Stocks vs Factors: The Real Fundamentals

Are factors really the essential building blocks of investment portfolios, or is it just clever marketing? In this episode of Skeptic's Guide, Clem boldly challenges the widespread belief in factor investing by arguing that individual stocks themselves are the true fundamentals. Clem dissects the unpredictable nature of factor performance and critiques the simplistic construction of factor ETFs. While he acknowledges the utility of certain factors like beta and sector emphasis, he remains wary of a rigid adherence to a value-focused approach. Tune in to hear Clem's compelling arguments and his nuanced view of the role factors play in investment strategy.

As we transition into our second chapter, we tackle the intricate balance between thematic and factor investing. We delve into the art of constructing a robust, diversified portfolio that can adapt to changing market conditions. Our discussion spans the challenges of market timing, the benefits of using recent data for predicting trends, and the complexities of combining thematic and factor strategies. With insights into high-growth sectors like AI and healthcare, and an examination of the cyclical nature of value versus growth investing, this episode offers valuable guidance on building resilient portfolios. Don’t miss out on these essential strategies that could help safeguard your investments across different economic landscapes.

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Chapters

• 0:27 Skeptic's Guide to Factor Investing
• 11:35 Balancing Thematic and Factor Investing

Transcript

Steve Davenport: 0:27

Welcome everyone. Today, here we are at Skeptic's Guide, and today we're going to talk about a little bit of an obtuse topic. There is a school of thought in investing that you should understand the factors that you're exposed to, and maybe even you should focus on factors as the way to invest versus a more global approach or a more general approach. And factor investing has been around for a long time and some people are ardent believers. There's people that are value investors and say value will eventually hold, and value is important, and the value factor is the factor that you should use, because then you're never overpaying for your investments, your growth rate is different, your results are different and your breakdown between how much is in income from dividends versus how much is in capital appreciation All of these things make for a lot of discussion in the investment world, and so we thought it would be good to give you the skeptic's guide to factor investing today, and we're going to start with Clem who, surprise, surprise is skeptical about factor investing and he's not sure it's the way to go.

Steve Davenport: 1:52

So for those of you who kind of like to take whatever Clem says and do the opposite, this may be an opportunity for you to build a portfolio that can go through good times and bad. So, clem, what is it about factor investing that really causes you to be negative, and would there ever be a time that you'd want to invest on factors like quality and something to do with shorting Something?

Steve Davenport: 2:27

to do with shorting. Those are factors that you use.

Clem Miller: 2:31

You say you don't like factor investing, so tell me, Clem how do you get yourself into these corners and then get yourself up?

Clem Miller: 2:42

Thanks, steve.

Clem Miller: 2:43

So let's talk about the way factors have been presented by the investment firms and the marketing of factors.

Clem Miller: 2:57

So this factor sort of came out as an investment concept, a marketable investment concept, something like five to seven years ago, as a marketed concept, and the one image that was put out there by the marketing people was that factors are sort of the building blocks or the atoms, so to speak, of investing, so to speak of investing, and that rather than invest in particular stocks, you would invest in these factor building blocks and some combinations of those. So I would definitely push back against that and say that no, the building blocks of investing are actually the stocks themselves. They're not the factors, and stocks represent a combination of all sorts of individual stocks, have all sorts of idiosyncratic elements to them and they are the building blocks of portfolios. I think that if you look at, if you look at things like Barra and you try to examine the exposures, you have to particular quote, unquote factors like value and quality and and really just I think the last time I looked at 60 or 70 different factors, I don't know how useful something that has 60 or 70 factors are but.

Steve Davenport: 4:45

I think there's some.

Clem Miller: 4:46

I think there's some utility to looking at factor exposures in a portfolio, but I don't think one should invest in factors themselves. Now, let's say, because there are things called factor ETFs, I would not invest in those. So why wouldn't I invest in those? Because it is very difficult to anticipate when a factor will do well. So you've got folks out there who have said well, in a rising market environment, or actually, more accurately, a rising economy, value stocks should do better. In a sort of flattish or declining market, Maybe growth stocks or certainly quality stocks should do a little better. But here's the problem the market isn't reactive to what the economy does. The market anticipates what the economy does. So really, value stocks should be rising before the economy turns around and quality stocks should be rising before economies start to turn down. So you really have to be able to be accurate in your projections in order to actually use these factor ETFs, and very few of us, I think, can be so predictive about what these individual factor stocks can do. The other thing I would point out, Steve, is that factor ETFs are a function of their construction. So some of these factor ETFs are based on two, three, four indicators. And are these really good indicators, Are they not good indicators? You can find a dozen ways to look at value. So are the two or three ways of looking at value in a value ETF, value index, a deep value index, let's say pure value are these the way that really measure?

Clem Miller: 7:05

When I look at a portfolio, when I look at my portfolio and I look at portfolios in general, I'm concerned not so much with value, as I am just looking at value and momentum. I'm more concerned about whether stocks fall into particular sectors or not, particular industries and in terms of being able to dial beta up or down. So I guess you could say beta is a factor right, and indeed in many formats it would be a factor. Not in all factor ETF or factor indexes is beta in ETF, but in some there are Probably BARA, I think, has it as an exposure, beta exposure. But when I anticipate the market to go up a lot, I'll have a higher beta in my portfolio. When I anticipate that there might be some unsteadiness or that it might decline or more likely to decline than go up, I would dial down my beta to below one. So I'm more interested in beta. I'm more interested in cyclical versus defensive sectors and the appropriate weight.

Steve Davenport: 8:30

You sound like a value factor investor, Clem, so I think we're going to classify you as somebody who is opposed to factor investing but does it for their own portfolio.

Clem Miller: 8:43

No, I wouldn't say that at all, and the reason I wouldn't say that is because I don't have the same kind of dividend focus as you might. Right, and also, at the same time I have, you know, I don't really invest in only one. I've only got one bank in my portfolio and sort of stay away from banks. I don't really have materials or energy stocks and those tend to be value stocks. I emphasize higher profitability and I emphasize earnings growth, revenue and earnings growth Within a more Garpy or growth at a reasonable price framework, peg-based framework. So yeah, I wouldn't call myself value and I wouldn't call myself a factor investor. I am an investor in particular stocks and I look at various indicators, including some I've never seen in these factor indexes like short interest ratio, unless you've seen I don't know if Barra these days has short interest ratio- but I certainly look at that.

Steve Davenport: 10:01

I don't remember all the factors for Barra, but I guess what I would say is that factor investing feels a lot like timing, like you're making a timing decision, and anytime you make a timing decision, you have to make two decisions. Anytime you make a timing decision, you have to make two decisions when to put it on and when to take it off Because I'm not sure that factors are, through time, going to be omnipresent. As leaders, I think that what happens with portfolios is you go through a period where momentum is the main factor and then, all of a sudden, as you get to a peak, people start to take off that factor and put on factors like quality, dividend, beta, lower betas, and so I think that when we look at this, it really is a timing question first. Second is which factor? All right, and you know, I like to think of the analogy of when you have people doing a dance around the chairs Right and everybody. When the music's playing, everybody is walking, everyone is happy, but when they pull a chair out and the music stops, you've got to find a seat very quickly. And so, in my mind, you build a portfolio.

Steve Davenport: 11:35

I build a portfolio a certain way, which is I look at the sectors and make sure I'm represented in the sectors and in some cases, a sector that I don't like and don't feel is going to do well in a particular period, we may underweight that sector by a half, a position or a full position. When I look at something and say I think this environment is going to be good, we may overweight that sector because technology has a lot of momentum names. If we think momentum is a, I would say that these are ideas but they aren't driving factors for our investing. I think that the idea of looking for something that has a lower beta during a time of anticipated trouble, I don't think of it as timing the market, because we're making adjustments not on a large scale but on a very small scale, meaning I may now suddenly say I like the presence of utilities in my portfolio. I think having another utility with the ability to update pricing based on inflation and other things gives me some inflation control, versus in a bond portfolio where I have no control over the Fed lowering rates. So therefore, I think there are reasons for us to consider factors, but I don't think I would say it's the primary concern.

Steve Davenport: 13:00

I think the issue is one, timing when do you get in, when do you get out and then two what are the factors that you want to use? I think that through time we know that markets don't tend to stick with one factor for too long, because as more and more people get in the boat, more and more people start to feel uneasy about having too many people in the boat and you start to realize that you could tip over. I like the idea that we're always considering all the factors but we're not married to anyone. I like to date my factors. I don't want to marry them and I think that's a common theme is I like names, I like their exposures, I like their operations, but as in the case of Schwab, I mean as in the case of Starbucks and Nike and a little bit of Estee Lauder, their performance recently has been so poor because their association with the growth in China and the slowdown in China that you know the factors that make them good companies still there.

Steve Davenport: 14:17

But the big question is do you use data from the prior year, from the prior two years, from the prior three years to go out one, two or three years? There is a lot of research that shows the more recent data is more helpful in terms of what the factors that are going to succeed going forward are. So you use more recent data. Therefore, you're more likely to catch whatever the theme or whatever the factor is. I think that when we look at these things, they're not the same cycle size. They're not the same magnitude cycle size. They're not the same magnitude. So a factor like dividend could be popular, but there are so many growth investors out there who are never going to consider these names that the market as a whole we've got so much indexing and that's, in general, going to be neutral to all factors that we have to look at active investing and say, of the active investors, what are their common ideas? And I'd say growth in this AI environment, growth in the issues around obesity, drugs I think growth has been at the forefront and people have been paying a premium for it.

Steve Davenport: 15:40

And the question is will that switch over? Historically, value has its day, but that day has been very short and not very great magnitude lately. And does that mean that we're going to go into a value market and it's going to be long and it's going to be hard and it's going to be, you know, to make up for the time? I don't know. We can all see that growth has had a great run. The question is is it about to flip? Are we going to see that change?

Steve Davenport: 16:13

And I think that for all of us, it's worth looking at and it's worth thinking about, and when the values get deep enough and the values get attractive enough, it will be natural for us to move from one to the other.

Steve Davenport: 16:29

So I believe that factory investing is really more of a concept for you to use, not necessarily a roadmap for which factors are going to be the dominant ones and which ones are going to be the minor ones, because I think it all depends, and therefore I wouldn't want to be sitting here saying well, if momentum has been the major factor in investing and I look at it through the last 12 months does that therefore mean that the past returns are going to be forecasting the future returns? I'd say we know that's not the case. So therefore, don't get too obsessed with one factor. Instead, try to look for balance, try to look for a portfolio that's going to deliver for you in adjusting its overall beta and also adjusting some of these factors, so that you have a chance to win in multiple scenarios, and that's what we call a balanced portfolio, or a portfolio that's got several characteristics that we think are going to be beneficial.

Clem Miller: 17:57

So, steve, I agree with that. Let me add on a few concepts here that I think are important for people to understand. One is that when you're putting together an overall portfolio, it's very easy to trip over some factors. For example, if some stocks in your portfolio you've put in there because of themes and then some others you put in there because of factor exposures that you like, the two could really trip over each other. I remember there was a time maybe it's still the case that Apple was considered a value stock If, if you have a magnificent seven kind of theme, you could end up having more Apple than you want to have, so you could have unintended exposures by mixing thematic investing and factor investing. You sort of have to do one or the other in order to prevent that problem from happening. Then another sort of along the same lines, there's a factor volatility called volatility, or actually more like non-volatility.

Clem Miller: 19:18

Some people might invest in a volatility ETF because they think that there's gains to be had by investing in volatility, but a lot of folks will invest in a non-volatility ETF, so a low vol ETF, min vol ETF, because they think that that will reduce volatility. But let's understand how those ETFs are constructed. What happens is those ETFs are constructed not necessarily by looking at stocks that have lower volatility, but those portfolios are constructed to create an internal portfolio that has lower volatility. So a lot of it has to do with the correlations among the various stocks within that portfolio. The instant you put that ETF and I have in my mind right now USMV, which is the US minimum volatility ETF the minute you put USMV in a broader portfolio, basically you don't know what you're doing, because the minute you put that in, all benefits from lower volatility are diminished. You really have to use you want lower volatility. You actually have to use that for your entire portfolio or for none of your portfolio.

Clem Miller: 20:48

And that's just the more extreme version of how it's challenging to be able to do mix and matching with some factor investing, some thematic investing, some individual stock investing. It's really hard to do mix and matching with some factor investing, some thematic investing, some individual stock investing. It's really hard to do all that. It's much easier to just look at and consistent, to look at individual names and to look at their individual exposures and, if you like, their individual exposures and my exposures. Uh, I do mean all of these different things uh, quality, uh, well, profitability in my case, and uh and value and so on. Uh, short interest ratios, uh, but at the individual stock level and not at this ETF level. That depends really on construction. It's like trying to understand the engine room in the ship, and the engine rooms might be taking portfolios in different directions.

Steve Davenport: 21:55

I look at this as part art and part science. I mean, I'm an engineer by trade in mathematics and I love the certainty of the mathematics. But you can get mathematical certainty but have actual idea is completely worthless. So, yes, you can have certainty on my prediction If momentum that existed in the past year is going to exist in the next year to the same degree and there are no other variables that influence it, yes, I would buy a momentum portfolio and I would make money, but that's not the world we live in. That's not the world we live in. So I like the idea that, yes, there is some degree of science and some degree of numbers that influences things, but there's also some art, and I think the art of portfolio management is being able to determine when do you want to put the foot on the accelerator versus when do you want to take it off.

Steve Davenport: 23:03

And sometimes that feeling and that bit of art, your instinct, has to do with how you succeed. If it were all about numbers, somebody would have come up with the algorithm, and the algorithm would be worth a lot of money and we'd pay somebody to do that. But guess what? The industry has evolved into a lot of different ways for a lot of different people to invest, and I can't criticize why someone would believe that Minvol would be a good strategy, except that there are people who have trouble sleeping at night and if they buy something that is a Minvol strategy and they put the money in there that they're going to use in the next three years for buying a house or paying for a kid's college, they feel better. And is that feeling rational? Is that feeling going to deliver results that are more consistent? Maybe, maybe not. So in my mind, we have these tools and these tools are there for us to think about and to consider, but we, ultimately, will speak with our money. Right, you can say all you want about not liking utilities, but if you have three of them in your portfolio, I got to say that doesn't make sense. But if you don't like utilities and you didn't put any money into them, you spoke with your money. And that, ultimately, is where I think you and I have a very similar attitude, which is we consider good ideas, and those good ideas can sometimes be good ideas for clients, but not necessarily our clients or our portfolio. So we have the ability to apply what I think are some of the great research in the space, with Sharp and PharmaFrench and all of the great researchers who've done work. Does all of their work make it come to a conclusion and a point that makes it silly for us to do anything else? No, we have individuals with needs and wants, and those individuals and needs and wants are what drive us towards portfolios that are slightly different, and I think that's what makes this a very interesting industry and a very interesting business, because it's unique.

Steve Davenport: 25:39

And then when we have a conflagration, some volatility in the markets in the Middle East, and it affects the price of oil and we have to decide do we want to up our oil exposure because this is going to last for a while? We approach the decision as we should, which is, with the most recent data and the most disciplined process. I don't think we're going to go 100% energy when oil price goes to 80, 90, 100. But we might go from a 6% energy average sector weight to 10. And I think that that's why we play the game is that it's interesting and it involves challenges and involves us trying to do the right thing for people, and I don't know how would you wrap up factor investing, glen. People should do it with their eyes wide open. People should do it on a limited basis, or people should just focus on quality and profitability and the rest. Let the rest take care of itself.

Clem Miller: 26:53

I would certainly advise that people do something similar to what. Well, first of all, you need to be consistent, so, whatever you do, you should be consistent. So that's number one. Number two you should not be scared of volatility, so you should persist through volatility. So that's number two.

Clem Miller: 27:12

Number three would be to consider the kinds of things that I consider in my portfolio, which would be low short interest ratio, which, as far as I know, is not included in any kind of factor framework.

Clem Miller: 27:29

Employee satisfaction, which is not included in any factor framework or even any ESG framework, as far as I know. And I do consider profitability, which is one element of so-called quality, um, and I consider, uh, I consider growth, uh, which is, you know, which is obviously considered within some of the growth factors, uh, etfs, or growth style ETFs, but not in some of these, uh, not in some of these other stylistic ETFs. So, yeah, I'm very skeptical of factor investing, and I would advise our listeners. Personally, my view is to be skeptical of factor investing too, too, and I think the most important reason for that skepticism is something that both Steve and I have discussed on this call, which is the great difficulty in being able to forecast when factory ETFs will do well and when they will do individual factory ETFs will do well or when they will do poorly. I don't think you can actually forecast that.

Steve Davenport: 28:43

That's great Thanks for those insights, clem, and realize everyone that these are all for the purpose of education our discussions here and we expect that individuals will do their own research and consult their own specialists for tax, legal and other advice. So again, great episode on factor investing. We wanted to talk about it and bring out some of the issues and I think we have. So thanks again for listening and please share, like and let others know that you enjoy Skeptic's Guide to Investing. Have a great day and have a great week, thank you.