Analytics

# A Fundamentalist’s Attempt To Take Advantage Of Factor Moves

For many fundamental investors, factors play little to no role in their portfolio construction process. In this article, we’ll give a basic primer on factors and a potential strategy for fundamental investors to take advantage of irrational movements in their investments.

#### Introduction

For many fundamental investors, factors play little to no role in their day-to-day portfolio construction process. In fact, many fundamental investors aren’t quite sure what factors are. Below we’ll give a basic primer on factors and a potential strategy for fundamental investors to take advantage of irrational movements in their investments caused by factors.

#### What are Factors?

Factors are tools designed to help explain why stocks move. The simplest factor is the market. If the market is down 15% in a month, you expect the average stock would be down 15% as well. So if a particular stock is down 10% (ignoring Beta for this simplified example), then it has generated 5% of positive alpha (to make it really confusing, it is also called idiosyncratic return and specific risk). Basically, alpha is the fundamental piece left over.

But the market is not the only “factor” that could explain why a stock moved. It was just the first. Academics and quants have been coming up with new factors since Fama-French added Size and Value to Market in the early ‘90s. Below are some common ones but there are many more:

#### How is a Factor Measured?

Let’s use the Value factor as an example. Imagine I take every stock and measure an average Price-to-Book (P/B) of 3.5x and a standard deviation of 1.5x. Then I take every stock and measure its Z-Score which is simply the P/B of the stock minus the average of 3.5x divided by the standard deviation of 1.5x. If a stock has a P/B of 5.0x then it has a Z-Score of 1.0x ((5.0x-3.5x)/1.5). To drive the point home, a stock with a P/B of 3.5x (equal to the average) would have a Z-Score of 0.0x and one that had a P/B of 2.0 would have a Z-Score of -1.0x. This is simply how many standard deviations away from the average a particular stock sits.

To drive the point home, if you hold a 5% position in a stock with Value Z-Score of 2.0x and another 5% position in a stock with a Value Z-Score of -2.0x, your portfolio has no exposure to the Value factor. This works the same if you are long and short equal amounts of securities that have the same Value Z-Score.

#### How Have Factors Been Moving Recently?

Market turbulence spurred by the COVID-19 outbreak has pressed many factors to multiples far outside of their historical averages. To illustrate this dispersion, the table below lists 12 of the most common style factors used by investors and ranks them based on the number of standard deviations that last month’s performance represented compared to their 10-year average (Jan 2010 – Jan 2020).

If we highlight a few of the factors that typically see minimal month-to-month movement, we see that Profitability sits at the top of the list with a 7.2x standard deviation. Profitability is typically referred to as the ‘Quality’ factor and comprises quality-related metrics such as return-on-equity, return-on-assets, cash flow to assets, cash flow to income, gross margin, and sales-to-assets. It’s abundantly clear that in the present environment, investors have been flocking in droves to quality names.

Not at all dissimilar to what occurred during the Financial Markets Crisis of 2008, investors have been dumping Leverage. Leverage is composed of metrics related to total debt-to-total assets and total debt-to-equity and is a factor that moves glacially in a normal market environment.  It ended down 3.44% last month, which actually represented a pull-back as its nadir for the month was -4.13%. Investors are seeing highly levered companies as much riskier than normal in the current environment.

Investors are also punishing companies that have supply and distribution chains more exposed to global foreign exchange movements (Exchange Rate Sensitivity) but are more prone to flock to larger market cap names (Size).

These large factor moves may be presenting great buying opportunities for fundamental investors who have seen their stocks move for non-fundamental reasons. But what are some practical methods that you can use to measure it?

#### Factors Movements Create Fundamental Investment Opportunities

As the markets become less and less rational, this may represent a golden opportunity for fundamental investors who track recent factor movements. When looking at their particular universe of stocks, fundamental investors should ask themselves, how much of recent moves are fundamentally-driven, and how much are non-fundamental? This environment presents potential arbitrage opportunities that they can dig deeper on.

Using the Omega Point platform (a tool to measure portfolio risk - Alpha Theory has a partnership driven by clients that use both products), below we will go through three examples of individual stocks that represent various sides of the factor opportunity spectrum for fundamental investors:

##### Moderna (MRNA)

Moderna is a biotechnology company focused on drug discovery and drug development. In January, Moderna announced the development of a vaccine to inhibit COVID-19 coronavirus with a subsequent announcement of an ETA in 2021. If you look more closely at its recent performance, it’s clear that the most significant component of this stock’s move is related to alpha, and much less so for irrational, non-fundamental reasons. The fundamental investors using a factor-based lens to uncover opportunities should skip this one and look at other names in their universe.

##### Avis Budget Group (AVIS)

Avis represents a more middle-of-the-road example based on a mix of factors and alpha driving its recent movement. Approximately 50% of its move has been related to fundamental factors, while the other half is alpha related. This makes sense, as Avis is in an especially difficult situation right now based on the global travel environment that impacts its core business. Some further analysis may be in order for Avis, but better opportunities may lie with names barely being driven by alpha.

##### Dupont (D)

As shown in the Omega Point screenshot above, Dupont is down over 20% in March but what interests us most here is that 95% of that movement is purely factor related. If we hone in on the sidebar, we can see the breakout of the different factor components. While the market and sector moves seem plausible, there is a 10% downward movement in style factors that may represent instant upside once the factor effect is neutralized. Dupont’s price has been driven almost entirely by factors (i.e. non-fundamentals) and may be a strong candidate for a buy if you agree the move is largely for non-fundamental reasons.

There may be several names in your coverage universe that share the factor characteristics of a Dupont, but we need to remind readers that fundamental investors shouldn’t take this type of analysis at face value. Although the increasing precision of factors to describe stock movements have been a huge boon to many investors, it’s still an imperfect science but in our view can give fundamental investors a powerful punch list of ideas which they can pursue.

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The table below sorts a group of stocks by the impact of factors vs. their total overall return. Names higher on the list such as Dupont exhibit returns that are much less fundamental, and may warrant additional research by you and your team.

Coupled with a strong fundamental story, a likely good bet in the long term:

- A buy: large negative factor move as a percentage of the total move

- A sell: large positive factor move as a percentage of the total move

We encourage you to perform this type of analysis to highlight names that have moved for non-fundamental reasons and compare them to where your position-sizing system is suggesting you make the biggest adds (see below).

While the current depressed market has been more favorable to uncovering potential buying opportunities, this analysis can be effective for finding both buys and sells in a more normal market environment.

#### Special Offer

While uncovering, researching, and selecting superior stocks will always remain the core focus of fundamental investors, a better grasp of how factors are impacting our portfolios can help us take advantage of irrational behavior.

And to that end, our friends at Omega Point are offering to provide Alpha Theory clients a customized factor-based analysis including the Factor Move for each security in your portfolio. Reach out to support@alphatheory.com or your Customer Success representative to get the details.

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