Hou, Xue & Zhang (2015): The q-Factor Model Revolution

#The Paper at a Glance

Title: Digesting anomalies: An investment approach

Authors: Kewei Hou, Chen Xue, and Lu Zhang

Published: Review of Financial Studies, 2015

DOI: 10.1093/rfs/hhu068

For decades, the Fama-French model ruled finance. Then Hou, Xue, and Zhang proposed the q-factor model, arguing that you don't need "Value" or "Momentum" as standalone factors if you properly measure Investment and Profitability.

It was a bold claim: We can explain the market better with fewer, more economically grounded variables.

#The Investment CAPM (Theory)

Legacy models focused on the buyer (the investor). The q-factor model focuses on the seller (the firm).

The Logic: - A firm invests in new projects until the Marginal Cost = Marginal Benefit. - High Investment: If a firm is investing aggressively, its cost of capital must be low (expect lower returns). - High Profitability: If a firm is highly profitable but not investing, its cost of capital must be high (expect higher returns).

Thus, expected return is purely a function of Profitability ÷ Investment.

#The Four Factors

1. 1Market Excess Return (MKT)
2. 2Size (ME): Small minus Big.
3. 3Investment (I/A): Low investment minus High investment.
4. 4Profitability (ROE): High ROE minus Low ROE.

The Death of "Value"?

The authors show that the classic Value effect (HML) is just a proxy for Investment and Profitability. - Value stocks tend to have low investment and decent profitability. - When you control for I/A and ROE, the Value factor loses its statistical significance.

This suggests Investment and Profitability are the "source code" of stock returns, and Value is just a derived output.

#Explaining the Anomalies

The paper tests 80 disparate anomalies (like earnings surprises, accruals, distress risk). The q-factor model successfully explains/digests almost all of them.

For example, the "Momentum" anomaly is largely explained because winning stocks tend to have improving profitability (ROE shocks), which the model captures.

#How This Applies to Our Rankings

The q-factor model validates our heavy weighting of: - Profitability (30%) - Investment (10%)

While we still include Value (15%) and Momentum (25%) (because they offer diversification and have unique behavioral drivers not fully captured by the q-theory in practice), the core insight of Hou, Xue, and Zhang drives our philosophy: High Quality (Profitability) + Disciplined Growth (Low Investment) = Superior Returns.

We place "Profitability" at the very top of our hierarchy because it is the denominator of the q-theory—the primary driver of expected returns.

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#Academic Source

Hou, K., Xue, C., & Zhang, L. (2015). "Digesting anomalies: An investment approach." Review of Financial Studies, 28(3), 650-705.