Beat the Market With the “Big Five” Factors

by Nicholas Vardy
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Every investor is looking for an edge to beat the market.

Factor investing offers just that kind of edge.

It's the investment "free lunch" that promises the holy grail of investing... beating the stock market with less risk.

So just what is a "factor"?

Factors explain why specific investment strategies outperform the market over time.

If you've heard the terms "value" or "momentum investing," then you'll already be familiar with two of the most important factors.

Today, I'll give you a quick overview of the "big five" most persistent investment factors - value, momentum, quality, size and low volatility.

1. Value

The idea behind value is both familiar and straightforward: Cheaper stocks outperform more expensive stocks over the long run.

Expensive growth stocks rarely meet their lofty expectations. Conversely, cheaper value stocks tend to surprise on the upside.

Published in 1934 in the middle of the Great Depression, Columbia Business School professor Benjamin Graham's Security Analysis is the bible of value investing.

Graham recommends that investors buy stocks at a discount to their intrinsic values.

Graham taught that you can calculate a stock's intrinsic value by using measures like price-to-book (P/B) and price-to-earnings (P/E) ratios.

Research by Fidelity Investments shows that between 1985 and 2015, stocks with a low average P/B or P/E outperformed a broader market cap-weighted index by 2% and 3% per year, respectively.

2. Momentum

Momentum investing is based on the observation that once a stock starts to rise, it tends to keep going.

Put another way... "The trend is your friend."

Academics and die-hard value investors cringe when they hear the word "momentum." After all, the success of momentum investing is an insult to their hyper-rational approach.

But it's no surprise to technical analysts. They know that investors tend to pile into a stock once it starts going up.

Momentum investing is less about abstract theory than real-world investor behavior. Unlike the perfectly rational "homo economicus" (economic man) you find only in finance textbooks, most investors are driven by FOMO - the fear of missing out.

Again, between 1985 and 2015, momentum stocks that outperformed over the prior 12 months beat a broader market cap-weighted index by an average of 1.5% per year.

3. Quality

It seems like common sense: Invest in high-quality companies and you generate higher returns.

Not surprisingly, research has confirmed that stocks of high-quality companies beat the market over time.

A strong balance sheet, stable earnings, increasing dividends and reasonable leverage are all hallmarks of quality companies.

Most importantly, high-quality companies have "wide moats" - sustainable competitive advantages - that allow them to earn higher profits than their competitors.

Think of what it would take to launch a rival to Visa (NYSE: V) or The Coca-Cola Company (NYSE: KO) and you'll understand the power of a wide moat.

Investing in a portfolio of quality companies between 1985 and 2015 outperformed the market cap-weighted index by an average of 1.6% per year.

4. Size

The "small cap effect" is the market anomaly that small cap stocks consistently outperform large cap stocks over the long run.

Eugene Fama, a 2013 Nobel Prize winner in economics, and his colleague Ken French found that small cap stocks outperformed for three significant reasons.

First, small caps are riskier than large caps. And higher returns compensate for that higher risk.

Second, analysts don't cover small caps as thoroughly as large caps. So the small cap market is less efficient and offers more mispriced stocks.

Finally, smaller companies are nimbler than their large cap counterparts. They adjust better to changing market conditions.

Between 1985 and 2015, small caps outperformed large caps by an average of 0.7% per year.

5. Low Volatility

The investment case for low-volatility stocks is harder to get your head around.

The original reason for investing in low-volatility stocks was to offer investors a smoother ride.

Surprisingly, research has shown that low-volatility portfolios not only are less volatile but also offer higher returns.

That's because low-volatility stocks hold up better during market pullbacks.

"Dividend Aristocrats" are low-volatility stocks that have increased dividends for at least 25 years in a row.

During the financial crisis of 2008, the overall market dropped 37%. In contrast, the Dividend Aristocrats tumbled only 22%.

Between 1985 and 2015, low-volatility stocks outperformed large cap stocks by an average of 0.8% per year.

There Is No Holy Grail

Over time, each of these factors outperforms the overall market.

Yet no single factor works all the time.

Value stocks fell out of favor during the dot-com boom. But they more than managed to earn back their losses in the years that followed.

Momentum stocks got crushed following the dot-com bust in 2000 and after the financial crisis of 2008. But momentum has trounced the S&P 500 over the past five years.

High-quality stocks may lag during momentum-driven market rallies. Yet their wide moats ensure these are the investment turtles that beat the hare.

Small caps can underperform large caps for many years, as they did during the tech bubble in the late 1990s and the financial crisis in 2008. But over the long term, they crush the S&P 500.

Finally, low-volatility stocks tend to underperform during market rallies following bear markets - such as in 2009. But they are the best way to preserve your capital in the midst of market crises.

I'll examine each of these factors in more detail over the coming weeks...

And I'll provide you with specific exchange-traded fund recommendations on how to profit from them.

Good investing,

Nicholas

Thoughts on this article? Leave a comment below.

The Private Sector Solution to Public Sector Waste

It's a true modern-day question: Why does the government take so long - and spend so much more money - to do things the private sector could handle in half the time and for half the expense? Short answer - bureaucratic red tape.

Enter Tyler Technologies (NYSE: TYL). Tyler sells the same technology to local governments that has helped private corporations optimize operations. Its profitability, recession-proof nature and industry dominance make it a winning recommendation from Alexander Green in his Momentum Alert portfolio...

Americans often complain about the gross inefficiencies of government. If anything, however, they generally understate the problem.

When you look at the billions of tax dollars lost each year to waste, fraud, ineptitude and irresponsible spending - not just at the national level but within state and local governments as well - it's tough to stomach.

Wouldn't it be great if the public sector - which doesn't have the profit motive to improve efficiencies - operated more like the private sector?

Thanks to Tyler Technologies (NYSE: TYL), the same technological innovation that has cut costs and driven profits skyward in business is coming to local government, making public sector operations more effective and less costly.

Based in Plano, Texas, Tyler sells and supports software services that make it easier for local governments to manage their complex, day-to-day business functions, including financial management, court cases, property taxes, citizen services, records and documents, public safety, and education.

Public sector software is the firm's specialty. It isn't just what it does. It's all it does. This focus and commitment has made it the national leader with cities, counties, states and school districts.

Tyler's client base now includes more than 13,000 local governments in all 50 states, as well as Canada, Britain and the Caribbean.

There is huge pent-up demand here. And no competitor has systems that are faster, more comprehensive or easier to integrate.

Tyler hasn't just left the competition in the dust. It has driven many rivals out of business.

Local governments like the fact that Tyler doesn't hit them with big, periodic licensing fees. Instead, it offers an evergreen program where clients pay small annual maintenance costs to get regular software updates and stay current.

Since it deals solely with the public sector, Tyler knows its industry forward and backward, differentiating it from larger players like SAP and Oracle who endeavor to be everything to everybody.

Tyler's industry dominance - unusual for an $8 billion company - should continue since it is seeing powerful demand from a broad customer base.

In the most recent quarter, earnings soared 98% on a 13% increase in sales. The firm's operating margin tops 19%. And management is earning a healthy 16% return on equity.

In addition to scooping up market share, Tyler is growing through acquisitions.

The company has the wherewithal for additional buyouts too. It has no debt, huge cash flow and more than $229 million in cash.

The stock is being pushed higher by cash waves from mutual funds, pensions and endowments. Institutions now own more than 95% of the outstanding shares.

You should own some too. This is a well-managed company with a profitable niche in a recession-resistant industry.

- Donna DiVenuto-Ball with Alexander Green

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