By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor

Part 3:  Active, Passive and Factors

”What is a Stock?” is a 4-part piece from our Advisor Insights series Talking Shop with David Koch. If you missed it, read Part 2: Large Cap, Small Cap, International, Emerging and Frontier Markets

Active Investing

When someone is choosing whether or not to invest in one company over another: That’s active investing. We most often think of managers as a bunch of investment professionals following the news on a company, diving deep into its reported financials, and postulating about how successful its product pipeline and the strength of its supply chain. They may be looking at Porter’s Five Forces* and conducting some intricate DuPont analysis. They may also just be some dude in a chat room like “Big Short” investor Dr. Michael Burry.

Until the creation of indices and later, the execution of an index fund in the 1970s (more on that later), all investing was active. People deciding which companies are worth investing in: That’s active investing. It doesn’t mean that a purchased stock trades much; it doesn’t necessarily mean that it’s expensive; it simply means that someone is thinking about what to buy.

I was interviewing a money manager some years back and the topic of trading came up – I was asking him how he trades, what software does he use, does he leg in or leg out, does he use VWAP, etc. He said “I don’t use any of that, I just don’t trade very often.” We pressed him to walk us through his last trade and he said three years ago he sold Mattel, “because kids grow up too fast, they don’t play with toys anymore.” Since he’s wasn’t following an index, he is an active investor; he was not actively trading, but he’s actively making decisions.

Value Investing

One early active investing strategy that has endured the test of time is the idea that price matters. If you want to make a profit on a trade, you follow the adage “buy low, sell high.” The concept isn’t difficult. Value investing is simply buying companies whose share prices look cheap on metrics relative to the share price – things like price/book value, price/sales, price/enterprise value. The magic is finding good companies that are still cheap, although of course sometimes they’re cheap because they stink.

Benjamin Graham, through the popularity of two of his books, Security Analysis (1934) and The Intelligent Investor (1949), is widely known as the “father of value investing.” You may not have heard of Benjamin Graham, but the “Oracle of Omaha” sure has. In fact, after reading The Intelligent Investor, Warren Buffett decided to go to Columbia Business School because Ben was a professor there. After school, Warren went back to Omaha and started selling securities, and for three years sent Ben investment ideas; eventually Ben offered Warren a job at his investment firm in New York. When Ben closed shop and retired, Warren went back to Omaha and started Berkshire Hathaway.

Fun fact: Warren even named his first son Howard Graham Buffett (Howard was for his father).

In the world of stocks, the opposite of value is growth. If a stock isn’t cheap relative to its peers – and therefore a value stock – it’s considered a growth stock. The opposite of cheap is expensive, right? Maybe the word “cheap” implies worth very little, and buying expensive stocks doesn’t sound like a solid investment thesis; in any case, neither cheap nor expensive investing would make it into any money manager’s marketing materials. Nevertheless, that is what value and growth are – cheap and expensive. The higher valuations in growth are, in theory, justified, because growth companies are expected to have above-average growth rates, through which their underlying metrics will catch up with their stock prices.

Passive Investing

Passive simply means following an index. Common indices include the S&P 500, the Russell 1000, the Russell 3000, the MSCI Emerging Markets, and the MSCI EAFE (Europe, Australasia and Far East). If it’s in the index, you buy it. If it is not in the index, you don’t buy it. You don’t get to choose. You don’t wonder or worry whether or not any particular company will be a good investment or not. You blindly follow the index. You get it all, good and bad. Hopefully, there will be more good than bad in that particular index.

Passive investing started with an investment made inside the Samsonite pension fund in the early 1970s (yeah, the luggage company). Then, in 1975, Jack Bogle started the Vanguard company, which focused entirely on index investing. Forty-five years later, Vanguard manages about $6.2 trillion (yeah, trillion). It no longer sounds like such a crazy idea – but at the time, buying shares in all the companies, good or bad, without doing any research, sounded like a terrible idea. People thought Bogle was nuts.

Factor Investing

In the early 1990s, former professors of the University of Chicago Booth School of Business, Eugene Fama (a Nobel Laureate) and fellow researcher Kenneth French, found that, over time, value stocks outperform growth stocks and small-cap stocks tend to outperform large-cap stocks. Along with a third factor, “the market,” their model became known as the Fama-French Three Factor Model.

Some short time thereafter, some managers started to think that they might be able to improve on index investing if they made some minor tweaks that incorporated these factors and others. Start with the index, and then screen for attributes of companies that you think you should avoid. Take the S&P 500, for example: Rank all 500 companies by their debt-to-equity ratio, and then eliminate the worst 1/3. Olé! You’re a factor investor.

Factor investing is kind of a hybrid between active and passive. You’re looking for factors you think will improve your results. Several have proven to be persistent over time: cheapness (value), or momentum (the price has been going up), or low debt (quality), or low volatility (the price does not move wildly around – unlike Tesla or Lululemon).

Combining factors is called multifactor investing. You might begin by ranking everything by cheapness, then throw out the most expensive 1/3 (a value factor). Then you rank everything that remains by debt load and throw out the 1/3 with the most debt (a quality factor). Then you eliminate every stock whose price is below what it was 12 months ago (a momentum factor). You buy everything that’s left. Congratulations, you just created a multifactor strategy.

Keep in mind, factor-based investors are not actively wondering if, for example, Apple’s moving away from Intel chips for their Macs is a good thing or a bad thing for Apple (or Intel for that matter) – but they’re avoiding the most expensive, most debt-burdened stocks in an index that bounces around a lot and whose price seems to be dropping lately (in this case, the XX Index). Sounds like decent thesis, right? It takes a little more work than just buying a particular index, but not as much work as flying to all of AutoZone’s eight distribution facilities to see how quickly inventory is turning over this quarter.

In our opinion here at HH, multifactor investing obtains the best of both active and passive. It mitigates the manager risk that an active manager will put too may eggs in one basket – and be wrong. It also mitigates the risk that you end up with more bad stocks than good stocks in the index you selected. Active managers are looking for these same attributes, but why not have a computer screen for them? These minor improvements on index funds should provide better results for investors over time.

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The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.

For those of you interested in more in-depth Shop Talk:

Porter’s Five Forces is a business analysis model that assesses five competitive forces that impact companies in any given industry.

DuPont Analysis, first made popular by the DuPont Corp., picks apart a company’s fundamentals in terms of drivers of return on equity (ROE).

Leg in, leg out: Adding to (legging in), or reducing the size of (legging out) an investment in stages rather than all at once

VWAP: Volume-weighted average price; the average price in a day’s trading based on both the volume of trades and the price.