Have you begun to fret that slow growth [1] could stall your escape from work like custard in a jet engine? Then, like me, you’ve probably also wondered if there’s any way of speeding things up a little.
We’ve talked about saving more and spending less [2], and we know that jacking up your allocation to equities exposes you to greater risk. So now let’s consider an alternative approach: the potential to earn more from return premiums.
In the same way that we invest in the broad stock market over government bonds because we expect a greater return in exchange for the stomach acid (the equity return premium), certain types of equities may offer even higher returns [3] as a ‘cheers, then’ for bearing risks beyond the market risk, or for exploiting persistent behavioural anomalies that seem rooted in human nature.
We’ll take a deeper dive into the expected return and diversification benefits of each premium in follow-up posts. For now, I’m just going to quickly map out the territory we’re exploring.
Also note the way I keep labouring the term expected return.
Although each return premium has been known to academics and investors for decades, there is no guarantee that the beneficial effects will continue to persist or offer the same froth on your returns as in days gone by.
[4]
Market risk – beta
The performance of the stock market obviously has an impact on most stocks. If the stock market tanks due to economic woes then it’s logical that the share price of a car manufacturer will fall too, as people buy less cars in a recession.
Beta is the measure of a stock’s riskiness1 [5] in comparison to the overall stock market. If the stock market falls and a stock drops in lock-step then its beta is said to be 1.
If a stock is less sensitive to the movement of the market then it will have a beta of less than 1.
A utility company is an example of a low beta stock. People still need to keep the lights on when times are tough (so the share price is unlikely to swan-dive during a crash) but they don’t go all Jean Michel-Jarre when the green shoots show (hence the share price is sluggish when the market rises).
A high beta company2 [6], conversely, amplifies stock market vibrations.
There is little argument about beta and we’d expect 70% of a diversified portfolio’s returns to come from this source, according to academic giants Fama and French [7].
But beta isn’t the only known return premium we can turn to. Several others have the potential to boost our rake, over the long term, if we overweight them in our portfolio…
Size
We’ll start with an easy one that you’ve probably heard of. Small companies [8] (small caps) are inherently riskier than big companies (large caps) so investors demand higher expected returns to compensate.
A small cap firm may be:
- Gobbled up by a larger competitor.
- Ruined by misfortune (e.g. failure to secure a patent).
- Run into the ground by an idiot manager.
- Fall foul of any number of threats that a bigger company could ride out.
Size is measured by market capitalisation [9] (market cap), but just how small is a small cap? Is it worth £1 billion? £500 million?
There is no consensus, but looser definitions tend to dilute the premium, which is already the weakest of the bunch.
Value
Value stocks [10] are companies whose star is fading. While fast-moving growth [11] companies wow investors with their uncoiling potential, value stocks have lost their lustre. They’ve taken some knocks and look like they’ll struggle in future.
Value companies are likely to have more:
- Debt.
- Dividend volatility.
- Earnings risk.
- Production capacity that’s hard to cut in a crisis.
Some academics believe the value premium persists because investors demand a greater return before they’ll risk taking on a potential basket-case.
Others believe that investors consistently undervalue weak-looking stocks.
Momentum
Momentum [12] is the financial epitome of ‘everyone loves a winner’. It’s the effect of rising stocks continuing to rise and stuttering stocks being cast further into the pit of despair.
Momentum strategies work by buying recent winners and selling off the losers.
Human behaviour rather than risk is thought to explain the momentum premium. People tend to follow the herd and respond to news slowly rather than instantaneously.
Volatility
Portfolios consisting of low volatility [13] (or low beta) stocks have been shown to deliver similar returns to the overall market but with up to 30% less risk.
Low volatility portfolios tend to go large on turgid stocks like utilities and non-durable goods while weeding out racy technology and manufacturing bets.
The upshot is that low vol strategies are resilient during times of trouble (see the beta section above) but underperform when markets sizzle. Over the long term, the low volatility premium flicks the Vs at the idea that you’ve got to choke down more risk to earn more reward.
Why should this be? Once again, investors are their own worst enemy, clamouring for the winning lottery ticket among high beta stocks [14] no matter how unlikely it is that they’ll discover the next Google.
Liquidity
The liquidity [15] premium is earned for taking on the risk of stocks (or bonds) that can’t be shifted in a hurry when you need to staunch a loss.
Yawning bid-offer spreads [16] and low daily trading volumes are tell-tale signs of poor liquidity.
The liquidity factor is strong in small cap and value stocks. The premium increases during times of crisis as takers of less liquid stocks can charge an arm, a leg, and a kidney to desperate sellers.
Gross profitability
This premium is fresh out of the gate [17] and makes hay from the seemingly bleeding obvious – namely that profitable firms produce significantly higher returns than unprofitable ones. Returns that are right up there with the value premium, and which may reveal that investors undervalue firms that are investing in jam tomorrow, not jam today.
Profitability [18] latches on to a firm’s gross profits-to-assets ratio. It seeks to uncover firms whose products sell for much more than they cost, but whose raw quality may be masked because of high investment rates that lower their net earnings.
Essentially, these firms are investing a high proportion of their earnings in R&D to enable them to succeed in the future, but are penalised because they deny investors juicy earnings now.
Profitability tends to suffer less in downturns and is complementary to value.
Factor flirty
Other return premiums can wink in and out of existence but the factors above are widely recognised and haven’t yet been worn away by investors flocking to them like tourists up the steps of Machu Picchu.
So how can passive investors [19] exploit return premiums? How big are they? [20] How risky? How do I incorporate them into a risk-factor portfolio [21]?
These are questions you can find the answers to by clicking on the links above.
Take it steady,
The Accumulator