“Diversified Equity Factor Investing” combines four complementary factors that are loosely correlated with one another

Alongside considerable academic research, our proprietary research has demonstrated that the Quality, Valuation, Momentum and Low Volatility factors, which we have weighted equally in our Diversified Equity Factor Investing approach, can be significant sources of long-term returns. These factors can also be viewed as generally stable, due to investors’ persistent behaviour biases.

Quality is an often overlooked factor, despite being positive, i.e. companies that manage to develop a profitable business are likely to see that reflected in higher share prices. But this criterion is not always easy to measure. Attention is most often paid to return on equity to assess whether a company manages its shareholders’ money efficiently. A more subtle assessment of future top-line growth can also be made on the basis of cash flows and/or the gross margin. But another indicator of quality has recently emerged in academic studies: accruals. This represents a company’s ability to be paid as soon as possible for the products or services it has sold. Generally, the lower the accruals, the more likely the company’s pricing power or the solidity of its balance sheet will be above average. These are two criteria that can help define quality.

Like Quality, the Value factor can be a source of alpha , given investors’ tendency to underestimate a company’s fundamentals. And yet it would seem wise to overweight “cheap” companies, i.e. those whose fundamentals are not properly priced in. A company’s undervaluation can be assessed in very many ways. At THEAM, we use indicators such as earnings and, in some cases, dividends, but also cash flows, which are generally more directly correlated with the company’s current business. More precisely, we use free cash flow and net operating cash flow, as using several indicators provides a clearer overview.

Momentum as a factor comes down to the old saying “the trend is your friend”. Buying shares that are on a roll may be a good idea if one assumes that “others” may possess useful information on the shares. But such information sometimes takes time to be priced in. One reason for this is that investors have a hard time changing their minds. A stock’s momentum, i.e. the trend in sentiment towards a given company, may be assessed on the sole basis of its performance track-record. Of course, the timeframe still has to be determined – generally one year – in order to avoid being confused by a short or medium-term reversal of trend. At THEAM, to define our own momentum indicator, we study the sentiment of the parties involved, in particular financial analysts and investors. Each forecast revision by analysts, for example, suggests a change in their sentiment on the company concerned.

The Low Volatility factor is counterintuitive, and even illogical, by nature. According to the “low-volatility anomaly”, which was discovered in 1972 and on which this factor is based, shares that have shown little risk in the past, based on their historical volatility, should not only continue to do so but also achieve returns that, on the whole, are similar to those of other types of stocks. Their risk-adjusted return (Sharpe ratio) is higher than that of other stocks but also far greater than the ratio of higher-volatility shares. One reason for this is that investors are most often drawn to familiar and volatile shares, and this triggers a supply-demand imbalance. So, over the long term, risk is not properly remunerated. In other words, caution pays off on the equity markets.

These four factors do not work at the same time, and each has its own risks. Combining them within the same portfolio unlocks synergies. It also helps lower their total cost. Risk management is also more optimal, as overall risk is kept under control.