Factoring In Value and Momentum in the US Market

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1 For Financial Professional Use Only Factoring In and in the US Market Morningstar Research Paper January 2014 Paul Kaplan, Ph.D., CFA Director of Research, Morningstar Canada Michael Leonard, CFA Chief Equity Strategist, Morningstar Canada A Brief History In the 1960s, several academics independently formulated what came to be known as the Capital Asset Pricing Model, or the CAPM. According to the CAPM, the expected excess return of every security is proportional to its systematic risk (beta) with respect to the market portfolio. This theory therefore implies that investors should hold nothing other than a combination of the market portfolio and cash (long or short), with the blend between the two reflecting an individual s specific risk tolerance. This later predication of the CAPM is the intellectual origin of broad market index investing. Size,, and Factors Identification However, research in the late 1970s and early 1980s showed that, over the long run, beta is not the only factor relevant to predict performance. Over long periods of time, various factors other than beta are predictive of relative outperformance, even after adjusting for systematic risk. A number of factors have since been researched, including: Size Small-cap stocks tend to outperform large-cap stocks. 2 Stocks with more favorable valuation ratios (such as price/earnings and price/book) tend to outperform those with less favorable valuation ratios. 3 Stocks with the best relative recent performance tend to outperform those with the worst recent relative performance. 4 Figure 1: The Discovery of CAPM Anomalies Current Size Emerging Market 1960s 1970s 1980s 1990s

2 Page 2 of 8 Factoring In and in the US Market 11 November 2013 As academics began to accept these empirical rejections of the CAPM, two schools of thought emerged to explain them: 5 1. The efficient market school, which views the size and value effects as systematic risk factors (or proxies thereof), in addition to the market portfolio, which the markets rationally awards risk premiums for taking. 2. The inefficient market school believes that market prices differ from fair values, but because the differences trend toward zero over time, value and size premiums will continue to occur without any connection to risk factors. Size,, and Factors Measurement While accepted as CAPM anomalies, without being able to overtly capture and measure, the knowledge of these factors would have little practical application. After all, it is the ability to identify and measure factors that creates opportunities for investors to exploit them. Size and The Morningstar Equity Style Box and Ownership Zone The introduction of the size and value effects led to the practice of dividing the market into groups of stocks on the basis of market capitalization to measure size, and valuation ratios to measure style, (or value versus growth orientation). Morningstar began to popularize the concept in the 1990s with its Equity Style Box--a nine-square grid that classifies a stock or stock fund by size as large cap, mid-cap, or small cap as measured by market capitalization on the vertical axis and by where it falls in the value, core (or blend), or growth area as measured by Morningstar s proprietary multifactor style model on the horizontal axis. (See Figure 2.) The Morningstar Equity Style Box is a clear, visual way to identify and measure a holding s size and style attributes. Figure 2: The Morningstar Equity Style Box Large Mid Core Growth The Morningstar Equity Style Box is an important tool to identify, capture, and measure value and size factors. Small Price momentum has been measured in several ways by different researchers. Those who focus on price momentum sort stocks on returns over time periods typically between six and 12 months and assign scores based on the ranking. Other researchers add factors such as earnings surprises, the rate of change of reported cash flows and earnings, or revisions of analysts estimates of future earnings.

3 Page 3 of 8 Factoring In and in the US Market 11 November 2013 Introducing Morningstar US Target 50 and US Target 50 Indexes In 2012, Morningstar began developing a suite of factor indexes for North American equity markets based on the expertise of Toronto-based CPMS (Computerized Portfolio Management Services). Acquired by Morningstar in 2009, CPMS is a leading expert on factor-based equity investing in the Canadian and U.S. markets. The Morningstar CPMS U.S. database covers approximately 95% of the institutionally investable U.S. equity market. Morningstar CPMS also includes back-testing capability, which features clean, survivorship bias-free month-end data sets going back to The CPMS Backtest Service allows us to calculate myriad test statistics when testing combinations of data items and their strategy weights over the life of a test. As part of the first phase of the rollout of the CPMS-based factor indexes in 2012, Morningstar introduced the Morningstar Canada Index and the Morningstar Canada Index. In 2013, Morningstar completed the second phase of the rollout of this index family by introducing the Morningstar US Target 50 Index and the Morningstar US Target 50 Index, which we summarize as follows: Characteristics 1. The Morningstar US Target 50 Index is suited for investors seeking to exploit the value effect by owning stocks with low price/reported earnings, price/book, price/sales, and price/cash flow ratios. Weight in the ranking is also placed on stocks with positive earnings estimate revisions. Figure 3 provides details on this index. 2. The Morningstar US Target 50 Index is suited for aggressive, active investors who are looking to exploit the momentum effect. This index searches for stocks displaying the best combination of these momentum indicators: positive revisions of fiscal earnings estimates, positive price momentum, and positive earnings surprise. The Morningstar US Target 50 Index also factors in return on equity based on trailing earnings to help ensure profitability and earnings quality. Figure 4 provides details on this index. Both indexes screen stocks to ensure they meet minimum liquidity requirements and that each stock s market capitalization is at least $500 million. At reconstitution, each index is an equally weighted portfolio of 50 stocks based on the weighted average of the selection factors as shown in figures 3 and 4, respectively. Findings In Canada and the U.S., most companies report their earnings late in the first month of each quarter or early in the second month of each quarter. Morningstar has conducted extensive testing in these equity markets to understand the importance of the timing of reconstitution within each quarter to determine optimal performance of the indexes. The results of Canadian testing show that

4 Page 4 of 8 Factoring In and in the US Market 11 November 2013 reconstituting the Canada and indexes at varying month-ends each quarter produces no appreciable difference in performance. However, research in the U.S. equity market has shown that index returns, particularly for the Morningstar U.S. Target 50 Index, are significantly better when the reconstitution occurs at the end of the second month of each quarter (February, May, August, November) than at the end of each quarter or at the end of the first month of each quarter. In addition, Morningstar CPMS research shows that earnings surprises and subsequent estimate revisions can affect the underlying stock positively or negatively for weeks and months after the company s earnings report. Therefore, reconstituting the U.S. family of indexes soon after most companies report their quarterly earnings captures more upside (and avoids more downside) performance than waiting until the end of the quarter to reconstitute. Therefore, unlike their Canadian cousins (the Morningstar Canada Index and the Morningstar Canada Index), which are rebalanced at each quarter end, the Morningstar US Target 50 Index and the Morningstar US Target 50 Index are reconstituted and rebalanced at the end of the second month of each calendar quarter. The results of this research lead to two conclusions: 1. The U.S. equity market is more efficient than the Canadian equity market. 2. The equity markets in both countries are inefficient; owning equities based on certain factors leads to risk-adjusted outperformance of the benchmark over time. Figure 3: Morningstar US Target 50 Index Eligible Universe Ranking (Selection Criteria) Sell Rules (At Reconstitution) Buy Rules Morningstar U.S. Target 50 Index SM Market capitalization minimum $500 million Stock universe ranking is determined using four common valuation factors (80%) plus analysts estimate revisions (20%) Sell any stock no longer ranking in the top 40% of universe stocks, and any stock for which analysts revise EPS estimates significantly downwards Replace stock(s) sold by buying the best-ranked stock(s) not already owned to bring the stock count to 50. Maximum of eight stocks per sector. 50 Stock Portfolio

5 Page 5 of 8 Factoring In and in the US Market 11 November 2013 Figure 4: Morningstar US Target 50 Index Eligible Universe Ranking (Selection Criteria) Sell Rules (At Reconstitution) Buy Rules Morningstar U.S. Target 50 Index SM Market capitalization minimum $500 million Stock universe ranking is determined using a combination of return on equity, analysts estimate revisions, earnings surprise, and a series of price momentum indicators Sell any stock no longer ranking in the top 40% of universe stocks Replace stock(s) sold by buying the best-ranked stock(s) not already owned to bring the stock count to 50. Maximum of eight stocks per sector 50 Stock Portfolio

6 Page 6 of 8 Factoring In and in the US Market 11 November 2013 A Practical Application of and Factors Ownership Zones As the Morningstar Indexes are specialized strategies, where might they fit into an overall portfolio of U.S. stocks? To help answer that question, Figure 5 shows the Ownership Zones for the Morningstar Target 50 and Target 50 Indexes. Figure 5 shows that these indexes offer significant style and size diversification with respect to broad large-cap US indexes such as the S&P 500. Not surprisingly, the and Indexes each have a mid- to small-cap focus, which can provide diversification across the size spectrum within a portfolio. Also, as we would expect, the Index has a clear value bias and the Index has a clear growth bias. However, the Index holds stocks widely over the entire value/growth spectrum. Figure 5: Morningstar US and Target 50 Indexes Ownership Zones 31 ember 2013 Deep- Core- Core Core- Growth High- Growth Source: Morningstar Direct, Morningstar Indexes Micro Small Mid Large Giant In addition to opportunities for style diversification as shown in Figure 5, the Morningstar indexes also provide opportunities for diversification across economic sectors. As Figure 6 shows, these indexes significantly differ in their sector allocations from the S&P 500 and from each other.

7 Page 7 of 8 Factoring In and in the US Market 11 November 2013 Figure 6: U.S. Equity Indexes Economic Sector Overlap 31 ember 2013 S&P 500 Source: Morningstar Direct, Morningstar Indexes, Standard & Poor s Sector S&P 500 r Basic Materials t Consumer Cyclical y Financial Services u Real Estate i Communication Services o Energy p Industrials a Technology s Consumer Defensive d Healthcare f Utilities % Performance Of course investors are ultimately concerned with performance and risk. Figures 7 and 8 show how the Morningstar US Target 50 indexes compare in both performance and risk with the S&P 500 from January 2002 through ember Figure 7 shows the growth of $10,000 invested in the S&P 500, the Morningstar US Target 50 Index, the Morningstar US Target 50 Index, and a 50/50 portfolio of the two Target 50 indexes from. 31, 2001, through. 31, 2013, with all income reinvested and with monthly rebalancing. As this chart shows, the US Target 50 indexes each outperformed the S&P 500 considerably. However, as Figure 8 shows, they did so with considerably more risk. Figure 7: U.S. Equity Index Performance: Growth of $10,000: January 2002 ember % + 50% S&P 500 $ 67,149 55,314 44,096 Source: Morningstar Direct, Morningstar Indexes, Standard & Poor s 20,479 10, ,000

8 Page 8 of 8 Factoring In and in the US Market 11 November 2013 Figure 8: Risk and Return of U.S. Equity Indexes and Index Portfolios: January 2002 ember % / 50% S&P 500 Possible Portfolios Source: Morningstar Direct, Morningstar Indexes, Standard & Poor s Large-Core Large- S&P 500 Large-Growth Mid- Mid-Core 50% / 50% Small- Small-Core Mid-Growth Small- Growth % % The results for the Morningstar US Style indexes demonstrate not only the size and value premiums but also the additional risk of the growth indexes compared with their value and core counterparts. 6 As Figure 5 shows, the Morningstar US Target 50 indexes are decidedly small- to mid-cap portfolios, so it is no surprise that they have similar levels of risk to the small-cap style indexes. What is interesting is that the portfolios that contain them have superior performance to nearly all of the style indexes. Conclusion Extensive academic research has shown clearly that there are distinct factors that explain returns on U.S. stocks. Because exposure to these factors, particularly size, value, and momentum, has been shown to generate premiums for investors that tilt their portfolios toward them over the long run, equity factor indexes and exchange-traded funds that embody them have become quite popular among U.S. investors. To help investors in the North American equity markets take advantage of these factor premiums, Morningstar has leveraged the expertise of CPMS to create a suite of factor indexes of Canadian and U.S. stocks that can form the basis of investment products. Here we have shown how investors can use these strategies in combination with broad U.S. market exposure to improve performance with risk control and sector diversification. 1. For a history of the development of the CAPM, see Bernstein, Peter L., Capital Ideas: The Remarkable Origins of Modern Wall Street, New York: Free Press. 2. The academic literature on the size effect begins with Banz, Rolf W The Relationship between Return and Market of Common Stocks Journal of Financial Economics (March). 3. The academic literature on the size effect begins with Basu, Sanjoy Investment Performance of Common Stocks in Relation to their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis Journal of Finance (September). 4. For a more detailed discussion, see Kaplan, Paul D., Investing at Full Tilt, Morningstar Indexes 2011/12 Yearbook, Morningstar, Inc. 5. For more on the style box and its uses, see Kaplan, Paul D. and Don Phillips, The Morningstar Approach to Mutual Fund Analysis Part II, Mutual Funds, John A. Haslem, ed., John Wiley & Sons. 6. For a more detailed performance analysis of the Morningstar style indexes and how they differ from the factor indexes of other providers, see Kaplan, Paul D., Don Phillips, and Travis Pascavis Purity of Purpose: How Style-Pure Indexes Provide Useful Insights, Frontiers of Modern Asset Allocation, Paul D. Kaplan, ed. John Wiley & Sons.