In a market dominated by large-cap stocks like the Fab 7, finding attractive investment opportunities requires a deeper analysis beyond just looking at momentum.

Investors seeking to diversify their equity portfolios and discover attractive stocks need to consider multiple factors.

This note explores how a multi-factor approach can help identify attractive stocks by examining valuation, growth, profitability, momentum, and investor sentiment, along with the associated risks of each factor.

We use such an approach to analyze our universe of stocks with market capitalizations exceeding $200M. Currently, our universe contains approximately 3000 stocks in the US.

Valuation: Finding Undervalued Stocks

Valuation is a crucial factor in determining the attractiveness of a stock. It involves assessing whether a stock is priced fairly relative to its fundamentals.

Common valuation metrics include:

Price-to-Earnings (P/E) Ratio: This measures a company's current share price relative to its per-share earnings. A lower P/E ratio may indicate that the stock is undervalued.

Price-to-Book (P/B) Ratio: This compares a company's market value to its book value. A lower P/B ratio can signal that the stock is trading below its intrinsic value.

More sophisticated valuation approaches attempt to model the whole company from the perspective of cash flows, growth, and profitability. Such an approach is the well-known discounted cash flow model.

Risk Factor: The primary risk associated with using valuation as a factor is that the market may not recognize the stock's true value for a long time.

This can result in prolonged periods of underperformance, even if the stock is fundamentally sound. When using valuation as a factor you will need to be patient.

Example: Consider a tech company with a P/E ratio of 20, while the industry average is 30. This lower ratio might indicate the stock is undervalued, making it an attractive buy for value investors. However, if the market continues to favor higher P/E glamor stocks, the undervalued stock may not appreciate as expected.

Stocks to consider: GILD, PYPL, MOS

Growth: Identifying Stocks with Strong Potential

Growth factors focus on a company's potential to increase its earnings and revenue over time.

Key growth metrics include:

Revenue Growth: This measures the increase in a company's sales over a specific period. Consistent revenue growth suggests a strong market demand for the company's products or services.

Earnings Growth: This metric looks at the increase in a company's profits. A company with rising earnings is likely reinvesting in its business, signaling future growth potential.

Risk Factor: The main risk of relying on growth as a factor is that the stock or industry may suddenly hit a wall, causing growth to fall short of expectations. Factors such as market saturation, regulatory changes, or economic downturns can negatively impact growth projections.

Example: A pharmaceutical company with a 20% year-over-year revenue growth rate and a new pipeline of drugs shows strong growth potential, making it a compelling investment opportunity. However, if the new drugs bring on additional competition, the anticipated growth may not materialize.

Stocks to consider: NVDA, LLY, AVGO

Profitability: Assessing Financial Health

Profitability factors help investors gauge a company's ability to generate profit from its operations.

Important profitability metrics include:

Return on Equity (ROE): This measures the return generated on shareholders' equity. A higher ROE indicates efficient use of equity.

Return on Assets (ROA): This evaluates how effectively a company uses its assets to generate profit. A higher ROA suggests better asset utilization.

Net Profit Margin: This metric shows the percentage of revenue that becomes profit after all expenses are deducted. A higher net profit margin indicates better profitability.

Risk Factor: The risk associated with profitability metrics is that past performance may not always predict future success. Companies may face operational challenges, increased competition, or cost pressures that erode profitability over time.

Example: A consumer goods company with a net profit margin of 12% and an ROE of 18% demonstrates strong profitability, making it an attractive investment. However, rising raw material costs could squeeze profit margins, impacting future profitability.

Stocks to consider: COST, AAPL, NVO

Momentum: Understanding Market Trends

Momentum factors examine the stock's price movement and trading volume to identify trends.

Key momentum indicators include:

Price Performance: This looks at the stock's price changes over a specific period. Stocks with strong upward price trends are considered to have positive momentum. Typically a 1 year holding period is used.

Trading Volume: High trading volume can indicate strong investor interest and potential price movement.

Risk Factor: The risk with momentum investing is that trends can reverse quickly, leading to significant losses. Market sentiment can change rapidly due to macroeconomic factors, news events, or changes in investor perception.

Example: A renewable energy stock that has consistently outperformed the market over the past year and is seeing increased trading volume may be experiencing positive momentum. However, a sudden shift in government policy or a technological breakthrough by a competitor could halt the momentum abruptly.

Stocks to consider: SMCI, PGR, ANF

Investor Sentiment: Gauging Market Perception

Investor sentiment factors reflect the overall market perception and attitude towards a stock.

Key sentiment metrics include:

Analyst Ratings: Positive ratings and target price upgrades from analysts can boost investor confidence.

Social Media Trends: Increasing mentions and positive sentiment on platforms like Twitter can indicate growing investor interest.

Option Market Activity: An increase in Put and Call activity is usually a signal that something is going on behind the scenes. A preponderance of call activity signals optimism.

Risk Factor: The risk with investor sentiment is that it can be highly volatile and influenced by short-term events. Sentiment-driven investments may lead to irrational exuberance or unwarranted pessimism, causing stock prices to deviate from their intrinsic value.

Example: A tech startup receiving multiple buy ratings from analysts and trending positively on social media suggests strong investor sentiment, making it an appealing investment. However, if the company fails to meet high expectations, sentiment can turn negative quickly, leading to a sharp decline in the stock price.

Stocks to consider: TJX, WMT, STZ

Market Shifts: The Need for a Multi-Factor Approach

The stock market is dynamic and often favors one factor or style of investing over another.

There are times when growth stocks are in vogue, and at other times, value stocks take the lead. Momentum might drive stock prices one day, while profitability becomes the key driver the next. These shifts can happen almost overnight, driven by economic changes, investor sentiment, or global events.

At the moment the momentum trade is king. Valuation is not a driving force in the markets. Investors are rewarding growth potential at the expense of under-valuation.

Using a multi-factor model helps mitigate the risks associated with market shifts.

By evaluating stocks based on valuation, growth, profitability, momentum, and investor sentiment, investors can build a diversified portfolio that is resilient to changes in market preferences. This approach ensures that your investment strategy remains robust, even when the market's focus changes abruptly.

Example: During a bull market, growth stocks with high revenue and earnings growth might outperform. However, in a market downturn, value stocks with strong fundamentals and low valuation ratios might provide better returns.

A multi-factor approach allows investors to benefit from both scenarios, balancing their portfolios across different market conditions.

Our Approach to Finding Attractive Stocks

We utilize a multi-factor approach to ranking stocks based on valuation, growth, profitability, momentum, and investor sentiment.

Our current universe of companies is comprised of all US-domiciled stocks with market capitalizations greater than $200 million and international stocks with company-sponsored American Depository Receipts (ADRs) trading on US exchanges. Our universe is currently composed of approximately 3000 securities.

Each week we rank all stocks in our universe based on various characteristics within each of the different factor categories of valuation, growth, profitability, momentum, and sentiment.

Some of these characteristics move a lot from week to week such as momentum and sentiment while others such as valuation, growth, and profitability vary a lot less over the short term.

Each category of factors is weighted (within a range) based on their historical ability to distinguish top from bottom-performing stocks.

On average, the weights for each factor category are currently as shown below with ranges within parenthesis.

• Valuation: 25% (20-40%)

• Growth: 20% (10-30%)

• Profitability: 20% (10-30%)

• Momentum: 25% (15-30%)

• Sentiment: 10% (5-15%)

Unlike a lot of other multi-factor models, we do not segregate stocks by sector preferring instead to treat all stocks the same regardless of economic sector or industry.

Our bottom-up approach allows us to segment our universe by whatever factor we are interested in. It might be sector, size, or momentum.

For example, the median model score by sector is shown below. Higher scores denote attractive stocks. The most attractive sector is currently Energy and the least attractive one is Real Estate.

In addition to allowing us to evaluate various segments of the stock market at the end of the day the main reason we employ a multi-factor model is to evaluate individual stocks.

The table below highlights the stock selection model information for the top ten holdings of the S&P 500.

The main column of interest is shown in grey. It shows the ranking of the stock aggregated up to deciles. The top decile for attractiveness is 1, and the bottom decile is 10.

The same information is shown for the top ten holdings of the Russell 2000, our preferred small-cap index.

This is just a sample of the output from our proprietary approach to evaluating stocks using a multi-factor approach. Further breakdowns and stock lists are available to our paid model subscribers.

In the past, we have only shared our information with larger Registered Investment Advisors, but shortly we will make the stock model information available to our paid individual subscribers.

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the rise in interest rates starting in 2022.

• Over the last three years, the GF Low-Risk strategy is only up 0.7% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.7%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF High-Risk strategy is up 2.4% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 7.9%.

• Strategies with heavier international allocations have underperformed more domestically focused asset mixes.

• Year to date, commodities have provided a nice boost. A big reason is higher oil prices. Most recently, precious metal prices have joined the party providing a further boost.

• Over the last month, US Large-Cap Equities have performed best in large part driven by the Fab 7 stocks.

• Fixed-income strategies focused on short maturities and credit have outperformed Treasuries.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns: Expect slightly lower than normal equity and bond market returns given valuation conditions

Risk: Diversify with alternative assets, market volatility has been significantly below historical measures

Equity Risk: Asset allocation portfolios are dominated by equity market risk, no different from the past.

A Bit of Wisdom Never Hurts

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this blog are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.