A Dimensional View of the Market

This article will cover just that and more:

• What a dimension of return is
• What we mean by “tilting a portfolio”
• What strategies we use to access these dimensions

What is a Dimension of the stock market?

Physicists understand that the universe consists of 3 distinct spatial dimensions:

• Up and down
• Left and right
• Back and forth

In simple terms, we live in a 3D world and if you ask some guy named Einstein, there is even a fourth dimension called time itself that keeps us all ticking along. Modern financial theory has applied the concept of viewing the world in dimensions to capital markets. Back in August, we discussed Factor Investing and how investors can take a parallax view at their portfolios and the markets. What are the dimensions or factors of return we target?

Factor	Definition
Market Beta	The stock market’s overall return over safe short-term treasuries
Size	The return of small cap stocks over large cap stocks
Value	The return of attractively priced stocks over expensive stocks
Profitability	The return of high profit stocks over low profit stocks
Momentum	The return of positive price momentum stocks over negative price momentum stocks

Table 1 – *Returns are calculated from Ken French’s Data Library using average long-short monthly returns¹

Factor	U.S. Historical Return Premiums	Time Period
Market	8.64%	1927-2020
Size	2.43%	1927-2020
Value	4.09%	1927-2020
Profitability	3.15%	1963-2020
Momentum	7.98%	1927-2020

There are actually 100’s of factors that have been identified but only a few hold up under scrutiny. In their book “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today”, Andrew Berkin and Larry Swedroe outline a checklist that investors can use to screen for factors they should consider in the portfolio construction process. According to Berkin and Swedroe, a factor must be:

1. Sensible – they make economic sense
2. Persistent – The premiums exist over long periods of time (multiple economic regimes)
3. Pervasive – The premiums exist in different countries, regions, sectors, and asset classes
4. Robust – The premium is not data mined or rely on a specific market period
5. Investable – The premium can be harvested after trading costs / taxes / market capacity

A Visualization of a “Tilted” Portfolio:

We now have a good idea of what ingredients we are cooking with so let’s see what the overall meal looks like. We can visualize this by looking at the individual holdings of a specific fund or portfolio and plotting them on an X/Y chart to give us a 2- dimensional view of our exposure to the above-mentioned factors.

Let’s begin with the Total U.S. Stock Market measured by Vanguard’s VTI fund:

Figure 1 – Portfolio Architect: 12/2/2021

• Each dot on the chart above represents a stock within the U.S. market and is scaled for its overall market capitalization
• We have Book / Price on the X-axis for value and Gross Profit on the Y-axis for profitability
• We notice somewhat of a linear relationship among companies highlighted in yellow from the top left corner down to the bottom right, indicating that the market places a higher premium on profitable companies, very intuitive
• The blue shaded box in the top left corner represents companies that are in the upper 75th percentile on gross profitability (Highly Profitable) and in the bottom 25th percentile on a valuation scale (Expensive)
  • The blue box includes: AAPL, AMZN, MSFT
  • Apple has 40% of the U.S. smartphone market
  • Amazon has 41% of the U.S. e-commerce retail market
  • Microsoft has 73% of the U.S. computer operating system market

It is simple to understand why the market places a high value on these companies. They are dominant in their industries and chances are every reader of this article is using 1,2, or even all 3 of these company’s services or products today. 70% of the companies in the S&P 500 have a lower market capitalization than the $63 billion Apple has in cash on their balance sheet! These companies have pricing power, cash on hand, strong balance sheets and competitive moats so the higher price multiples are very well justified.

For comparison, circled in the lower right corner is Berkshire Hathaway (Warren Buffett’s holding company). Berkshire appears “relatively inexpensive” when sorting on Price / Book and this may be a reason why the Oracle of Omaha has purchased over $51 billion of Berkshire Hathaway stock over the last 3 years. The chart of the U.S. stock market explains one very clear message to investors: The majority of highly profitable companies are expensive to buy, and the majority of attractively priced companies have low profits and earnings.

“Whether we’re talking about socks or stocks, I like buying quality merchandise, when it is marked down.”

– Warren Buffett

Stocks represent an ownership interest in a business, and we believe that investors should view their equity portfolio from this perspective. What Warren is telling us in the above quote is that he likes buying quality (high profit) companies when they are marked down (value priced). If we are going to target profitable companies, let’s make sure we pay an attractive price and if we are going to search for attractively priced stocks, let’s make sure they are profitable. This sounds remarkably simple, but the chart of the total U.S. market shows that there is a relatively small number of stocks that fit this mold. Let’s return to that original chart above showing the total U.S. stock market.

We already know some of the companies in the blue box, but what about the dimension in the upper righthand corner?

• Aaron’s Company Inc (AAN)
• Oppenheimer Holdings Inc. (OPY)
• Alpha Pro Tech, Ltd. (APT)
• L S Starrett Co. (SCX)
• Weis Markets, Inc. (WMK)
• Reliance Steel & Aluminum Co. (RS)

Certainly not household names and to be honest, I had to search the internet to find out what they do. Aaron’s Company is a leader in rent to own furniture for households……Reliance Steel & Aluminum is the largest metals service center in North America…..Alpha Pro Tech is an industry leader in weatherized products for new homes……L S Starrett Co. is a leader in tool manufacturing for the construction industry. Anyone living in Austin, TX knows that the housing market has been on fire lately, yet I don’t hear people throwing these company names around like Apple, Amazon, and Tesla among others??

“Skate to where the puck is going, not where it has been.”

– Wayne Gretzky

Just like we can’t time the market, we also can’t time factors such as relative price and profit. Patience is perhaps the ultimate investor attribute, and we can only stress the importance of being there when sentiment shifts. Markets move fast and returns happen quickly, only investors who remain dedicated to holding this dimension of the market will reap the rewards.

Silicon Hills Strategies:

“The worst thing I can be is the same as everybody else. I hate that.”

– Arnold Schwarzenegger

So, we have identified a dimension of the market where we would like to invest; now let’s examine fund managers that Silicon Hills Wealth utilizes within our Global Equity portfolio to accomplish that goal:

Avantis U.S. Small Value (AVUV)

• Vanguard U.S. Total Market (VTI) is in blue
• Avantis U.S. Small Value (AVUV) is in red
• Outlined in yellow, we can see that the strategy is tilting towards attractively priced highly profitable companies in the small cap arena
  • Top holdings include:
    • Louisiana-Pacific (LP) – world’s largest producer of engineered wood building products for homebuilders
    • Saia Inc. (SAIA) – Trucking company, anyone heard of supply chain demands lately??
    • Herc Holdings Inc. (HRI) – Construction equipment rental company, anyone in Austin can look around at the buildings and houses going up daily

Alpha Architect U.S. Quantitative Value (QVAL)

• Vanguard U.S. Total Market (VTI) is in blue
• Alpha Architect Quantitative Value (QVAL) is in red
• Outlined in yellow, again we see a similar pattern where the fund is concentrated in those highly profitable companies trading at an attractive valuation multiple
• Top holdings include:
  • Westlake Chem Corp. (WLK) – Think vinyl products like siding for new homes
  • Winnebago Inds Inc. (WGO) – People are out traveling again
  • Tyson Foods Inc (TSN) – Everybody’s gotta eat
  • Autonation Inc. (AN) – pent-up demand + low interest rates = hot demand for cars
• Equal-weighted and concentrated portfolio of attractively priced stocks within the U.S. market
• Uses EBIT / TEV to screen for value and profitability
  • EBIT = earnings before interest and tax, also called operating income
    • This metric is directly from the income statement and reflects a company’s profitability
  • TEV = total enterprise value which differs from market capitalization as TEV adds in the total debt outstanding of a company since bond holders have a stake in the cash flows along with equity investors
    • Helps mitigate any accounting issues when valuing a company across different sectors or industries

Conclusion:

When we talk with current and prospective clients, a common concern many have is that the U.S. stock market has been going up for the better part of a decade. Incredible returns year after year that far outpace long-term averages have people worried about a pullback. While we can’t predict the future with a high degree of accuracy, we can encourage investors to take a page out of Warren’s playbook and focus on the quality merchandise that is still attractively priced!! The future in capital markets always embeds a degree of uncertainty and thus, the rationale behind the returns investors are rewarded with. Jack Bogle once noted that he uses a simple formula to explain long-term market returns:

Future Market Returns = Dividend Yield + Earnings Growth +/- Change in P/E Ratio

• Dividend Yield & earnings growth drive the long-term return of the U.S. stock market
• Changes in P/E Ratio is simply noise over time and represents investors sentiment in markets

We are confident that at the end of the day, it all comes back to fundamentals because intuitively, investors share in the profits and earnings of the companies they own. Not all stocks are created equal and with patience, we are confident that the markets will reward investors who seek out attractive profits at an affordable price.

“Buy cheap; buy strong……. anything less would be uncivilized.”

– Wes Gray, Ph. D., CEO at Alpha Architect

---

¹ https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html