Quality and Momentum: The Other Side of Value

If you are just seeing this article and are unaware of the conversation that I am having with my Dad lately, you can check these parts out first: Part 1 and Part 2. With that being said, I will let you listen to the talk with my Dad about factors. 

Last time, we discussed how the information gets embedded into the price and the three factors that have been highly influential in explaining the average returns in the market.

Dad: Yup, I am aware of that and those explanations were fairly straightforward, though I am still interested in the "Why" question. I mean you said previously that this "Why" question is not easy and we do not have a definitive answer but I would still be interested in hearing the different explanations that the researchers have come up with.

I appreciate your enthusiasm to learn more but I deliberately do not want to overwhelm you with lots of information. My advice for you would be to first get the fundamentals of factors down and then we can later talk about risk vs behavioral explanations that the researchers have been fighting over for the last 40 years. 

(P.s. Just to clarify the statement, when academics fight, this takes the form of writing and publishing competing theories and research)

Dad: Alright! So, what are we learning today?

We are going to look at what lies on the other side of the value? What I mean by that is we shall be talking about the two factors which in its behavior and economic rationale present themselves as contradictory factors to value. These factors are Quality and Momentum. 

Dad: Let me take a guess. Does this mean we should invest in quality stocks?

You are exactly right. It is as simple as that. But can you tell me, how do you define quality? How will you know if a company is a quality company or not?

Dad: Uhh...I don't know the details but I would assume that the company would have high profit, low debt, a good management team, a good strategic plan, etc. Is that correct?

That is correct. But since in our framework we need a quantitative definition, we shall be using some financial ratios and metrics to help define quality. Now, it gets slightly tricky. Researchers have defined quality in many different ways. So, within the world of quality factors, there is one fairly well-known factor called the Profitability factor. This was first introduced by Novy-Marx (2012). 

At its core, what the profitability factor is saying is that the more profitable companies tend to outperform the less profitable companies. In other words, if a more profitable company is trading at the same price to some fundamental as the less profitable company, the more profitable company must have higher discount rates applied to its cash flows.

Dad: But that is totally counterintuitive. Don't you think? I mean why would the more profitable company have a higher discount rate? Because the simple logic dictates that the more profitable companies would have stable cash flows and therefore less risk. So, if anything, it should have lower discount rates applied to its cash flows.

I can understand your frustrations Dad. Those are all valid points but this is what the empirical data in at least most of the markets around the world tells us. Let me again explain this concept by giving an example: 

There are two companies: A and B. Company A and B are generating 10 million and 8 million per year in profits respectively. But their price relative to their book value is the same. So, this means that the profit of the more profitable company is being discounted at a higher discount rate for the price multiple of the two companies to be equal. So, from just looking at the price and its relative fundamentals, all we can tell is that something is going on. 

Dad: Ok, that was a bit hard to get compared to how easy it was to understand the value factor because this looks like the complete opposite to the value factor that we talked about last time.

 Yeah, one can think of this as the opposite of value, at least on the surface. I do not want to dig deeper on this as it may confuse you more. So, just write in your notes that the more profitable companies tend to outperform less profitable companies.

Dad: Alright, now what's the other factor?

The momentum factor. Perhaps the simplest and intuitive to understand, momentum as a trading strategy goes back to hundreds of years ago where people have been recorded to have bought and sold goods on the basis of their price trends. 

Dad: So, are you telling me that this momentum is the same as the price trends that you see people (or technical analysts as they call themselves) on YouTube talking about all the time?

How many times have I told you to not watch those silly trading videos on YouTube?!!!

But to answer your question, yeah kinda but not really. What the chartists or a technical analyst are basically doing while they form a trend line or follow a moving average to trade is called the time-series momentum. However, in the world of factors, we are focused on cross-sectional momentum. These two are different things. The idea of cross-sectional momentum was first brought by Jegadeesh and Titman (1993).

I will put it simply. Basically what the momentum factor does is it says to buy companies that are trending upwards and sell/short the companies which are trending downward in the last certain period. (The period can be any number from 3 months to 12 months). Usually, the traditional investment management firms offer long-only momentum products to retail investors because of the complexity associated with a long/short portfolio. Essentially, the momentum factor is telling us that the assets which go up tend to continue that trend for a while.

I really want to stress that last “for a while” part because nothing goes up for an infinite amount of time. This is why there are a lot of tools used by quantitative researchers to manage this problem.

Dad: In a way, this feels the opposite of value as well. So, when we have all these competing factors and competing theories behind it, how can we implement all these historical premiums in our portfolio to achieve better returns?

Well, that is a very good question but way beyond the scope of this article. We can talk about that later sometime in the future. But for now, we have to place a full stop on the factor series. So, to wrap it up, an investor, if they want to maximize their expected returns, should make sure to have these risk factors in their portfolios.

I hope I was able to give you the basic intuition behind the independent factors in the world of finance.

Dad: Yeah, I think so, at least on the surface level. 

I will take that as a success. 

References

Novy-Marx, R, 2012. The other side of value: The gross profitability premium, Journal of Financial Economics, 108(1), pp. 1-28. http://rnm.simon.rochester.edu/research/OSoV.pdf

Jegadeesh and Titman, 1993. Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, The Journal of Finance, 48(1), pp. 65-91. https://www.bauer.uh.edu/rsusmel/phd/jegadeesh-titman93.pdf

Bivek Neupane is a recent graduate of MSc. Finance and Economics. His master’s thesis titled “Is more always better? The impact of quality in alpha and factor premia” was focused on analyzing independent risk premiums around the world. He is specializing in quantitative finance and research. If you have any questions, do not hesitate to contact him. You can connect with him via LinkedIn , his blog or e-mail.