Factor Investing

Unless you like to open the occasional dusty academic tome, chances are you're not intimately familiar with factor investing. It's really not as esoteric as it sounds. You've heard of style investing--small cap versus large cap, or value versus growth. If you've ever tilted to a particular style, you've engaged in factor investing. Style investing is a kind of factor investing, dealing with only two factors: size (large-small) and value (value-growth).

A working definition of a factor is an attribute of an asset that both explains and produces excess returns. Factor investing can be thought of as buying these return-generating attributes rather than buying asset classes or picking stocks.

None of this is new. The original factor theory, dating back to the 1960s, is the capital asset pricing model, or CAPM, which predicts that the only determinant of an asset's expected return is how strongly its returns move (or, in technical terms, covary) with the market's. The strength of the relationship is summarized in a variable called beta. A beta of 1 indicates that for each percentage point the market moves, an asset's price moves in the same direction by a percentage point. CAPM predicts asset returns are linearly related to market beta. However, since the 1970s, academics have known that stock returns don't seem to be related to beta. This finding spurred many fruitless or convoluted attempts to explain how market efficiency could be squared with a world in which CAPM didn't work.

Eugene Fama and Kenneth French "fixed" the CAPM, at least for stocks, by adding two factors: size and value. They observed that smaller stocks outperformed larger stocks and stocks with high book/market outperformed stocks with low book/market. More importantly, the relationships were smooth; the smaller or more value-laden the stock, the higher its return. Fama and French interpret the smoothness of the relationship as indicating the market is rationally "pricing" these attributes, which implies that size and value strategies enjoy higher expected returns for being riskier.

Further research has uncovered more stock factors, including momentum, quality, and low volatility, in nearly every equity market studied. They also display the same smooth relationship: The stronger the factor attribute, the higher the excess returns. The interpretation of these factors depends on whether you believe the market is efficient. In an efficient market, they must be connected to risk. However, if the market is not perfectly rational, some may represent quantitative strategies that exploit mispricings to produce excess returns.

I don't believe value, quality, momentum, and low-volatility strategies work because they are riskier. The strategies were exploited by investors before academics triumphantly published them in journals as "discoveries." It's also hard to reconcile them all as representing risk because if you lump them all together, you get an eerily smooth return stream.

7 reasons for a September crash

Think last week's 2% decline in stocks was annoying? Get ready for worse.

The reason: September is historically the cruelest month in the stock market. Several potential shockers and market dynamics are aligned to suggest that this year will be no different.

"Late August through roughly the end of September is going to be a difficult period," predicts Fred Dickson, a veteran market commentator whom I've watched make many good market calls in his role as a strategist at Davidson, a brokerage.

"We have a convergence of perfect-storm factors," says Dickson. They include the age of the current bull market, investor complacency, signs of consumer weakening  an imminent change in Federal Reserve strategies, unrest in the Middle East and budget bickering in Washington.

Dickson predicts that major U.S. indexes will fall roughly 5% to 6% from their 200-day moving averages, a common support point in pullbacks. That would be a drop to around 1,554 for the Standard & Poor's 500 Index ($INX) and 14,376 for the Dow Jones Industrial Average ($INDU). But pullbacks of 10% are common in corrections for bull markets as powerful as this one (up about 19% this year alone).

inverted questions

Here are the top 5 inverted questions I like to ask myself when looking at stocks. It helps me break up the mindset of trying to find bullish reasons.

    How can I lose money? vs How can I make money?
    What is this stock NOT worth? vs What is this stock going to be worth?
    What can go wrong? vs What growth drivers are there?
    What is the market implied discount rate? vs What is a fair discount rate?
    What is market implied growth rate? vs What is the future growth rate?

and a bonus question.

    If this drops 50% today, will I buy more? vs When will I sell?

Thank you Charlie Munger for teaching me to “Invert, always invert”.

-- by Jae Jun

value investing is not for everyone

The simple truth is that value investing, especially asset based deep value investing, is not for everyone. For obvious reasons, I am grateful that so few people actually invest this way.

Deep value investing is simply not enough of an action sport for many people. I do not trade every day, or even every week or every month. I hold positions until they work. Sometimes this happens in a few months usually because of a takeover offer or restructuring proposal. Most of the time I end up holding the shares of an undervalued company for several years. I have held positions for over a decade during my career.

Deep value investors do not feel the need to play just because the casino is open. The ringing of the bell at the NYSE does not hold the same significance for me that it does for my more trading oriented friends. Daily market movements are more a curiosity than a matter of life, death, and profit and loss. Quarterly earnings reports are just a checkpoint and not the end all and are all of trading existence. I buy when I identify a solid value that passes my screens and checks. I sell when a holding becomes fairly or overvalued depending on the quality of the underlying business. The rest is just noise.

You will not own exciting stocks. While others chatter at the water cooler or cocktail party about Apples newest phone, surgical robots and other exciting products you will not garner the same attention with your stocks. Asphalt plants, safety garments, and staffing companies are just not going to be as sexy. Although in all probability they will end up making you big money without the risk of permanent loss of capital, no one else will care. You will own stocks no one has ever heard of and for the most part do not want to know about. Deep value investors need to become well versed in literature and sports so as to not be totally ostracized at public gathering.

You have to be able to be a buyer when others around you are selling in a panic. Bargains are not created in a vacuum so you will be buying stuff no one else wants. Your busiest buying binges will come after market meltdowns. John Templeton called this buying at the moment of maximum pessimism. It takes some courage and conviction to be a buyer of bank stocks in a credit crisis or tech stocks after a crash but it works. A deep value investor will often be buying stocks that others are puking up as a result of margin call. Seth Klarman refers to this as being the buyer of last resort and once again it is not easy but it does work. Value types look at corrections and crashes as inventory creation events and not catastrophes

The other side of this is that you will be selling when others are starting to get excited about stocks. It can be frustrating to hold cash balances when others are bragging about huge day trading profits and new paradigms. As market rally to the frothy point and everyone is excited your stocks will become overvalued and you will be selling. It is not market timing so much as a natural part of the value cycle. Cash balances will rise as you are unable to find suitable new bargains to replace stocks you have sold. It will be frustrating until it is rewarded by the inevitable decline and birth of a new value cycle.

Value investing is not for everyone. You will not trade all the time. Your stocks are almost never on TV. You will be selling when friends and neighbors are excited about the market and buying when they are depressed. There is lots of reading involved. It is more like an extra innings pitcher’s duel than a sudden death overtime football game. It has been proven to be wildly profitable over time but many people just do not have the discipline and patience. Fortunately I do.

-- by Tim Melvin

Buffett on cash

Warren Buffett, the largest shareholder of Berkshire Hathaway (NYSE:BRKA), once explained how investors should view cash. He said, “The one thing I will tell you is the worst investment you can have is cash.

Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don’t want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it.

We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially.”

***

Inflation is a major risk of cash. With inflation averaging 3 percent, the value of cash decreases over time. Over 10 years, your money is worth almost half of what it is worth today if only invested in cash. Cash is a great place to store your money for a short period of time until you make your next investment. Cash in itself should not be an investment. Warren Buffett says, “The one thing I will tell you is the worst investment you can have is cash.”

Cash has averaged a negative return. If you look at annual returns for the past 86 years and taking into account inflation and taxes, cash has returned -0.8 percent, where the stock market as returned 4.5 percent and bonds have returned 0.6 percent.

Motley Fool 1-2-3

Good old-fashioned buy-and-hold investing might not be exciting enough to interest daytraders. But it can nevertheless produce exciting longer-term returns — and beat out newfangled strategies.

Consider this: The three top spots in the Hulbert Financial Digest’s five-year rankings of more than 200 investment-advisory services all buy and hold quality companies. Remarkably, all three are subscription newsletters published by the same advisory firm, the Motley Fool in Alexandria, Va., which was founded by brothers Tom and David Gardner in 1993.

The newsletters’ names are Inside Value, Rule Breakers and Stock Advisor, and their model portfolios have produced average annual returns over the period of 18%, 16% and 15%, respectively, each more than doubling the 7.2% return of the overall stock market over the same period, as measured by the Wilshire 5000 index, with dividends reinvested.

Andy Cross, the firm’s chief investment officer, wrote in an email that the firm’s Inside Value service, which focuses on value stocks, searches for “great businesses at beaten-up or misunderstood stock prices.” In contrast, the Rule Breakers newsletter, which focuses on high-growth stocks, searches for “the most innovative companies, often early in their history, that are in disrupting industries.” Finally, the Stock Advisor service searches for “winning businesses with a special edge to keep them winning.”

Since very few stocks are held in common by these three top-ranked services, one must credit the firm’s underlying investment approach for their stellar performance. That philosophy, Mr. Cross said in an interview, is to invest in “great and amazing growth-opportunity businesses” whose full potential “other investors are ignoring,” typically holding them for three to five years.

One particular challenge that investors face in following the Motley Fool’s investment approach is that it requires the all-too-rare discipline of holding on to recommended stocks through bear markets. Mr. Cross points out that investors who bail out of stocks during declines seldom get back into equities in time to participate in the bulk of the subsequent recovery.

“Trying to figure out when to invest is a fool’s errand,” he says, and therefore his firm urges investors to get into “the practice of regularly investing as much as they can” in the stock market.

When questioned about the specific parameters the firm’s investment team uses when picking stocks, Mr. Cross wrote back that it focuses “on where the company, not the stock, will be in the next 3-5 years, and even beyond.” He called the approach “a business-owner mentality more than a ‘stock-buyer’ one,” listing such criteria as assets, competitive advantages, boards and managers and market opportunities.