usually correlates with outperformance and then makes them candidates for purchase.  For instance, if I invested in companies with stable earnings and relatively low levels of debt, that would be called “quality” factor investing.  Here is a short list of some of the more widely known factors:

  • Yield:  Stocks with high and sustainable dividends
  • Low-Volatility:  Stocks whose prices do not fluctuate as much
  • Quality:  Profitable companies with less debt
  • Value:  Downtrodden stocks surrounded by lots of bad news
  • Size:  Smaller companies
  • Momentum: “Hot” stocks which have recently performed well

The reason why you won’t hear much about factor investing in the news or on the internet is because it distills companies and stocks down to a few key statistics.  In other words, people are more likely to read an article on how a company came into being with a charismatic founder and how they recently filed for a patent on a novel invention which could change the way we live versus an article which says that a company is small and has a high, sustainable dividend and thus should outperform.

Please find below a chart of the performance of four factor strategies and the S&P 500 Index from the end of 1998 through the beginning of 2020.  Each portfolio below is “tilted” to own stocks which exhibit a specific factor.  The raw data is provided by MSCI & Yahoo Finance.  Next, we’ll dig into why these strategies work.

Performance of various MSCI factor strategies since 1998

Why Factor Investing Works

The reasons factor investing works are unique to each specific factor.  Many have to do with behavioral finance while others have to do with company operations.

Yield Tilt

Buying stocks with high, sustainable dividends often leads to outperformance because the interest of company management is better aligned with investors in these companies.  In other words, if a stock has been paying a 5% dividend every year for the last 40 years, management knows that investors will hold them accountable if they are frivolous with cash and ever need to reduce that dividend.  Cutting a long-established dividend may lead to enraged shareholders who then sell the stock and/or try to get the company’s management replaced.

The key with dividend investing is finding a stock with a sustainable dividend.  Studies show that the stocks with the highest dividends (90th to 100th percentile) underperform over the long run because the dividend is unsustainable.  I generally find sustainable dividends to be no more than 6%, depending on the company.  Stocks within the utilities and telecom sectors often offer the highest dividends.

Low Volatility Tilt

These stocks don’t go up much when the market goes up.  They also don’t go down much when the market falls.  These are the boring, relatively recession-resistant stocks like Colgate-Palmolive, NextEra Energy, and Procter & Gamble (as of 2021).  They typically underperform in rising markets, but more than make up for it by outperforming in down markets.  That leads them to outperform over the long run.

Why don’t more people own these types of stocks if they outperform?  Simply because they are boring.  Saying you own these stocks at a cocktail party is like telling someone your favorite food is plain, uncooked tofu (imagine that reaction).  You’re more likely to be viewed as a respected investor by owning stocks that are in the news and that everyone wants to own.

Momentum Tilt

Speaking of stocks that everyone wants to own, you can make money off of these if you treat them properly!  Research shows that stocks which have recently performed well, called “momentum stocks, tend to continue to perform well for a short period of time. That’s the caveat.  Hot stocks can make a lot of money, but you should not own them for more than a year (preferably less), after identifying them.  These types of stocks, once the limelight shifts away from them, quickly fall from grace, often delivering disappointing returns over longer timeframes.

Size Tilt

This one is easy to explain.  Smaller companies tend to be overlooked by investors as there is less media and analyst coverage on them.  Therefore, there are more investing opportunities which have not yet been discovered by the public.  This would be called in the industry a “market inefficiency.”

The Pièce de Résistance – A Multi-Factor Strategy

This is what I do with the portfolios I manage.  Mixing different factors together and in specific ways may create a better performing portfolio than a single factor strategy.  One example is a LoVM (pronounced “love ‘em”) strategy which incorporates stocks with strong momentum and low volatility into the same portfolio.  The specific reasons for creating such a strategy are compelling, but too much to dive into with a short article like this.

Conclusion – Factors Are the Low Hanging Fruit Nobody Picks

Factor investing is still relatively new in the world of finance, only becoming mainstream over the last ten years.  Because of this, most of the people who are aware of this method of picking strong stocks are industry professionals and statistics geeks like myself.  Congratulations, you have now been brought into our circle.  If you’re interested in learning more, FactorResearch.com, iShares, and MSCI offer easy-to-understand lessons.

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