Looking ahead, we believe that the US is likely to enter a shallow recession from mid-2024 onwards. Across the Atlantic, Europe, and the UK are quite possibly in recession already. That said, there's also a growing possibility that the US will successfully bring inflation under control without dragging its economy into recession – the so-called soft economic landing.

How should investors position themselves to take advantage of outcomes which are very different but seem, at least for now, to be almost equally likely? Rather than pick individual stocks, quantitative equity investors can build highly-diversified portfolios, often constructing baskets of stocks that are designed to have exposure to specific factors that may include value, quality, and momentum – factors typically perform quite differently from each other.

Investors supplement this factors-based approach with a long/short strategy or buying stocks that are expected to appreciate while selling those expected to fall.

Why value?

There is a wealth of empirical and academic evidence that show how a value factor can help stocks outperform over the longer term – as value can often be well hidden, especially if investors are chasing the latest hot trend.

But how do you measure value? In fact, there are many different value measures, each with its own risk and return profile (Figure 1).

Source: abrdn, (Jan 2000–Nov 2023).

Book yield, free cash flow yield

It is worth examining in more detail two of these: Book yield (the reciprocal of price-to-book) is a measure of deep, cyclical value, and Free cash flow (FCF) yield is a value factor that also has quality characteristics.

It's the relationship between these two that is a key reason why a multi-factor investing approach can be so attractive.

What back testing tells us

We tested book yield and FCF yield on a global equity investment universe going back to 1990, to see how these value measures perform in a variety of market conditions (Chart 1).

For each month, we ranked every stock by the chosen factor and go long (buy) the 20% of stocks which have the highest book yield or FCF yield, and short (sell) the most expensive 20% of stocks according to the same value measures.

We then calculated performance for the subsequent month and repeated this process for every month over the back-test period.

Source: abrdn, November 2023. Note: IR (Information Ratio) is a measure of risk-adjusted return relative to the benchmark (the higher the better).

Findings

While book yield does well over the long term, this value measure has failed to shine during periods of low interest rates, such as the one since the 2007/2008 global financial crisis until the beginning of last year. Meanwhile, FCF yield stocks – with stable revenues, earnings and dividends – are able to do better in a variety of market environments. While FCF is considered a value factor, which is biased towards cheaper stocks, it also has quality attributes that can deliver diversification benefits.

What does this all mean?

As we approach a potential inflection point for inflation and global interest rates – which may or may not lead to a US recession – it is worth considering what this means for a multi-factor approach. We think investors should consider investing in multiple types of value to gain ‘deep value’ exposure that will likely do well in a ‘soft landing’ scenario, as well as ‘defensive value’ that should perform relatively better in a recession.

Quality

We can further boost expected risk-adjusted returns by exploiting attractive correlation properties available across measures of capital structure and profitability.

While interest rates are expected to decline next year, they are likely to remain higher than investors have become accustomed to. This will be challenging for companies as slower consumer spending due to high prices and the erosion of pandemic-era savings will restrict revenues. Labour costs will remain elevated, while corporate debt will likely be refinanced at higher rates. This suggests companies with good profitability and disciplined capital allocation are better positioned to do well. In other words, quality companies.

We define quality as a composite of profitability, low accruals, and low investment (firms with aggressive capital expenditure plans often invest in projects that earn less than their cost of capital).

Momentum

This is the glue that helps hold a multi-factor portfolio together. The dynamic nature of momentum helps us capture trends over time as investors change their views and preferences.

During a year of great uncertainty, an exposure to momentum can help to remain invested in the stocks that will emerge as winners.

In the multi-factor back-test, we also combined value, quality, and momentum to gauge how all three factors perform separately and in aggregate (see Chart 2).

Source: abrdn, November 2023. Note: IR (Information Ratio) is a measure of risk-adjusted return relative to the benchmark (the higher the better).

Although all three individual factors have contributed to adding value over the review period since 1999, they can suffer from prolonged periods of mediocre performance. That said, and crucially, the individual factors have fairly low, zero, or even negative correlations with one another (Table 1). This can help investors mitigate the risks that may arise in different economic scenarios and increases the benefits of a diversified multi-factor approach.

Table 1. Value, quality, momentum factors correlations

Source: abrdn, FactSet, Jan 2000- November 2023. Note: A positive correlation shows that factors move in the same direction and a negative correlation shows that factors move in different directions.

Final thoughts

The need for real diversification has become painfully necessary over the past two years. This has been especially true for factors investing this year. Although one factor – cyclical value – was challenged in the US market, FCF yield has compensated for this. Whereas balance sheet quality has underwhelmed, value and small size (small capitalization stocks) stepped up. Everywhere, momentum has been supportive of a multi-factor approach.

In 2024, we see a continuation of the tailwinds benefiting a systematic approach that diversifies both across and within factors by identifying, and investing in, different types of value and quality. We believe, therefore, that a pragmatic and judicious mix of measures across the factor spectrum is a good approach for next year and beyond.

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