Factors that drive DAF's Investment Selection

Factor-based investing is an approach that involves targeting specific drivers of return or "factors" across asset classes. It has gained significant traction in the investment world in recent years. While the ISOA Dynamic Advantage Fund is built on the principles of a factor-based strategy, some of these factors are unconventional and leave scope to incorporate subjective market views. Here's a little sneak peek into the system:

(A) Business Quality, (B) Valuations, and (C) Market Perception are three broad category of factors that are the cornerstone of DAF's investment strategy. Each of these has a sub-set of factors which are a blend of both qualitative and quantitative parameters.

(A) Business Quality

The table below captures the key pieces that make up the business quality score. Each prospective company gets shortlisted into one of the buckets based on the five factors listed below.

(B) Valuations

The model uses a two-part analysis for gauging the valuation levels:

Reverse DCF: The Reverse Discounted Cash Flow model is a valuation method used to determine the implied growth rate or the required rate of return that justifies the current market price of a company’s stock. Essentially, it’s the reverse of the traditional DCF analysis, where the target price is an outcome. With Reverse DCF, the current price is an input.

The idea is simple - what level of growth the market has already priced in with the current stock price. If it's below our expected growth levels over a 3-5 year period, there is value in the stock and vice versa. For example, if the reverse DCF shows that the market expects very high growth rates, but your analysis suggests more modest growth, it could indicate that the stock is overvalued based on current expectations.

Relative Valuations: Relative valuations are industry specific metrics (Price/book for Financials for example) both as a comparison to peer group and against the company's historical ranges as well.

Both these measures in isolation have their own flaws. For example, just because a bank is trading at relatively lower multiples vs. peers, does not make it a buying opportunity. However, a combination of both measures covers a lot of bases together and adds value to the overall positioning calls.

Both methods are combined and a single score is given to each company. This ultimately feeds into our 'Zonal Score' which helps us on the positioning side of things in terms of which company to go overweight/underweight on. The higher the margin of safety, the higher the target allocation.

(C) Market Perceptions

Capturing market sentiments into a datapoint is highly subjective. DAF's market perception monitor uses a simple three input model which takes into account (A) Recent news flow sentiment (B) Fund flow analysis (where are the volumes flowing) and (C) Retail Euphoria check. The model has some inspiration from Howard Mark's 'Mastering the Market Cycle', Morgan Housel's work on Investment psychology and also from my experience so far in understanding the behavioural decisions that market participants make in different situations.

One of the key advantages of breaking the process down into factors is its ability to provide a more systematic and rules-based approach to portfolio construction and reduce some of the personal biases from the investment process.

All these factors tie-up at different points in the investment process. To understand how these connect with each other - head over to our note on the DAF's Broad Investment Process.