Much has been written about how buying cheaper, smaller companies with rising prices, and shorting the opposite, has helped investment returns. These concepts, often called factors, were popularised by the research of Eugene Fama and Kenneth French. Indeed, this approach is now sufficiently popular that low-cost Exchange Traded Funds (ETFs) exist to programatically replicate aspects of these strategies. Nonetheless, research, including papers by Fama and French once again, have unpicked other themes that help drive investment performance.
Generally, companies that spend less money on big projects, see better share price performance than those that are big spenders on a new plant or machinery. This makes sense because spending money on plant and machinery is cash that is not being returned to shareholders, and may tend toward empire-building rather than disciplined capital allocation. Also, large capital projects have a tendency to run late and over-budget, so greater capital spending exposes companies to potentially greater risk. The idea was highlighted in Fama and French’s 2015 paper updating their asset pricing model.
One insightful measure of profitability is to look at profits relative to assets. What return is a company actually making on the investments it has already made? When this number is higher, it has historically lead to improved share-price performance on average. This result appears to be quite robust, since other measurements of profitability seem to reach the same result. Arguably, this is an important aspect of Warren Buffett’s investing approach, building on the work of Ben Graham. Buffett works to find companies that are not merely earning profits, but are doing so in a way that they can then reinvest those profits at a high rate of return. Academic research has shown the validity of that approach. This has been highlighted again, in the 2012 paper by Robert Novy-Marx and subsequently reflected in Fama and French’s work.
Not Issuing Shares
Issuing shares typically hurts share price performance. Again, the issuance of shares may suggest a firm that demands capital rather than producing it, hurting investment performance. Also, management’s decision to issue equity rather than to fund projects differently or delay them, may suggest a lack of alignment with shareholders. Research by David Ikenberry found that companies that repurchase their own shares tend to outperform the market. R. David McLean has shown that companies issuing shares tend to underperform, and this result tends to hold across countries.
Taking Less Risk
Contrary to what you might expect, researchers have not found an expected relationship between risk and return, in fact, they have found the opposite. Companies which are less financially secure, actually tend to perform worse than more robust firms. It appears that, on average, investors have a tendency to seek out risky situations, and bid them up in price more than they should, but that returns to these setups can be unattractive on average.
A Terrible 2018
Nonetheless, many of the approaches, along with the original factors just described have had a terrible 2018. Kenneth French’s website tracks performance of various factors here. Nonetheless, a bad year is perfectly normal in the context of these approaches. It remains to be seen whether the weak 2018 suggests muted returns for these strategies going forward, that or a rebound in factor performance may be coming. The latter seems more likely given the weight of evidence behind these approaches, however it also appears that as these strategies become more public, returns to them can decline over time.