INVESTMENT STRATEGIES FOR TORTOISES ASSET PRICING THEORIES AND QUANTITATIVE FACTORS

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1 INVESTMENT STRATEGIES FOR TORTOISES ASSET PRICING THEORIES AND QUANTITATIVE FACTORS Robert G. Kahl, CFA, CPA, MBA

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3 CAPITAL ASSET PRICING MODEL (CAPM) In the early 1960s, developed by William Sharpe, John Lintner, and Jan Mossin Based on the work of Harry Markowitz s mean-variance portfolio optimization Simplifying assumptions Investors have the same set of beliefs regarding Investment strategy Time horizon Investors have different Wealth Risk tolerance

4 CAPM EFFICIENT PORTFOLIOS All efficient portfolios (comparing expected return to potential volatility) will be some combination of Risk-free asset and Market Portfolio (all traded risky assets) Allocation will depend on investor s risk tolerance

5 CAPM EXPECTED RETURN OF AN INDIVIDUAL ASSET Expected return of an individual asset E(A) = RF + b(e(m) RF) A beta coefficient of 1 would mean the asset is expected to move with the market, have the same volatility, and the same expected return. A beta coefficient greater than 1 would mean the stock is more volatile than the market and would have a higher expected return.

6 ARBITRAGE PRICING THEORY (APT) 1971 through Stephen Ross offered an alternative to CAPM Assets may deviate from fair value but they are quickly repriced due to arbitrage undervalued securities are purchased and overvalued securities are sold short to restore equilibrium to the market. Assets are priced according to a factor structure with different risk premiums for different macroeconomic factors and different exposure or sensitivity for specific assets to those factors. APT does not identify or define the number of important factors.

7 FAMA & FRENCH 3-FACTOR MODEL BETA, VALUE AND SIZE In June 1992, Eugene Fama and Kenneth French introduced a three-factor model which isolated the effects of two easily measured variables size (market capitalization) and book-to-market equity. After adjusting for size and book-to-market equity, they considered the explanatory power of beta. Their conclusion: In a nutshell, market beta seems to have no role in explaining the average returns on NYSE, AMEX, and NASDAQ stocks for , while size and bookto-market equity capture the cross-sectional variation in average stock returns that is related to leverage and Earnings/Price. Companies with higher book-to-market equity ratios (or lower price/book value ratios) had higher returns. Average returns decrease with size; smaller companies had higher returns.

8 WHAT IS A FACTOR? Any quantitative variable that can be used to explain expected risk and return of financial assets.

9 VALUE Various definitions of value include: Price to book value Price to earnings Price to operating cash flow before considering capital expenditures Price to free cash flow after capital expenditures Price to sales

10 MARKET CAPITALIZATION AND LIQUIDITY Some researchers consider market cap and liquidity to be distinct factors but they are likely to have similar characteristics. Small cap companies have had higher total returns in the past according to some studies. Higher returns are explained by higher risk. Higher risk of business operations Narrower product line or service offerings Less access to capital Less liquid more difficult to buy or sell in size without impacting the price

11 DIVIDEND YIELD Some researchers say it is a proxy for the value factor Stocks with higher dividend yields tend to be more mature companies with lower growth rates and higher dividend payouts

12 SHAREHOLDER YIELD Meb Faber defines it as = (dividends + net share buybacks + net debt pay down) / market capitalization Share buybacks and debt pay downs benefit shareholders indirectly

13 MOMENTUM Based on recent past price performance Relies on herding behavior and recency bias of others Investment managers Some combine momentum with fundamental factors Others choose not to use Lack of intuitive economic rationale Higher expected trading costs

14 PROFITABILITY Fama and French published a working paper in September 2014 to describe results of a 5-factor model Beta Size Value Profitability (measured by return on equity) Investment patterns (measured by changes in total assets) Per F&F research, profitability and investment resulted in higher returns

15 LOW VOLATILITY Several studies concluded that this factor achieved higher returns Larry Swedroe, director for BAM Alliance: much of advantage has disappeared Volatility factor had high exposure to value factor in the past Low volatility is now more expensive and has lower exposure to the value factor

16 QUALITY There is no agreement in literature re definition of quality. Definitions include: Profit margins Growth in profitability Financial leverage Earnings stability Accounting quality Expense levels that should lead to future growth (R&D, advertising) Kalesnik & Kose at Research Affiliates skeptical that a quality factor on its own is a good investment approach research supports using qualitative measures in addition to the value factor to make better portfolios

17 TACTICAL CONSIDERATIONS Expected returns for factors are not stable Some factors may become popular or unpopular for several years Relative values change Expected returns should be modified for potential changes in relative values of different factors

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