Which Factors Are Most Important When Selecting Individual Stocks?
Factor investing came to the forefront in 1992 with Eugene Fama and Kenneth French’s paper “The Cross-Section of Expected Stock Returns.” A factor is a characteristic or set of characteristics common to a broad set of securities that both explains performance and provides a premium or above-market return. Factors deliver above-market returns because investors demand a forecasted or ex-ante premium for accepting the higher risks associated with such securities.
In an article for the April 2017 issue of the AAII Journal, Larry Swedroe discusses research he and Andrew Berkin did for their book Your Complete Guide to Factor-Based Investing. Swedroe and Berkin established a set of criteria in order for a factor to be considered worthwhile. Beyond providing incremental explanatory power to portfolio returns and having delivered a return premium, factors must also be:
- Persistent: It holds across long periods of time and different economic regimes;
- Pervasive: It holds across countries, regions, sectors and even asset classes;
- Robust: It holds for various definitions (for example, there is a value premium whether it is measured by price-to-book ratio, earnings, cash flow or sales);
- Investable: It holds up not just on paper, but also after considering actual implementation issues such as trading costs; and
- Intuitive: There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.
Based on their research, Swedroe and Berkin found several factors that meet these criteria: market beta, size, value, momentum, profitability and “quality.”
AAII Weekly Survey Question
To see which of these factors are most important to our readers when selecting individual stocks, last week’s survey question asked:
Of these factors or characteristics, which one do you place the largest emphasis on when selecting individual stocks?
Here are the results:
In all, 1,352 votes were cast through 1:15 p.m. (Central) on Sunday, April 9.
Of the factors discussed by Swedroe and Berkin, the “quality” factor was most important to our readers, garnering 37% of the votes. Swedroe and Berkin define quality stocks as having the following characteristics: low earnings volatility, high margins, high asset turnover, low financial leverage, low operating leverage and low specific-stock risk.
Coming in a close second was valuation with 33% of the votes. Swedroe and Berkin define value stocks as those that are cheap based on measures such as price-to-book ratio, earnings, cash flow or sales.
In third place was profitability with 16% of the votes.
I am a little surprised that size came in last with only 1% of the votes. Small stocks are the arena where individual investors have an advantage over professional investors such as money managers, fund managers and high-frequency traders.
Weekly Special Question
With the end of the first quarter, we were interested to see how our readers think the market will do for the rest of the year.
Therefore, last week’s special question asked:
Through the first quarter of 2017, the S&P 500 posted a total return of +6.1% and closed on March 31 at 2,362.72. Where do you think the S&P 500 index will be at the end of this year?
In all, 247 readers offered their opinion as to how the S&P 500 will perform for the rest of this year. The median or midpoint projection has the S&P 500 ending 2017 with a 10% total gain, meaning it will rise roughly another 4% the rest of the year. The average estimate from our readers is slightly lower, having the S&P 500 gain an additional 2.9% over the final three quarters of 2017. This graph shows the dispersion of forecasts:
The projections ranged from a loss of 25.9% for 2017 to a gain of 69.3%. Most, however, settled into a range of 2,310 to 2,590, which translates into a loss of 2.3% to a gain of 9.6% over the remaining nine months of 2017.
Everybody has an opinion! Why not give us yours? Participate in our weekly member poll, updated every Monday, and see the results online at http://www.aaii.com/memberquestion.