August 29, 2022

How Camber uses portfolio science to increase returns

Financial independence is a critical component of a life well lived. Investing is how people can create their own financial independence and hedge against rising inflation and longer life expectancy. This article explores the timeless principles of markets and finance.

By

Camber

Foundations of markets

The most informative question to ask in investing is: what explains the performance difference between two portfolios?

Before the advent of computers, historical databases, and dedicated researchers, we couldn't answer this question with confidence. But today, we have a way to understand and explain around 96% of the difference between two portfolios.

Before we explain the underlying drivers that influence and explain the way investments behave, let's consider the fundamentals of markets:

1. Every sale is a purchase.

2. $100 bills don't lie around on the street very long.

First, every stock sold is purchased by someone else, and vice versa.

A trade in the market only happens if somebody sells and somebody buys. When you buy shares in the market, in the vast majority of cases, you aren't buying those shares from the company; you are buying shares from another investor.  

This means that the stock market, as a whole, is a zero-sum game. After accounting for expenses, investing becomes a negative sum game.  

While outperforming the market is possible, such additive gains must come at the expense of other investors.      

Second, $100 bills don't lie around on the street very long. The world is competitive, and fast moving. If the stock market were to leave $100 bills lying around, it would not take long for those bills to be picked up.

Think of the market as a live and continuous auction. There are a lot of eyeballs looking for deals, discounts, mispricings, and $100 bills. The daily average volume of the stock market is $653 billion per day – that is a lot of eyeballs. As an investor, you are competing against all these other people, and their computers, who move fast and are highly incentivized.

The reality of these two facts is that markets are hard to consistently outperform.

This fact plays out year-over-year in the well-documented dismal performance of many professional money managers.  Professional money managers do not pick winning stocks at a level of consistency beyond what is expected due to chance alone. This has been proven repeatedly in studies dating back to the 1960s.

Risk & reward

The most important rule in investing is that there's a relationship between risk and reward.  They are forever related - always have been, always will be. This rule is to finance what gravity is to physics.

There is an expression in chess that goes something along the lines of:

Q: How do you beat Bobby Fisher, the grand master of chess?  

A: Play him at anything but chess.

Consider this in the context of investing, don’t focus on beating the markets. Focus instead on improving your returns by increasing your risk.

Over the long run, a bond investor will not out perform the bond market.  But, by allocating a portion of their money to stocks, which adds more risk, the bond investor increases the likelihood of achieving a higher return.

The risk is real, though, and there may be periods, sometimes long periods, where stocks do not outperform bonds. That is the reality of earning risk premiums. They are not a miracle, and they're not a perfect solution. If risk premiums worked perfectly, they would no longer be a true risk, and much like the $100 dollar bill on the street, the premium would disappear.

But investors who understand probabilities, and practice patience in periods of underperformance, can ultimately benefit from premium capture.

Risk premia within stocks

The original factor, the equity premium, comes from the Capital Asset Pricing Model (1952). This is the return premium an investor receives from owning stocks over bonds. This makes sense when considering the relationship between risk and reward, as buying ownership in a company is riskier than lending to a company.

But within stocks, there are additional factors of risk that create premia for the astute investor to capture. These factors are driven by the characteristics of companies, and  explain a lot about the way stocks have performed over the last 100 years.

Small-cap premium

Within the stock market, companies can be categorized by market their capitalization: large-cap, mid-cap, small-cap.

The theory behind the small-cap premium is that small companies carry more business risk than large companies. So, to incentivize investors to buy small companies, they are priced in a way that compensates investors with higher expected returns.

In aggregate, the returns of small companies have been greater than the return from large companies. This was first documented by Ralf Bonds in 1981.

Value premium

The price you pay for a stock is inversely correlated with the future return you are expecting.

When you buy a stock, you're buying ownership in that company's future profits. The return you get as an investor is a function of how much you pay for your ownership; this is called the discount rate.

The more you pay for a company's future profits today, the lower your return will be in the future.  

Well-known brands, like Mercedes and Rolex, have premium prices attached to their products. The same is true for the stock prices of popular and well-run companies; they are expensive stocks to buy. In order to own a portion of a big, popular company's future profits, investors are forced to pay up.

Lesser-known companies have future profits that are cheaper to buy. As an investor, you aren't buying a product, you are buying future cash flow. So the cheaper you can buy future cash the better.  

Profitability premium

Profitability is a less intuitive premium to understand. Why would profitable companies be characterized with risk that warrants a return premium?

Think of profitability less as a characteristic and more as a conditional overlay, or quality metric, that improves stock selection. Profitability is a characteristic that helps investors determine value-companies from value-traps.

Based on these characteristics, we can objectively explain the differences in returns between two different portfolios.

The need for diversification

Diversification is a critical tactic to the successful factor investor.

Buying a small subset or, at the extreme, a single small-value stock would be too risky given the idiosyncratic risk of an individual company.

Historic returns clearly show a wide dispersion of stock return results. Not all small-cap value stocks will do well. In fact, many of them will do poorly. However, some value small-cap stocks will do exceedingly well, more than compensating for the poor-performing stocks.

Given there is no reliable way to separate winners from losers, the rational approach is to own as many companies with these factor characteristics as possible.

This mathematically sound principle results from investments having asymmetrical returns, meaning that a stock's upside is unlimited, but the losses are limited. You can't lose more than you put in; stocks can go to zero, but they can't go negative.

Investors who hope to capitalize on factors and higher returns must diversify widely to be successful.

Multifaceted benefits of the premium

Greater returns are a highly attractive reason for tilting your portfolio to risk premiums, but there are more factors to consider that increase the reliability of your outcome.

These factor premiums perform differently at different times - they are uncorrelated. While the equity premium might be out of favour in one specific period, it can be offset by a different premium, like the small-company factor, being in favour at that exact same time. We can see examples of this in historical data.

In the US market from 1999 to 2009 (10 years), the US stock market lost an annualized 0.19%. However, over that same time, US small value stocks returned 9.51%.

In Japan, from 1990 to 2019 (30 years), the market had an annualized return of 2.4%, but over that same time, Japan's small-value stocks delivered an annualized 8% return.

Factors that do not drive returns

Wealthy individuals (mostly men, experience shows us) often feel the need for investment extravagance - things like individual stocks, insider tips, and last minute advice to move in and out of markets. We believe that comes from a place of feeling the need for control. However, such control is an illusion.

Markets are too complex and too sophisticated for the casual observer to have an impact. The mathematical reality is that the average active trader must lose.

Niche investments create nothing but busy work, helpful for cocktail conversations but practically unjustified for sustainable returns that compound.

This section explores common misconceptions about prudent investment strategies.

Buy "good" companies

Conventional thinking is that buying good companies will lead to good returns. But, as we’ve covered above, $100 bills don't lie around on the street very long, and if you want to pick them up you need to move quickly. You need an advantage, an edge.

Something as simplistic as buying the most popular companies of the day is not a defensible edge. It's not how asset pricing works, and the evidence supporting the negative consequences of this strategy is pervasive.

The underperformance of this strategy comes from investors believing that well-run companies are good investments, regardless of the price they pay to own the stock. The discount rate they apply to future profits is too low. This leads to overpayment and eventually leads to underperforming returns.

A study of Fortune magazine's annual list of "America's Most Admired Companies" found that stocks of admired companies had lower returns, on average, than stocks of companies considered to be less attractive.

"The spurned (think unattractive) portfolio beat the admired portfolio. The mean annualized equally weighted return of the spurned portfolio from April 1983 through December 2007 was 18.37% beating the 16.27% return of the admired portfolio by 2.07 percentage points." Source: Stocks of Admired Companies and Spurned Ones by Meir Statman, Deniz Anginer :: SSRN

Pick individual stocks

The easy answer for not picking individual stocks is to look at the historical success rate of professional money managers. If 20% (the same percentage we’d expect from chance) of professional money managers who live and breathe investing can't outperform the markets, why, then, would the average investor be able to?

You are going to have an investment portfolio for as long as you live and if you leave a legacy to your loved ones, even longer. Because compound returns mathematically outperform higher but unrepeatable, or lumpy, returns, you need an investment philosophy long in duration.

Buying investments that you never have to sell lets your returns compound and allows you to defer and minimize transaction costs and taxes. The goal is to find a balance between return and consistency - a maximum sustainable pace.  

In the words of Jack Boggle, "forget the needle, buy the haystack."

This is a strong analogy given the very small percentage of individual stocks that do well in the long run. Hendrik Bessembinder's paper, "Do Stocks Outperform Treasury Bills?" explores this.  The statistics from this paper show how stock picking odds really are comparable to a needle in a haystack.

Only 4% of stocks (1,092 companies out of 25,332) account for all US stock market wealth creation (1926-2016).  

The top 50 stocks (0.2% of stocks) had an average annualized return of 15.92%. That compares to a 10% average annualized return from buying all the stocks in the market or an index like the S&P500.

While these 50 stocks did beat the market, the additional 6% return seems like a disproportionately low reward, given that those stocks made up only 0.2% of the available choices.  

Buy dividend-paying stocks

Looking up what a company pays as a dividend does not constitute an informational edge. A divided is not relevant in determining which stocks will have good future returns.

One common misconception is that dividends are free. A distribution of a dividend from a company results in a reduction in the company's value.  

Targeting a portfolio of high-dividend companies would reduce the diversification of your portfolio because roughly half of the world's companies don't pay dividends.

Companies that forgo paying dividends often chose to reinvest in high-growth areas of their business leading to high-growth investment potential.

Time market buying & selling

No matter what your timing is you have a 95% chance of NOT getting the best price when you invest cash into the market.

This is the reality: at some point, you are going to see prices that are lower than the price you paid. The markets are volatile in the short term.

Nick Maggiulli's article, "Why Market Timing Can Be So Appealing", asks the question: How much better off would you be if you had perfect information and only bought at the bottoms?

Maggiulli compares this strategy to mechanically buying into the market each and every month. With perfect information and only buying the absolute bottoms from 1970-2019, you see an increase in performance of about 22% in total or 0.4% annually.

Time spent compounding is what matters most, so why waste it? Get invested and stay invested.

Perfect information is not possible, and even if it was, the additive returns would be insignificant to lifetime performance. Imperfection is part of the process.

Conclusion

Attempting to beat the market, through market timing or individual stock selection, is a fool's errand. Markets are random, volatile, and complex.

We can, however, improve the likelihood of earning higher returns through broad diversification, maintaining a long-term focus, and allocating our money across stocks possessing the characteristics and factors of risk premiums: small-cap, value, profitability. The risk is real. There will be periods of underperformance, but additive returns will be captured by the investor that maintains consistent exposure.

Trust in science. Diversify broadly. Maintain a long-term focus. Stay invested.

Be sure to read: The untold story of your investment portfolio.

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Appendix

This chart documents long-term average returns for the dimensions of expected returns. This data offers evidence that the size, relative price, and profitability dimensions have been persistent across time and pervasive across markets. Each premium has appeared over many decades in the Canadian equity market. Looking beyond Canada (i.e., out of sample), these premiums have also appeared in the US, developed ex US, and emerging markets.

The data supporting the dimensions of expected returns, combined with a strong story about why this approach makes sense, offers greater confidence that the premiums will persist in future time periods.

Past performance is no guarantee of future results. Actual returns may be lower. All returns are in USD, except Canadian stock returns, which are in CAD. MSCI indices are gross div. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. For Canadian stocks, indices are used as follows. Small Cap minus Large Cap: Dimensional Canada Small Index minus the S&P/TSX Composite Index. Value minus Growth: Fama/French Canada Value Index minus the Fama/French Canada Growth Index. High Prof minus Low Prof: Fama/French Canada High Profitability Index minus the Fama/French Canada Low Profitability Index. For US stocks, indices are used as follows. Small Cap minus Large Cap: Dimensional US Small Cap Index minus the S&P 500 Index. Value minus Growth: Fama/French US Value Research Index minus the Fama/French US Growth Research Index. High Prof minus Low Prof: Fama/French US High Profitability Index minus the Fama/French US Low Profitability Index. For developed ex US stocks, indices are used as follows. Small Cap minus Large Cap: Dimensional International Small Cap Index minus the MSCI World ex USA Index. Value minus Growth: Fama/French International Value Index minus the Fama/French International Growth Index. High Prof minus Low Prof: Fama/French International High Profitability Index minus the Fama/French International Low Profitability Index. For Emerging Markets stocks, indices are used as follows. Small Cap minus Large Cap: Dimensional Emerging Markets Small Cap Index minus MSCI Emerging Markets Index. Value minus Growth: Fama/French Emerging Markets Value Index minus Fama/French Emerging Markets Growth Index. High Prof minus Low Prof: Fama/French Emerging Markets High Profitability Index minus the Fama/French Emerging Markets Low Profitability Index. See "Index Descriptions" in the appendix for descriptions of Dimensional and Fama/French index data. S&P and S&P/TSX data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2022, all rights reserved.