As the name suggests, factor-based investing is a strategy of investing that looks at different factors to provide diversification, generate above-market returns and manage risk.
The types of ‘factors’ that investors will typically base their investing strategy on are:
Value
Value investing means that investors look at the Price to Book (P/B), the Price to Earnings (P/E), the dividends and free cash flow to see if a stock’s price is under, over or in line with the value of the company. If the stock price is under the value it means that the share price is trading for less than what the underlying company is worth. This means that an investor (like Warren Buffet) who uses this strategy can potentially gain higher returns when the stock price rises in line with the company value.
It’s important to note that stocks like Amazon are not considered undervalued, meaning their share price is not less than the company’s value. Value investors (like Warren Buffet) may miss out on the growth returns on stocks like Amazon, that are not ‘undervalued’, can provide.
Size
Size refers to the market capitalisation, such as small, mid and large cap companies which essentially means young to more established companies. Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. This is because large caps are typically less volatile and have already experienced a lot of growth whereas small caps have larger potential to grow over the short and long term.
Momentum
A momentum strategy is based on the previous performance of a stock usually over the past three to twelve months. Stocks that have outperformed in the past tend to exhibit strong returns going forward.
Quality
Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance. Financial data like Return on Equity (ROE), Debt to Equity (D/E) and earnings are a way for investors to understand the quality of a company’s stock.
Volatility
Volatility is also known as risk or beta. Looking at the volatility over the past one to three year period is a common way to understand the level of volatility in a stock. Typically, stocks with low volatility earn greater risk-adjusted returns than highly volatile assets, meaning they typically don’t have as many losses or as greater chance of investors selling their stocks over the fear of losses.
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.
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