Factor investing is an investment strategy that chooses securities on attributes which based on empirical research are associated with higher returns. Sometimes they are also known as “style factors”. Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk. The main equity factors known are value, small cap, quality/profitability, momentum, and minimum volatility anomaly.
What is value investing?
Value investing seeks to exploit the irrational behaviour of emotional investors. Emotion is a constant feature of investment markets through time, the human nature of the investors themselves does not change much. Fear and greed remain ever present and frequently lead to poor investment decisions based on perception and emotion rather than reality. Periodically these miss pricings can become extreme (the tech bubble of the 1990s or, conversely, the great depression of the 1930s), however, they exist to a greater or lesser extent in most markets. This creates an opportunity for dispassionate, long term value investors. Although this concept seems simple, sensible and, hopefully, appealing, it is not easy to be a “value investor”. The main cause is that investors need to avoid the companies known as “value traps”, businesses which are fundamentally challenged and highly leveraged, businesses which destroy value for investors i.e. companies which are trading at lower stock prices for the right reason.
In short, value investing is an investment strategy that involves picking stock that appear to be trading for less than their intrinsic value i.e. looking out for stocks value investors think the stock market is underestimating. Usually this is done by screening for stocks which have a low Price to earnings (PE) ratios, Price to sales ratios, and Price/book ratios.
The best time to be a value investor is in periods when the markets can be susceptible to large-cap growth bubbles, something we had in 2000 (see chart below). Probably now there is that time again.
Looking at the stock markets now, we can see that many large stock growth stocks: Apple, nVidia, Microsoft, Meta Platforms, Amazon.com, Intuit, Intuitive Surgical (P/E ratio of 73) are at their highest (or close to) stock price, others like Tesla (P/E forward ratio of 110), Crowdstrike Holdings (P/E forward ratio of 79), Palantir Technologies (P/E forward ratio of 105) trade at very high valuation metrics.
The case of nVidia is worth mentioning. In this case the hype has led to an increase in sales of leveraged notes (nVidia 3x ETF etc) and options, which has generated a ‘gamma squeeze’. A gamma squeeze is a rapid and significant increase in a stock’s price, usually triggered by large volume in one direction within a short span of time. This event typically starts when many investors buy call options for a certain stock, exactly the case of nVidia 3x ETF. When a large volume of call options is bought, the investment banks (which are the counterparties writing these options) are compelled to buy more of the underlying stock to hedge their position, which drives the stock’s price even higher. People who bought nVidia 3x ETF early in July at the top of the market have seen their investment going down by 60% by mid August.
Another thing that is worth mentioning is that interest rates have started to fall; the FED cut from on 18 September 2024 gave the bull market another leg, because this lowers the discount rate used to calculate the stock prices. (you can read more here: Gravity – why we should not fight it! (n2-am.com))
Initially, growth stocks react first to a cut on interest rate, as their earnings are expected to come later (in 5 to 10 years’ time) and as a result they go up first when interest rates are cut. However, a cut in interest rate helps “value” companies too as these companies tend to be more leveraged. It reduces the cost of replacing their debt by issuing new corporate bonds at lower interest rates. As a result, leveraged companies tend to benefit too, especially property companies, but also other sectors with high leverage and a relatively stable business, for example telecom companies.
At N2 Asset Management Limited, as part of our tactical approach, when the gap in valuations (measured by Price to earnings (PE) ratios, Price to sales ratios, and Price/book ratios) between the growth and high-quality factor versus value factor is high, we will reduce the exposure to the growth and ‘high quality’ factor and add some exposure to ‘Value’ factor. Combined with our understanding of the economic cycle, we use a ‘value’ factor screen to look for companies with a lower Price/book and P/E ratios, however even in this case some “profitability” screening of the stock selected takes place. It is simple and intuitive; we sell companies which are very expensive, and we diversify buying cheaper companies.
Please get in touch with us if you want to learn more.
IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.
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