What’s your stock picking process look like?
Today I’m going to share a glimpse into my stock picking “process of elimination” with you by breaking down what I factor into consideration.
FACTOR #1: Momentum
The momentum factor alone can be a total hit or miss.
Some years, it was the gleaming factor: 2015, 2017 and 2020.
Other years, it was a pile of dog dung: 2016 and 2021.
The momentum factor is among the second-strongest return drivers. However, it does come with the fourth-largest amount of volatility … but that’s a pretty favorable trade-off nonetheless.
Momentum can be used by itself.
Though for longer-term investors, it helps to consider other factors alongside momentum.
FACTOR #2: Size
Contrary to what most say, size does matter!
The so-called size premium shows that small-cap stocks tend to outperform large-cap stocks.
Small caps produced either the best or second-best return of all factors in 2010, 2013 and 2016.
More recently, they’ve been through a tough stretch. They’ve been the worst or second-worst performing factor in 2011, 2014, 2015, 2017, 2018, 2021 and 2022.
While small caps have outperformed over the long haul of market history, that has most certainly not been the case since 2008.
Small caps performed the worst between 2008 and 2022, with the most volatility!
This past bull market was dominated by astonishing outperformance of large and mega cap stocks. But you shouldn’t necessarily expect that to continue over the next bull market.
FACTOR #3: Volatility
Somewhat counterintuitively, lower-volatility stocks tend to outperform stocks with higher volatility.
Minimum-volatility stocks outperformed in 2008, if you count “losing less” as outperformance — which, to be fair, losing less really does matter!
The volatility factor also held the top or second-best spot in 2011, 2014, 2015 and 2018.
What’s interesting is, the low-volatility factor was in the bottom two slots only one year: 2013.
That was a particularly bullish year for stocks, and the factor returned 25.3% … even though it trailed the other factors, which produced stronger gains.
All told, the low-volatility factor gave investors the most favorable trade-off between risk and return over the 2008 to 2022 period. It’s produced the highest return at 9.5% — with the least volatility at 13.9%.
FACTOR #4: Value
Like the momentum factor, the value factor can be a hit or miss play just the same.
Value was the best or second-best performing factor in 2009, 2012, 2013, 2014 and 2021. Though, it was the worst or second-worst one in 2010, 2015, 2018 and 2020.
Overall, the value factor has struggled since 2008. It generated the second-worst annual return at 8% — with the second-highest amount of volatility, at 21.4%.
Much like the size factor, the value factor’s performance during the 2008 to 2022 period runs counter to the longer arc of history.
Considering that many market historians summarize the 2009 to 2021 bull market as being driven by “Big Tech,” it’s easy to see now how smaller “value” stocks lagged in marching order.
But again, you should be cautious against assuming the next bull market will be a replica of the last one. If anything, there’s an expectation for “small” and “value” stocks to outperform in the years ahead.
FACTOR #5: Quality
Quality tends to be a more “Goldilocks” factor.
It’s been in one of the top two positions only once — in 2019. But it’s been in one of the bottom two positions only once also — in 2014.
All told, the quality factor has produced the third-strongest returns, at 9.2% annually, since 2008. And it’s done so with the fourth-lowest amount of volatility. That’s a favorable trade-off.
FACTOR #6: Growth
All other things equal — and particularly during times of economic expansion and in bull markets — the stocks of high-growth companies tend to outperform those of low-growth companies.
The cyclical sectors are more sensitive to the economy’s ups and downs. And they tend to skew toward high-growth sectors, including: technology, consumer discretionary and communication services.
That said, the same high-growth cyclical sectors tend to fall the hardest in down markets. They were the worst-performing group in 2008, down 44.8% … and also in 2022, down 27.2%.
Over the whole 2008 to 2022 period, this group’s average annual return is exactly in the middle of the pack, though its volatility is the third highest. That’s not a particularly good trade-off.
Which leads to this near commonsense statement: looking solely at growth is not the best investment strategy.
The “Multifactor” Approach:
You can think of taking a “multifactor” approach the same way you should think about investing in a diversified basket of stocks versus just one stock:
You’ll never get the best performance from the diversified basket … but you’ll never get the worst either.
The multifactor approach performed in one of the top two spots just once — in 2010. But it’s never been in the bottom two positions!
It’s a “fair” trade-off, and it tends to be more consistent than most of the individual factors used as a decision process alone, particularly when considering a longer time frame that includes surviving both bull and bear market conditions.