Factors of Returns | AWM Insights #118
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Episode Summary
Investing in index funds or ETFs is a great place to start, but can you do better?
There are segments of the stock market that have proven over time to deliver better results than the averages. This is backed by almost one hundred years of data and research across time periods and found in markets globally.
Exposure to these parts of the market, known as factors, in a cost-effective way can provide higher expected returns rather than just settling for market returns. The caveat is that you have to be a long-term investor to capture these premiums and the patience required for most investors is maybe the hardest part. If it was easy every investor would be doing it.
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Episode Highlights
(1:17) What are the actual drivers of returns in the public stock market? Why is there compensation for putting your money at risk?
(2:25) If you want to get into the details and go deeper on investing, text 602-704-5574 for a longer conversation.
(2:55)) An index approach is the epitome of letting the markets work for you.
(3:13) A broad index market approach is a good place to start. However, there is evidence in the research of other factors that drive returns.
(3:55) When you analyze the data there are groups of companies that perform differently than the whole.
(4:08) The data shows there are parts of the market that underperform the general index and parts of the market that outperform the index. These are well researched and acknowledged factors in finance.
(4:51) Company size is one factor measured by big companies versus small companies.
(4:57) Valuation or relative value is another factor and is based on paying less money today for future earnings. If you pay a substantial premium for future earnings the evidence shows your returns could be better if you instead bought at a discount (lower relative price).
(5:09) Profitability is another factor that is intuitive. Companies with higher profits tend to outperform companies that have lower or negative profits.
(6:10) These groupings of similar stocks continue to show up in the data in a persistent way. Meaning they show up across time periods, across the world’s stock markets (not just the US), and across the different market cycles. For a factor to be valid, it has to be sensible and backed by the data. It can’t be an opinion and it has to be cost-effective to implement.
(6:36) These factors also have to be cost-effective to capture. If the taxes generated eliminate any benefit then the factor isn’t valid for the investor. Trading costs can also eliminate the benefits of other researched factors.
(7:38) Small companies are defined as having a smaller market capitalization. Market capitalization is the number of shares multiplied by market price. This is the size of the company or what the market determines is the fair market value of what a company is worth.
(8:39) If you rank the smaller companies (smallest 10%) versus the biggest companies since 1928, they have outperformed by almost 2% per year. An extra 2% compounded per year for that many years delivers staggering differences in wealth.
(10:23) The price of a stock comes down to what you pay for the future earnings of a company. If you pay a lower relative price you are considered a value company. A higher relative price is a growth company. Relative price always relates to their expected future earnings.
(11:27) Early-stage technology companies tend to fall into the growth category.
(12:18) Do these factors show up over shorter time periods?
(12:35) There will be periods where the factors underperform and that can be thought of as the cost to pay for higher expected returns than the index.
(13:05) If you can generate between around 2% for small caps and 3% for relative price, that is 5% of additional performance, why don’t we go fully into small-cap value?
(13:23) Comparing it to baseball and hitting. You can’t expect the factors to hit every year but you do want to give them more at-bats so the odds over time are in your favor.
(14:31) The third factor is profitability. The group of profitable companies have higher rates of return over long periods of time when compared to the group of less profitable companies.
(15:40) Multi-generational investing allows for these factor premiums to be captured because of the long time periods and patience that can be assumed.
(16:15) These factors also provide diversification when implemented together. When one factor is underperforming another factor may be outperforming. This reduces dispersion of returns and lowers volatility.
(16:50) These factors implemented in your portfolio can target higher expected returns than just settling for what the market index will give you.
(17:07) Don’t run out and buy the first small value fund you find. Make sure you choose a good manager that uses a systematic approach index like approach.
(17:45) You don’t have to play the game of which sector of the market will do well. Rather you can own a well-diversified portfolio that over time has proven to provide statistically better returns. This is a great investing experience that lowers uncertainty and increases your chances of achieving your priorities.
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Brandon Averill: Well, Justin we're back, we're kicking off, continuing this series here on pursuing a better investment experience, just trying to go through some of the nuts and bolts and really what are some of the real foundational principles to investing in probably the most responsible way certainly within the public markets. We've tapped into the private markets a little bit, but really spending this series mostly on the public markets. And we're going to stick with that today. Last week we really harped on really letting the market work for you, not trying to get too cute and predict things one way or the other. And today we're going to dig a little deeper there. We're going to go into considering what are the actual drivers of returns in the market, and maybe how can you use that information to your advantage? I'd love to start off by saying, let's just start with the simple statement that for many investors, a well diversified total market approach is a really great portfolio.
Justin Dyer: Totally.
Brandon Averill: It is low cost, tax efficient, low turnover. There are so many things to love about just a well diversified, simple, passive portfolio. However, there is a better way to invest in our opinion, and it's really rooted in academic research. And when we start to talk about this we're going to be talking a lot about something called factors and really getting into that. And this is definitely, we're going to spend a lot of the conversation over here on the other side of the table, we're going to let the CFA dig into this for the most part, we're going to try not to, I've warned him not to get too far into the weeds here.
Brandon Averill: If you want to get into the weeds, you know how to contact us, give us a text, give us a call. If you want the text number, we'll go off the top here, shoot us 602-704-5574, if you want to get in the weeds, I'll get that text over to Justin. He'll get back to you, but let's keep it high level. What are we talking about here, Justin, when we talk about factors and how can they benefit maybe add a little bit on top of this well diversified approach?
Justin Dyer: Sure thing. And let me even piggyback on what you said around a broadly diversified approach or index based approach. I think that really is, it's the epitome of letting the market work for you. So it really dovetails nicely into what we've been talking about over the last couple episodes. But getting in under the hood, if you will, or digging deeper, and I'll really try my best to keep things high level here, to thinking about drivers of returns. So you look at the broad market, you look at that broad index based approach, and that is good. That's an excellent place to start. However, there is a lot, as you mentioned, there's a lot of academic research and this research continues on a regular basis to try and look under the hood.
Justin Dyer: I mentioned that statement not too long ago, but to divide the market up into certain characteristics or what are called factors, we mentioned that term. To say, okay, are there discernible characteristics or these factors or qualities of companies, of an aggregate group of companies, that stand out, that act differently, that perform differently than the market as a whole? And the short answer, and we'll get into what these factors are. The short answer is yes, the academic data, the research at the end of the day shows in a very rigorous way that there are parts of the market that perform differently. There are parts of the market that underperform the general index. There are parts of the market that outperform the general index. This isn't consistently on an annual basis. This is over very long periods of time, a great amount of discipline, and actually figuring out, can you get exposure to those factors in a cost effective way, all of that matters.
Justin Dyer: And so that's just a quick teaser. Again, we'll get into exactly what these factors are, and we've touched on them, excuse me, we've touched on them time and time again, right? These things are size. The size of the company, big companies versus small companies, the valuation of a company. Are they a high growth company? Are you paying a substantial premium for current and/or future expected earnings, or you paying a discount? Is it a profitable company? Is it an unprofitable company? These are the three big factors that we'll dig into.
Brandon Averill: And I think that's a great point. When we start to look at this, right, rather than looking at individual stocks or individual bonds, and should we buy these and predict markets? I think we beat that dead horse, that doesn't work, but really, what you should be doing is like Justin just hit on, is looking at grouping of these companies and saying what are the similar characteristics? And you start to look at it and size is a similar characteristic, right? You group larger companies together, you group smaller companies together. Value is a characteristic. You start to group that together, or growth as a characteristic. You start to group that together. And really what started to, through the academic research, became available is when they started to group these stocks and these bonds together, it became really evident over long periods of time that these factors actually do show up in a very persistent way.
Brandon Averill: And I think that's one thing to really hit on is that for a factor to be investible or to really be valid, right? It's got to be sensible. It's got to be backed by data. It can't be an opinion that we read the tea leaves this morning and think something's going to happen. And it has to be backed by that data over time, across different markets, not only the U.S., but in the entire world, right. It's got to go through different market cycles. And then it has to be actually cost effective to capture. That's the other big thing. We were actually with a prospective client yesterday and he works in the big state run kind of government programs, investment programs, where they don't have to worry about taxes. And so it's a totally different implementation, right?
Brandon Averill: Some of the strategies they may look at don't work in the tax world. So anyways, it's got to be cost effective to actually implement these things, but what ends up showing up, you've already hit on him, Justin, at least on the public equity side, is it's going to be the company size, it's going to be the relative price. So is it a value or is it a growth? Profitability. Maybe spend a little bit of time, just unpack for us. How do we group companies into those? What are some broad definitions of those and what have we actually seen from the data over time? Why does it make it useful to go get that?
Justin Dyer: Yeah, well, let's start with company size. So company size, the common term and definition to use is what's called market capitalization. Market capitalization is simply the number of shares that are outstanding. So you become a public company, you issue a certain number of shares, and it's actually really an arbitrary number, but that's an important factor or variable in this calculation, you take that number of shares, multiply it by the market price and you get what's called market capitalization. That gives you the size of the company. A lot of times, you'll see this in the financial media where Apple became the world's largest company or the first trillion dollar market cap company. Those are mega cap companies. We're talking about the broad market. Those are part of the market, but they're outliers. There's very few companies that really fall into that mega cap bucket.
Justin Dyer: And so there's a whole laundry list below them of size of companies. And then if you rank them essentially from biggest to largest, and then look at the performance over long periods of time, the data that we have here to reference today goes all the way back to 1928. I mean, it's almost a hundred year period of time. And if you look at that from a company size standpoint, to answer your question directly, small companies, so think about that, generally speaking as the bottom 10% usually, I mean, the definition can vary quite substantially depending on who you're talking to. But if you look at say the bottom 10% of companies based on market capitalization, they have outperformed by just under 2% over that nearly a hundred year period of time since 1928 through the end of 2021, in actual annualized performance numbers, that's 12.14% versus 10.19% or 10.2%, let's call it, so meaningful difference.
Justin Dyer: And if you think about that as well from a compounding standpoint to... This is as nerdy or as giggy we'll get, compounding over long periods of time at a higher rate of return, even what you think of as relatively small differences, like a quarter of a percentage point. So 0.25%, if you compound two different returns, meaning you earn that over long periods of time on two different assets, a difference of 0.25%. You end up with substantially different values at the end of the day. And you start to see this over 10, 20, 30 year periods. We're talking about almost a hundred years here, and it's a meaningful difference in wealth. So that's on the company size standpoint, I'll touch on relative valuation or relative price.
Justin Dyer: So valuation is what you're paying for future earnings of a company. That's really what the price kind of comes down to you. You are paying, when you're buying a stock, we've touched on this. There's a podcast about actually what a stock or what an equity is and what you get by owning a share of a company or a piece of a company. And really at the end of the day, what it is, it's a stream or a claim on future earnings. And there's a price that people pay for that. Is it a high price? Is it a low price, right? That is what the market is trying to determine. And really, relative price is basically saying all things being equal, let's look at the market and say, okay, a value company is a low relative price to future earnings. A growth company is a high relative price to future earnings.
Justin Dyer: A lot of the big tech companies, just to put some context around this, a lot of the big tech companies, especially early in their careers or early in their maturation, if you will, definitely fall into that growth, still largely do today. And a lot of the more financial companies, banks kind of tried and true industrials, generally fall into more of a value oriented association. So that's a quick intro. Well, not quick, but an intro nonetheless, into the two definitions there.
Brandon Averill: Yeah. So, and when we started to think about that, Justin, one thing that always goes into my head and I think goes into a lot of clients' heads is 1928. That's a long time. I'm not investing for a hundred years. Hopefully most people for this podcast actually are, if you think multi-generationally.
Justin Dyer: Yeah, that's true.
Brandon Averill: However, let's assume that you're not, that's still a really long period of time and does it break down into shorter periods of time? The answer is yes, but like you said, it is a long term game. We may go, there might be a five, a 10 year period where it underperforms. But the persistence has continued to show up. So you don't need, just to be clear, that full hundred years for this to show up, this is something that does show up more often than that.
Brandon Averill: And oftentimes it will go through long periods of underperformance, but then it comes back in a massive way in a short period of time. And so when we start to think about these things, because I get this question a lot. Okay, great. You just nailed it. Okay. I get 2% from company size going for small companies. Relative price, those value companies versus growth outperformed by 2.84% over that period of time, this is great. I've got an extra five percentage points annually. Why aren't we just a hundred percent small value? And I think it goes back to the point I was just making earlier that there are periods of time where it doesn't always show up. I make the analogy to sports, where there's a reason why in baseball right now, there's a lot of stats that have showed that the two hole hitter actually gets more at bats, right?
Brandon Averill: So you want to generally put one of your best hitters in the two spot. So they get more at bats. It's very similar with your portfolio. We want to make sure that... Now that two hitter, he doesn't get a hit every single time.
Justin Dyer: Right.
Brandon Averill: He doesn't even get a hit at eight out of 10, right? The best, if you're Tim Anderson, you're getting a hit 3.3 times out of 10. So at the end of the day, what you're really trying to do here is just put the odds in your favor. So if you think of the old school ice tray, right. We've got water in every cube that represents the entire market. All we're doing is we're tilting that ice tray so a little bit more water flows into this area of small value and then the third factor of profitability. And when you do that, right, you start to overweight your exposure there to the places in the market that at least data tells us where we can expect higher returns.
Justin Dyer: Right, right, right. And let jump into profitability. And this one, it's almost like, well, duh, it makes plenty of sense, right? We're basically saying more profitable companies have a greater rate of return over the long term than less profitable companies. Anybody who understands business, that's basic business, that just makes a ton of sense, but it didn't actually come up in the academic research or the academic literature until somewhat recently. There's a lot to it, again under the hood, and we're not going to go too much into the weeds around that one. But there was a lot of questioning about what's actually driving that, is it purely the profitability metrics of a company? Is there something else that's really behind that greater rate of return? At the end of the day, the academic community basically said, yeah, this is a true factor. A more profitable company, again, or a group of companies, generally outperforms less profitable companies.
Justin Dyer: And the cool thing, and just to hit on your comment, Brandon too, around, Hey, you don't need to be invested for nearly a hundred years. Although again, for a lot of our clients that we're working with, multi-generational wealth truly is a priority and a goal. And so thinking about it in terms of a hundred year timeframes actually is relevant, but it's an incredibly long period of time. There are periods of time where small caps underperform or value underperforms. That's definitely been the case of recent in the United States, most definitely. But the interplay or the combination of these three factors is really important to touch on, where you're getting the benefit of diversification.
Justin Dyer: So maybe value doesn't perform as well as it has in the past, which it definitely has been the case, like I said, well, but the small cap factor actually has done well in certain markets and has overcome, or at least diminished the underperformance of value. And then take profitability. Profitability has done very well as of late. And so you get the interplay of these different factors within the portfolio, working together to give you the benefit of diversification amongst them, but also still in the aggregate, give you a higher expected return than the general market or the general index, which again, is a great solution, but we actually can take the data and say, Hey, there are ways to outperform, like we're talking about here.
Brandon Averill: Yeah. I think that's a great point to make. And to be clear too, don't run out and just buy the first small value fund that you see, because those aren't all created equal, right. There's the active versus the more index type approach, we're talking about the more index type approach. So just be careful there, talk to your advisor before you run out and throw money into small value somewhere, make sure you have the right small value manager that's taking this more indexed-like approach to small value. But I think to close this out, the beautiful thing about a factor based approach really is that it's all about capturing returns that isn't reliant upon predicting stocks, predicting bonds, which market areas, is tech going to do well, is tech not going to do well, industrials, right?
Brandon Averill: You don't have to play any of that game. But what you rather can do is you're holding a well diversified portfolio that's going to, over time, back to the data, it's statistically going to provide better results for you if you're emphasizing what are the true factors of higher returns, expected returns? Are you controlling costs and really focusing on the tax efficiency and low turnover. If you're doing that, you don't have to go play this game that's not successful anyways. You can have the tried and true approach that's backed by data, backed by financial science. And it's just a really successful, great experience as an investor.
Brandon Averill: So we're going to close out today. Hopefully this was helpful. But as I mentioned at the top, text us 602-704-5574. We want to hear from you guys, but until next time own your wealth, make an impact, and always be a pro.