Rebecca Hotsko (02:38):

What are factors? To say it simply, factors are common traits amongst all stocks that are empirically known to drive stock returns. The most commonly known factors are market risk which is also known as beta, small cap stocks, value stocks, companies with high profitability and low investment. I’m going to get into what these all mean and what drives these premiums of these certain characteristics in a little bit, but first I kind of want to dive into the background of where factors even came from and when they were discovered.

Rebecca Hotsko (03:15):

Before researchers discovered these factors, they were noticing that diversified portfolios of small cap stocks were outperforming diversified portfolios of large cap stocks. There used to be no explanation for this difference in returns. However, as research on factors began to emerge over time, it became clear and very robust in the evidence that stocks with certain characteristics, being ones that are exposed to these factors, actually explain most of the differences in returns between diversified portfolios. This was bad news for many portfolio managers at the time because most of the alpha they generated which used to be chalked up as their skill in picking stocks was then proven to be explained by them just having stocks with more exposure to these certain factors which is very easily to replicate for the average investor.

Rebecca Hotsko (04:08):

An important thing to remember, to just set the stage for this whole discussion today, and it’s the backing of most financial theory around asset pricing models is that investors want to be compensated for taking on more risk with higher returns, or else why would you take on an investment that is higher risk if you weren’t going to expect to receive a higher return. Because of that, stock prices contain very valuable information of the markets perceived riskiness of a stock. However, not all risk is created equal, or not all types of risk mean you get a higher return in investing. For example, investors don’t get compensated for taking on idiosyncratic or company-specific risk which is the risk that comes by owning individual stocks. This is the risk that maybe a factory shuts down, and that is a unique risk to the company, or Elon Musk steps down a CEO would be very devastating for Tesla stock. So those are unique company specific risks.

Rebecca Hotsko (05:11):

Michael Gayed brought this point up in one of our recent episodes which was episode 363, so definitely go check that out if you haven’t yet. But the reason that investors aren’t compensated for taking on this risk that are individual to companies is because investors can just eliminate that risk by buying more stocks and having more diversification. So, the market doesn’t reward investors with a higher expected return for taking on this type of risk. Taking us back a bit in financial history, for many years, it was commonly thought that market risk which is also known as beta was the only risk factor that investors were compensated for because while you can diversify away specific company risk, market risk cannot be diversified away. Every company is exposed to the risks of the market which include things like inflation, interest rates, recessionary risks, and all of these risks are common to every stock.

Rebecca Hotsko (06:10):

However, as you probably know, some companies are more exposed to market risks than others. How exposed companies are to market risk is shown in their beta. Companies either have a beta of 1, meaning they are as risky as the market and in general will fluctuate the same as the market does. So, if the market goes up by 10% and a stock has a beta of 1, the stock will also go up by 10%. A company with a beta of less than one means the stock is less sensitive to market risk. Usually these are utilities, defensive stocks, and are considered safer investments because as mentioned, they don’t move as much and are often what investors go towards in a market downturn. A company with a beta over 1 means that the price will be more volatile than the market and is riskier which are often stocks like tech stocks, high growth, and these ones usually have higher betas.

Rebecca Hotsko (07:06):

For a long time, it was commonly thought that higher beta portfolios or taking on more market risk was the only risk factor that could explain the differences in returns between two diversified portfolios or among stocks, and it was widely believed that the only way to generate higher returns was by taking on more risk or more beta. However, in 1992, research emerged on factor investing from Eugene Fama and Kenneth French, and they found that market risk or beta isn’t the only risk factor that explains differences in returns and will lead to higher expected returns over time. In fact, they found that beta only explains roughly 67% of the differences in returns between portfolios. That led many researchers to question what explains the differences in returns between stocks if it isn’t just beta. In their early research which won them the noble prize, they found that stocks with certain characteristics or factors being value stocks and small cap companies earned a higher risk adjusted return than what was expected based on their betas.

Rebecca Hotsko (08:19):

This is where factors started to come into play. In Fama and French’s original three-factor asset pricing model, instead of just looking at the sensitivity to market risk or beta as driving higher returns over time, they included a size factor and relative price factor as two additional independent risk factors, and they found that after including these two risks in addition to market risk, they were then able to explain about 90% of the differences in returns between diversified portfolios which was a drastic improvement from what beta could explain alone. More specifically, they found that small stocks tend to outperform large stocks over time, and cheaper companies or value stocks tend to have higher returns than more expensive companies or growth companies, all else being equal, and that is how the size premium and value premium came to be.

Rebecca Hotsko (09:11):

Why this matters is because before, investors didn’t understand where the differences in returns came from, and as I mentioned, they were likely attributed to luck or the skill of a portfolio manager, but now today, any investor can increase their expected returns by exposing themselves to more stocks with these characteristics or known factors. Taking this research together, we know that combining these three independent risk sources, being market risk, small cap companies, and value companies, was able to explain almost all of the differences in returns between two portfolios. But it doesn’t stop there, and since that finding in 1992, there have been even more factors that have been identified beyond the traditional three Fama and French factor model. In 1997, Mark Carhart introduced momentum as another factor, and today many academics also recognize momentum as a factor that will lead to higher expected returns over the long run. And in 2012, Robert Novy-Marx introduced profitability as another factor that explains returns.

Rebecca Hotsko (10:20):

This now gave five factors which together, these factors explained over 95% of the differences in returns between diversified portfolios. In 2014, Fama and French came up with their own five-factor model which included market risk, size, relative price, profitability, and investment as the five factors that explain differences in returns, ignoring momentum. They ignored momentum for a few reasons, but mostly because momentum requires a high turnover strategy and it incurs a lot of costs. So, without getting into much detail, it isn’t that it doesn’t work. They just didn’t include it in their model because of these issues. It impacted its robustness. With this new five-factor model, they found that you can explain almost 100% of the differences in returns between stocks or diversified portfolios based on their sensitivities to the five independent factors.

Rebecca Hotsko (11:18):

So, now you might be wondering what actually drives these factor premiums. Why do stocks with small cap, value, high profitability, low investment characteristics lead to higher returns over time? Well, there are two arguments for this. The first one is a behavioral argument. The basis of this argument is that investors tend to overreact and they overprice certain securities, and that is one explanation why say growth stocks tend to underperform value over the long run because of this irrational exuberance in the market where everyone wants to buy these hot stocks which drives up the price beyond what it’s worth, and whenever the price rises, your expected returns decline.

Rebecca Hotsko (12:02):

The other argument is a risk-based argument. The whole premise of the risk-based argument relies on the fact that some of the factors I mentioned are riskier in nature, and that’s why they demand a premium for taking on more risk. So, it isn’t a free lunch. It’s compensation for taking on more risk. However, Pim talks about both of these arguments in more detail in our upcoming interview and actually mentions that the risk argument can’t be used to explain some of the factor premiums. Rather, they are more explained by the behavior argument which I will leave the details for him to discuss, but I just wanted to mention that here.

Rebecca Hotsko (12:43):

So, for this next part, I just want to walk through each of the factor premiums in more detail, and to start off and set the stage for this discussion, I think it’s helpful to start with what a stock price is. A stock price is the company’s book value, plus the discounted value of all future cash flows. The discount rate is the important part because it reflects the amount of risk associated with those cash flows, and it’s often referred to as the expected return of the stock. The higher the discount rate, the more the cash flows are perceived by the market to be riskier and therefore should be lower in price than a less risky company expected to have the same cash flows. Using this risk-based argument to explain why these certain factors lead to higher expected returns, we can see that these factor risks must show up in the discount rate.

Rebecca Hotsko (13:37):

Let’s walk through each factor in more detail. So, looking at the size factor first, it has been empirically shown that smaller companies tend to outperform large companies over the long run, and one reason this might be explained is because they are riskier than large companies, and therefore smaller companies are more likely to have a higher discount rate which would reduce its current price but increase its expected returns over time.

Rebecca Hotsko (14:05):

The next factor is one that we all know well which is the value factor, and this one means that cheaper companies tend to outperform expensive companies over time, based on some relative price metric. This factor’s premium is more largely driven by the behavioral argument in recent years where overreaction tends to bid up prices of growth stocks, making them overpriced and they’re expected returns lower, whereas the price of value stocks are lower which means they have a higher expected return over the long run.

Rebecca Hotsko (14:37):

The next factor is the profitability factor which is largely intuitive, and this says that more profitable firms are expected to outperform less profitable firms over time, and the last factor premium I’m going to talk about today is the investment factor where this one says that a company with lower or more conservative investment is expected to outperform companies with aggressive investment, where in this model, investment is captured by growth in book equity. So, a company with lower growth in total book equity is expected to earn higher returns over time than companies that have higher growth in book equity.

Rebecca Hotsko (15:19):

Taking this all together, this model says that the highest expected returns can be expected by investing in companies that are small, highly profitable value companies with lower growth prospects over time. However, I do encourage you to do your own reading on the topic because it does go way beyond what I could cover in a single episode, as well as make sure to tune into my upcoming episode where I chat with a very special guest who’s an expert in the field in factor investing, and he touches on an important point about why it’s not always better to include more factors. A good starting point for you all might be including a couple into your investment process.

Rebecca Hotsko (16:00):

So, what are some practical takeaways from today’s conversation as we covered a lot here? Well, an easy way to get exposure to factors are to buy an ETF that invests in companies with exposure to these characteristics. There are a ton of great ETF products that do all the work for you. So. You don’t have to go out and find all these companies for yourself, and over the long term, you can expect by holding one of these factor ETFs, such as say a small cap value ETF like VBR, for example, it is expected that over the long run, you will earn a higher return than the market index.

Rebecca Hotsko (16:38):

However, if you are like me and you like to take a more active approach to your portfolio and you want to add this to your stock picking process, a great way to do this would be to look for companies that check the boxes of these factors to improve your expected returns. A way I do this easily is by using the screener on our TIP finance tool as this allows you to screen for all of these relevant company metrics I talked about today to determine if the stock has exposure to these factors, and it even has a momentum indicator which is also something that I really look for when I’m picking my investments. I hope this helped you understand more about what factors are, why including more factors into your portfolio can help improve your returns over time, and why you might want to consider adding some of these if you haven’t already yet.

Rebecca Hotsko (17:29):

All right, that is all I have for today’s episode. I hope that you found this episode valuable and you learned something new today, and I just wanted to quickly let you guys know that this will be the last mini-episode for a little while. I am planning on resuming them shortly, but until then, if you have any topics you want me to cover in future episodes, make sure to reach out to me on any of my socials and let me know. If you guys aren’t already connected with me yet on socials, you can find me on Twitter @rebecca_hotsko, and Instagram @millennialinvestingpodcast. Thanks so much for listening and I’ll see you again next week.

Outro (18:08):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin, and every Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.