Factor Fiction: Quality, Value, & Momentum

Tom Shipp (00:00):

Equity factors are characteristics of individual stocks expressed as data that help explain the risk and return of equity markets beyond beta. While any piece of data could be described as a factor, there are a few deeply research factors such as quality, value, and momentum that have consistently delivered over time what many may consider to be an anomaly of the market, outsized above market returns. But what happens when one factor stays in favor too long? In this edition of LPL Street View, we will review how the equity research team thinks about quantitative and fundamental research, particularly equity factors, while revisiting a topic our CIO Marc Zabicki covered last month, the prolonged outperformance of the momentum factor.

Tom Shipp (00:43):

As a bit of background, the equity research team within LPL Research conducts quantitative and fundamental research on individual equities. Our research is expressed across published content and delivered via model portfolios. Our investment philosophy is simple, we seek quality businesses trading at reasonable valuations. To do this, we take a quantitative and fundamental approach, what we like to call "quant-amental research". Proprietary quantitative factor models score and segment different universes of stocks in the market. Fundamental bottoms up research on individual stocks provides clarity on the underlying opportunity. Focusing on the quantitative side, over long periods of time, we believe excess exposure to three core factors, quality, value, and momentum, can serve equity investors well. Research has shown these factors have provided diversification and the potential for excess returns relative to the market. In shorter time periods, however, one factor can get extended relative to others, and given the nature of the momentum factor, which is simply to favor recent winners over recent losers, it's no surprise that it's typically the momentum factor that experiences periods of overextension, at times followed by sharp corrections.

Tom Shipp (01:52):

So much so that the phenomenon has its own name - the momentum crash. Over the last two years, the momentum factor, measured here by the S&P 500 Momentum Index, has steadily outperformed the market as well as representative quality and value factor indexes. Now, we're not calling for a momentum crash or a pronounced drawdown - market and factor timing is something we do not recommend. However, we think when any trend gives so much for so long, it warrants a closer look. A quick fundamental diagnostic we like to use is expected returns relative to valuations, or to put that in plain English, how much do I have to pay and what am I getting? Here, we look at forward price to earnings ratios relative to expected returns on equity. What this is telling us is that the S&P 500 Momentum Index is expected to provide below market returns on equity at an above market P/E multiple over the next 12 months. Now, this analysis is no magic formula, but it does highlight how a strategy focusing solely on recent winners can become detached from fundamentals, and when expectations become too high, the price paid for not

Tom Shipp (02:58):

living up to them becomes high as well. Pairing this with seasonal headwinds, August and September are historically weak months for the market, and investors over index to momentum may be well served by diversifying strategies over the coming months. That's all for now. Thank you for listening and have a great day.