Introduction
When it comes to Investing, we all want that one Multibagger stock which could change our fortune. We are all looking for the next Titan, HDFC Bank or Bajaj Finance, which has created immense wealth for their shareholders. In terms of CAGR over last 20 years, Titan has compounded by ~38%, Bajaj Finance ~40% and HDFC Bank ~ 21%.
While this journey is certainly rewarding it’s not easy to hold them, especially during periods of large drawdowns. Obviously, in hindsight it all looks easy to hold such businesses but in reality, it’s not. Further, there are actually very few businesses which can achieve such a scale and create similar wealth. So, instead of looking for the next multibagger stock, how about we look for ways and means to create a multibagger portfolio which can help us generate 25-30% CAGR for a long period of time and help us create immense wealth. That’s where factor investing is immensely helpful. It offers a disciplined rule-based and data driven approach to investing and has great potential to generate market beating returns.
Factor Investing has been around for quite some time but surprisingly it’s still a less traveled route for wealth creation here in India. This approach goes beyond traditional methods of fundamental research but can still enhance returns and manage risks in a more systematic manner. In India, we have certain benchmark indices such as Nifty Quality, Nifty LowVol 30, Nifty Momentum which are all example of factor investing strategies. The chart below highlights how they have performed as compared to Nifty 50 over the last 5 years.
Interestingly, all of these strategies have outperformed the benchmark i.e Nifty50. It’s not just about the returns but also how easy it is to use some of these strategies to get market beating returns. We live in a world of information overdose and when it comes to financial markets, the information flow just gets magnified multi-fold. In such a scenario having a rule book of investing, which tells you what to buy, when to buy and when to sell is like a magic wand for investor. Factor investing is one such magic wand which does just that. It offers you a less stressful route to wealth creation.
In this article, our aim is to explain the basics of factor investing and why this is a simple yet powerful way to create wealth in the stock market.
What is Factor Investing?
Factor Investing is an investment approach that involves selecting investments based on specific attributes or “factors”. These factors have historically been associated with providing higher returns (or alpha). These factors influence the performance of a security and hence have potential to generate alpha.
A portfolio return has two components i.e Alpha and Beta. Beta refers to portfolio or a security performance with respect to Market. Beta is also referred to as Market risk. A low beta portfolio will have risk lower than market and high beta carries higher than market risk.
Alpha component is the excess return over benchmark. Portfolio managers’ primary goal is to create alpha generation by taking minimal risk (i.e Higher risk adjusted return). To create alpha, there are broadly 5 factors which are associated with alpha creation as mentioned below.
Types of Factors
There are 5 main factors which contribute to excess return of a portfolio. These are “Value”, “Size”, “Momentum”, “Quality” and “Volatility”. Depending upon the investment objective, one can create an investment basket based on each of these factors or a combination of these factors (i.e Multifactor investing). Over last few years, momentum investing has gain lot of popularity in India. However, Momentum is just one of the factors and there are many other factors to play around. We primarily focus on multifactor investing across market caps. If you wish to learn more about our strategy, please read this article here
1. Value
The Value factor focuses on companies that are undervalued in relation to their fundamentals, such as earnings, book value, or cash flow. The idea is to buy stocks that are priced lower than their intrinsic value.
2. Size
This factor pertains to the size of a company, often measured by its market capitalization. Small-cap stocks tend to offer higher potential returns, but they can also come with higher volatility compared to their larger counterparts.
3. Momentum
Momentum investing centers around the belief that assets that have recently performed well will continue to do so in the near future. This factor capitalizes on trends and market movements. The idea here is to buy high and sell higher
4. Quality
Quality focuses on companies with strong financials, high return on capital, stable earnings, and low debt levels etc. Investors often view these as more resilient and less susceptible to economic downturns.
5. Volatility
This factor aims to identify stocks or assets with lower price fluctuations (Low Beta). It targets investments that tend to be less risky, making them attractive to risk-averse investors.
Benefits of Factor Investing
Factor investing eliminates the emotional quotient that is often associated with money management. As this approach is completely backed by data and driven by a set of rules, it simplifies the decision-making process without worrying much about everyday news flows and market noise.
The other important benefits are:
1. Potential for Enhanced Returns across market cycle: By choosing a factor carefully one can generate consistently higher returns over benchmark across market cycles. For example, in a strong bull market, momentum-based investment strategies work very well. However, after a period of strong return, one can shift to value-based strategy or a combination of value and momentum to continue generating higher alpha.
2. Risk Management: By strategically selecting factors such as low volatile or higher weightage to quality, investors can tailor their portfolios to align with their risk tolerance and investment goals. Also, as the market gets into a riskier zone after a period of extended rally one can make these shifts in the portfolio to get better risk adjusted return. Remember this, in the stock market, we can only control risk as returns are not in our hands. If we can avoid big losses, we will do very well (like really well)
Our Approach
We primarily focus on this style of investing as we believe the systematic approach followed over the long term delivers exceptional results. As our captain cool, MS Dhoni says, one should always focus on process and not the results. If we follow a process and aim to improve consistently, we will get the desired result. This resonates with us deeply. We constantly evaluate our strategies and always look to improve them based on how it has performed in the live market.
There are multiple approaches to factor investing. Famous author and portfolio manager, Joel Greenblatt (Author of “Little Book that Beats the Market” and founder of Gotham Capital) used “Quality” and “Value” factor to create Magic Formula portfolio which has generated exceptional returns.
We mostly use Quality, Growth and Momentum factor more in our investment portfolio as in our research this has generated far better returns in Indian market.
Conclusion
In conclusion, factor investing stands as a disciplined compass in the ever-changing landscape of financial markets. As you embark on your investment journey, factor investing can be your guiding star, leading you to create a portfolio that not only weathers storms but also discovers the hidden gems of tomorrow.
If you have any queries, feel free to write to us or mention below in the comments box.
