More and more investors are talking about multi-factor equity investing, and many are asking questions. We discussed the distinct characteristics,challenges and opportunities available through different factor premiums with a pioneer in the field, Research Affiliates Chief Investment Officerand PIMCO Portfolio Manager, Christopher Brightman.
Q: There has been a surge of interest in factor-based strategies recently. Where do you see the most robust equity-factor premiums, and where do thepremiums appear potentially less sustainable?Brightman:We’ve done considerable research on this subject. We find some so-called factor premiums are sustainable, meaning that we have a strong conviction that thefactor will provide a future return premium, while others are less robust.
The value factor is quite robust over time. Whether you use price to book, price to earnings, price to sales, or EBITDA to enterprise value, we believe theresults are the same: Companies with low prices relative to their fundamental characteristics tend to provide higher returns than companies that have highprices relative to those fundamental characteristics. To paraphrase Charlie Munger, all sensible investing is value investing, and there is a long historyof value providing a positive excess return.
In contrast, the small cap and quality premiums, appear less sustainable on a stand-alone basis, and we have found that premiums like momentum andilliquidity generally require very thoughtful, non-transparent implementation in order to be profitable over longer periods of time.
Q: Despite all of the research supporting the existence of a value premium, value strategies have underperformed growth strategies for the past decade.Is this an anomaly, and if yes, why?
Brightman:Yes it is atypical. However, it is certainly the case that there will be periods of sustained outperformance and sustained underperformance, and we’ve beenin a multi-year period of sustained underperformance for value. In fact, it is starting to resemble very much the opportunities that existed during therecession in the early 1990s and the tech bubble in the late 1990s when value was extraordinarily cheap. And so, looking forward, we expect that value isgoing to have a good run because it’s unusually cheap.
Q: The small cap sector has traditionally been considered one of the less efficient areas of the stock market. How can investors look to capture this market inefficiency, while avoiding many of the pitfalls?
Brightman:There’s no evidence at all that companies with smaller sales, smaller assets or several other measures of size have higher returns than the larger companies. However, researchdoes show that high market cap companies have lower returns because they’re high-priced companies. It’s not their large assets or their large sales oranything about them being a large company, the difference in returns is a function of smaller companies with artificially inflated prices being included inlarge cap indexes and larger companies with temporarily deflated prices being included in small cap indexes. Removing price from the equation also removesthe excess return of small companies.
However, we do find that the pricing of small companies is far less efficient than the pricing of large companies, so to the extent that you have some kindof information edge, you probably are going to find more opportunity applying that edge in smaller companies than in larger companies. For this reason it’sentirely rational that a skilled stock picker would spend more time looking at small companies than large companies. And even if you are applying arelatively simple value strategy, you may get better returns from that value strategy in small companies rather than large. Of course, when you’re goingdown the size spectrum, you need to pay more attention to market impact, liquidity and transaction costs.
Q: While robust and observable, momentum seems like a factor premium that may be more challenging to successfully capture over time. Do you agree?
Brightman:Yes. The research is overwhelmingly clear that there’s positive serial correlation over the short run with stock prices. Companies that have been going uprelative to the rest of the market over the past few weeks, months and quarters tend to continue to go up versus the rest of the market over coming weeks,months and quarters.
Now, the flipside of that coin, of course, is that over longer periods there is negative serial correlation, or mean reversion. Companies that have beengoing up versus the rest of the market over the past couple of years tend to be a little more likely than not to go down versus the rest of the market overthe next few years, and the companies that have been going down versus the rest of the market over the past few years tend to go up.
As a result, it’s not necessarily easy or straightforward to extract an actual return after fees and transaction costs from a momentum strategy. Rather, we believe this is a veryspecialized and perhaps limited opportunity set that may be best implemented by a skilled active manager rather than a broadly available factor premium.
Q: At face value, investing in high quality companies makes a lot of sense. Yet, your research shows that quality is not a robust source of returnpremium. How do you reconcile these two points, and what does it mean from an investment standpoint?
Brightman:The highest-quality companies had much lower drawdowns in the financial crisis, and what we have seen since then is just one crisis after another that have caused a continued flight to quality. Compounding this, of course, is investors having to deal with the consequences of quantitative easing. Theycan’t get sufficient yield out of their bond portfolio so they’re searching for stocks that act like bonds. This has bid up the prices of high qualitycompanies to the point where we believe they’re really quite expensive from relative historical norms in pricing.
High profitability companies don’t typically provide higher returns on average through time than lower profitability companies, but there are periods wherethey do and we’ve just seen one of those periods. Like size, that doesn’t mean that we should ignore quality when investing, quite to the contrary. Quality is a very important characteristic to understand, but it has to be combined with price, with value. Adjusting the valuation measurefor different elements of quality makes it possible to implement a price-conscious value strategy with a very strong signal and much less noise. We believethat’s the sensible way to apply the quality factor when investing.
Q: Would simply blending different factors together in a portfolio be likely to produce a desirable outcome?
Brightman:Investors need to be careful with the concept of blending. Let’s say I were to blend a concentrated value portfolio and a concentrated quality portfolio, what am I going to get? I’m potentially going to get half of my portfolio inout-of-favor companies and half of my portfolio in expensive companies. That’s not a great investment strategy. What I want is to find companies that arehigh quality and reasonably priced or companies that are really cheap, but of reasonable quality; that’s a very small subset, but where I see the realopportunity.
Q: Looking forward, where do you see attractive factor-based opportunities today, and what are the most relevant implementation considerations?
Brightman:I would say now is one of the most attractive entry points for a value strategy. If you examine what the world’s great equity investors do, it’s findcompanies that are cheap given the quality of the company, whether that’s deep value investing or whether that’s finding the very highest-quality companiesin the world and then looking for opportunities to buy them at an attractive price. One of the most common mistakes of a naïve equity investor is to failto appreciate the difference between a great company and a great stock. Price always matters.