We constantly learn more about investing, build disciplined strategies to capture the best of what we've learned, and share our broad findings with other curious investors.
In Factors from Scratch, we showed that value investing works through a re-rating process. The process begins when the market develops an expectation that the earnings of certain companies will decline or grow at depressed rates into the future. The market then prices those companies at a discount relative to their current earnings, turning them into "value stocks." Over the short-term, the market usually ends up being right in its expectations: value stocks usually do go on to experience declines or slowdowns in their earnings, particularly in comparison with the rest of the market. But over the long-term, they usually recover and return to normal growth. When the market prices value stocks, it tends to underestimate the likelihood and extent of their eventual recoveries.
In this quarter’s letter, we describe the more interesting, next stage of factor investing: alpha within factors. This simple idea describes what we’ve pursued at OSAM over the years, and what we continue to pursue through our research agenda today.
The excess returns associated with Value and Momentum result from convergent and divergent processes, respectively. Value stocks are systematically underpriced and gradually converge on their fair value over time. Momentum stocks start out fairly valued or slightly overvalued, and go on to become more overvalued in the short-term, before reverting back. Both styles represent a market mistake that can be captured as alpha. In this piece, we're going to make all of these points more clear through a unified framework that we've developed to explain how factors work.Listen to the Podcast