Factor Based Investing

“Price is what you pay. Value is what you get.” – Warren Buffet. [All returns are quoted in US Dollars, to avoid the currency effects of Brexit on Sterling returns. The basic premise, however, is not changed by the base currency choice as currencies tend to be correlated with the economic cycle, whereas the Value (and Size) premium is understood to be independent thereof. I have used the MSCI World Index, as a global equity proxy. Essentially the same situation pertains throughout the regions of the world and especially so in the UK].

“Bankers are just like everybody else – except richer. Ogden Nash (US Poet 1902-71).(This post is going to be a little formula heavy. Sorry, I shall return to my usual inanity next week). Since 2009 Central Bankers (via QE etc.) have created a situation whereby all asset prices now have more or less the same expected long-term returns, such that Investors are now indifferent between them. So, Investors have (as was intended), been forced to look for alternative strategies to improve their return outlook. Two such strategies have emerged: the “reach for yield”, namely the buying of High Yield equities on the one hand, whilst others have focused on “Value”, to wit, the purchase of assets that are relatively cheap compared to their respective alternatives. Both contain some assumption flaws, which we will look at in turn.

There is nothing permanent except change – Heraclitus In the early 1990’s Fama and French demonstrated that Company Size and Price-to-Book (Value) explained the majority of investment returns, in what was dubbed the Three Factor model. This was the addition of two factors to the market risk (Beta), that the CAPM stated was the cause of stock returns. These have since expanded to 5 (operating profitability and investment policy), and more recently to 6, as investors have judged Momentum to be a “factor”. It is the last of these that has had the most influence on market behaviour over the past few years, in both directions.…

Value Investors have had a hard time in recent years – what was cheap has remained so for what seems like an age. Does it still exist, or like the Betamax, Walkmans and the Lib Dems has it become a relic of a bygone era?

Are Small Caps a truer proxy for UK plc? The performance of UK Small Cap shares has outshone both the overall market and the widely quoted FTSE 100 Indices as the chart below shows. It is worth going over the make-up of the various Indices. The FTSE 350 Index is the sum of the FTSE 100 and the FTSE 250 Indices (in Market Cap terms) The FTSE All Share Index is the sum of the FTSE 350 Index and the FTSE Small Cap Index (in Market Cap terms) FTSE 100 Aggregate Market Cap £1.71 Trillion FTSE 250 Aggregate Market Cap £354 Billion FTSE 350 Aggregate Market Cap is thus £2.06 trillion FTSE Small Cap Aggregate Market Cap £77.05 billion. FTSE All Share Aggregate Market Cap is therefore £2.14 trillion.