Public Domain: Source: Wikipedia
Factor investing is just a new way to talk about stock-picking. Thirty years ago Gene Fama and Ken French discussed what goes into stock market returns, and why stocks gradually go up. They came up with three major elements: the equity market itself, the size of the companies, and their market valuation relative to their accounting valuation.
The market captures economic growth and put it into a company’s share price. That is, when the economy grows, a residual of that growth goes into the stock market. So the market grows faster than the economy. Small companies grow faster than large companies, because small companies eventually become big companies. And cheap shares return more than expensive shares, because at some point they stop being cheap.
Photo: Kevin Connors. Source: Morguefile
These factors work – and keep working – because they embody economic and financial verities. It’s risky to own stocks, and more risky to own small stocks, and even more risky to own small, cheap stocks, because things can go wrong and firms can fail. Small companies have fewer resources – financial, human, customer – than large companies, and cheap companies are cheap because they don’t look good. People don’t like them. As the world turns around though, enough small, cheap firms become large, rich corporations to make factors valuable.
Over time, people have found other factors that seem to work—things like company quality, or corporate governance, or operating and market momentum. But identifying a factor and finding an investable thesis can be two very different things
If you’re going to use these to invest, just make sure you can stick with them if things don’t work out right away. Because things often do go wrong—just when you can’t afford it.
Douglas R. Tengdin, CFA
Chief Investment Officer