Ah, the promise of a new year.
While we enjoy the resolutions and optimism that accompany the turning of the calendar, we’re far more skeptical when it comes to a “new you” version of portfolios.
That said, there’s an exciting enhancement to client portfolios in 2020, and a close look under the hood is required to see what’s new. It’s called the investment factor.
While Wall Street constantly peddles new strategies, ideas worthy of inclusion in Vista portfolios don’t come along every day.
Long before we’re willing to incorporate new market research, we want to see sturdy, empirical support for it. We must also be able to cost-effectively apply it to real-life portfolios.
The investment factor—defined as the level of earnings a company must plow back into itself to sustain its profits—has withstood this degree of due diligence.
Factor Investing, Revisited
Before we dive in, let’s zoom out.
We have long managed our clients’ portfolios by tailoring their exposure to stock market factors with higher expected returns.
In the early 1990s, Professors Eugene Fama and Ken French—whose research underpins Dimensional Fund Advisors’ mutual funds—described two such factors: size and relative price. Their research concluded that small-cap stocks outperform large-caps, and value stocks beat growth.
In 2012, Professor Robert Novy-Marx documented the profitability factor, which was later incorporated into client portfolios via Dimensional’s funds.
More recently, Fama and French added to this body of research by identifying the investment factor.
The Investment Factor: A Deeper Dive
How does the investment factor work?
Rather than distributing cash to shareholders, a high-investment company reinvests earnings at a high clip, or even takes on debt, to fuel its growth. This shows up as asset growth on its balance sheet, which Fama and French have concluded leads to poor future stock returns.
During a recent visit to our office, Dimensional Fund Advisors’ Marlena Lee shared a helpful analogy. She compared each stock market factor—size, value, profitability, and investment—to qualities you’d look for in purchasing a rental property.
You’d compare the properties’ asking price (size), price per square foot (value), and how much rent you could charge (profitability).
You’d also consider the necessary spending (investment) to maintain each property’s value and future rentability.
In evaluating two otherwise identical rentals, the one requiring less investment is likely the better option.
Combining Factors: Investment and Small-Cap
Not surprisingly, the investment factor appears more frequently—and matters more—among small-cap stocks.
Why is this?
A large, mature company like Amazon or Walmart would have trouble doubling its already-significant assets within a year. It’s much easier to imagine a small, fledgling, or struggling company doing so, as it stretches to take flight.
This is why Dimensional has begun excluding small-company stocks with the highest investment factors from its small-cap mutual funds.
While it’s a tiny group—just 2.5% of the small-cap universe meets Dimensional’s criteria for exclusion—they pack quite the punch. Past returns from this excluded batch have been so extremely negative that omitting them would have historically delivered about 0.15% to 0.30% of additional return per year.
This extra performance might seem negligible, but it would have added about $10,000 to every $100,000 invested in U.S. small caps over the last decade, and close to $40,000 over the past 20 years.
Taking Care of Investment Business
While Vista has already incorporated these insights into your portfolio, it never hurts to periodically take a closer look at the engine we expect to fuel your portfolio.
By knowing what’s under the hood, we hope clients can share our enthusiasm when we take another small step forward in building better portfolios.