Is Size Really Everything?

Source: Ken French, JQR Capital


Is Size Really Everything?


In certain parts of life, size is a stereotypical measure of success - the size of your house, for example. The amount of land in your name. The speed of your new car. In the investment world, the ending value of your portfolio may be the ultimate measure of financial success. I often remark to my clients that when we think about the long term (translation: decades), the short term decisions are both trivial and easy. Some quantitative investment professionals (AKA quants) have hundreds of individual factors in their quiver of data from which to discern long term patterns - or payoffs. A factor is the investing term for an individual piece of measurable data for a stock. In this discussion, we will focus on seven factors published by Professor Ken French on his website.

What Can We Measure?


Yahoo Finance data allows us to look at about 123 individual pieces of data for each stock in our universe. As a reminder, market capitalization for a company is defined by current share price multiplied by current shares outstanding. It is one measure of the size of a firm and is sometimes referred to as the “market” equity. This is in contrast to the “book” equity or book value presented on the balance sheets of each periodic quarterly (10-Q) or yearly (10-K) report.


Ken French return data starts in 1927 for two of his famous factors - market equity (ME) and the book equity divided by market equity ratio (BE2ME). More data started showing up in 1928 in the form of the dividend payment divided by market equity (DP2ME) factor. The rest of the data for individual factors fills in between 1952 and 1964. So, the earliest we can compare all seven of his individual factors is 1964. This just so happens to be my birth year and it gives us 58 years of observations for our cross sectional view of factor investment performance.


Source: Ken French, JQR Capital


The chart above shows the median annualized performance of seven factors grouped into five quintiles between 1964 and 2022. The seven factors are as follows moving left to right along the base of the chart.


  1. Investments divided by total assets (Inv2TA)

  2. Operating profit divided by book equity (OP2BE)

  3. Cash flow divided by market equity (CF2ME)

  4. Net income divided by market equity (NI2ME)

  5. Dividends paid divided by market equity (DP2ME)

  6. Book equity divided by market equity (BE2ME)

  7. Market equity (ME)


The five quintiles in each of the seven factors are consistently colored to show the difference in annualized performance between the smallest quintile (Q1) to the largest quintile (Q5) over this period. Visual inspection of the seven factors in this chart show that Inv2TA and ME both exhibit a negative payoff with increasing size. So - for these two factors - smaller has actually been better from a performance standpoint over the past 58 years.

How Do They Compare?

Another way to describe this data is to calculate the slopes of the quintile payoffs. Since a negative slope provides useful investing information, taking the absolute values of these slopes is one way to measure the usefulness of a factor in the stock selection process. Using this methodology, here is a ranking of the seven individual factors published by Professor French between 1964 and 2022.


Factor

Q1

Q2

Q3

Q4

Q5

SlopeQ

ABS SlopeQ

Rank SlopeQ

Inv2TA

22.09

17.68

16.62

15.83

10.81

-2.44

2.44

2

OP2BE

16.17

16.53

16.03

16.50

16.13

-0.01

0.01

7

CF2ME

12.75

15.27

16.50

18.29

20.95

1.94

1.94

3

NI2ME

13.57

15.12

15.91

17.32

20.28

1.56

1.56

4

DP2ME

15.42

15.94

16.32

16.87

15.93

0.19

0.19

6

BE2ME

10.66

14.43

16.08

18.08

22.60

2.75

2.75

1

ME

17.88

14.05

13.81

13.33

11.88

-1.27

1.27

5

Source: Ken French, JQR Capital


This table ranks book equity divided by market equity (BE2ME) as the most influential factor of the seven individual factors published by Professor French on his website. Investment divided by total assets (Inv2TA) is the second highest ranked and cash flow divided by market equity (CF2ME) is the third ranked individual factor. Next time we will look at the correlation of returns between these individual factors.

References

https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

https://www.investopedia.com/terms/w/wilshire5000equityindex.asp

https://www.brainyquote.com/topics/overnight-success-quotes


Location: 23 Foxridge Rd, West Hartford, CT 06107, USA

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