Investors usually choose stocks based on specific factors that differ from one investor to another, but they all come together under one strategy, which is Factor Investing. And in which the investor simply looks at factors that he determines in advance and do searches for it in companies and stocks until he filters what he sees as attractive to investment based on his own factors. You may not have heard of the term “factor investing” before or use it effectively in your portfolio, but most of you may be familiar with the concept of factor investing.
In factor investment there are two main types of factors, which are macroeconomic factors, and typical factors. In theory, investors who follow a "factor investing" strategy target the following in selecting stocks for their portfolio:
- Lower risk
- higher returns
- More diversification
We will mention 5 of the most famous “factors” that are relied upon in choosing the stocks that make up the portfolios of some investors who follow this strategy.
Quality
The “quality” factor aims to select stocks that have a high probability of outperforming the index when they have several characteristics that characterize them, such as:
- low debt
- Continuous growth in the size of assets
- Continuous cash dividends
Investors can find high quality stocks by referring to some financial ratios that help them to better read the company's situation such as return on assets, return on equity and debt to equity ratio. The "quality" factor has proven to outperform its returns during times of economic downturn.
Value
The “value” factor aims to select stocks that have a high probability of outperforming the index when the stocks are trading at a market value below their fair or essential value (trading at a discount to the fair value of the stock).
When looking for good "value" stocks, it's usually searched for stocks that are trading at a fair value higher than the current market price, and this is usually determined by financial indicators such as:
- P/E Ratio
- Sales Ratio
- Free Cash Flow Ratio
- Price to Book Value Ratio
The return of the “value” factor is better during times of economic recovery after many shares have decreased in their market value due to the impact of the economic recession, not due to a failure to record revenues and profits, so the shares begin to rebound and rise to their fair value.
Momentum
The "momentum" factor aims to select stocks that have a high probability of outperforming the index based on their historical performance, as stocks that have outperformed the index in the past usually register high returns in the future as well. The historical performance of a stock with high momentum is usually measured over the past 3 to 12 month time frame.
The "momentum" factor return is best during times of economic expansion, which is the stage when an economy's GDP growth is above average.
Size
The "size" factor aims to capture stocks that have a high probability of outperforming the index based on the company's size (market capitalization). Based on the principle that companies with a lower market value have more space and room for growth than large companies that may have passed the stages of growth.
Historically, portfolios containing small companies stocks in terms of market capitalization have reported greater returns than portfolios containing only large companies. Any investor can seize opportunities by considering the "size" factor by looking at the market value of the company before making a choice. The "size" factor return is best during times of economic recovery.
low oscillation
The "low oscillation" factor aims to select stocks that have a high probability of outperforming the index's performance based on the oscillation and historical movement of the stock, which can be compared by the "beta" coefficient, which is measured by the stock's standard deviation, the lower the "beta" coefficient of the stock. This means that the stock is less affected by the market movement, which means less oscillation and risks, and vice versa.
Research has proven that stocks with low oscillation have higher returns than stocks with high oscillation considering the risks of both. Measuring the standard deviation of a stock over a time frame of the past 1-3 years is the common time frame. The "low oscillation" factor return is best during times of recession.
These factors are used in investment strategies to choose stocks and companies in investor portfolios, and you have previously used them in your selection of stocks, but without knowing that they exist as a common investment strategy. Targeting these factors may help you reach your investment goals, including maximizing returns and profits and managing risks.
Sources:
Regulated by the DFSA
Past performance is no guarantee of future results. Your investment can fluctuate, so you may get back less than you invested. Consider each product’s risk(s) before investing.
Baraka is not a financial adviser and therefore does not provide financial/investment advice. Our content is informational only.
