Understanding what drives stock returns is the foundation of every investment decision. Decades of academic research — from Nobel Prize-winning economists to quantitative hedge funds — have converged on a set of systematic drivers that explain the vast majority of equity performance.
The Academic Foundation: Factor Models
The breakthrough came in 1993, when Eugene Fama and Kenneth French published their three-factor model, explaining over 90% of diversified portfolio returns (compared to roughly 70% from the Capital Asset Pricing Model alone). The three factors:
- Market Risk (Mkt-RF) — the excess return of the broad market over the risk-free rate
- Size (SMB) — small-cap stocks historically outperform large-caps
- Value (HML) — cheap stocks (high book-to-market) outperform expensive stocks
In 2015, Fama and French expanded to a five-factor model, adding:
- Profitability (RMW) — firms with robust operating profitability outperform those with weak profitability
- Investment (CMA) — firms that invest conservatively outperform aggressive investors
The five-factor model explains between 71% and 94% of the cross-section variance of expected returns. International data confirmed these findings hold globally.
Historical Factor Performance
| Factor | Annualized Premium | Period | Sharpe Ratio |
|---|---|---|---|
| Value (HML) | ~2.9% | 1963–2024 | 0.30 |
| Profitability (RMW) | ~3.2% | 1963–2024 | 0.40 |
| Quality (QMJ) | ~4.7% | 1964–2023 | 0.47 |
| Factor Momentum | — | Multi-decade | 0.84 |
AQR's Contributions to Factor Research
AQR Capital Management demonstrated that value and momentum premiums exist across eight diverse markets and asset classes: US, UK, European, and Japanese stocks; equity index futures; government bonds; currencies; and commodity futures. Their research shows factor premiums have been "an ever-present phenomenon in financial markets for more than 150 years."
Key AQR papers include "Value and Momentum Everywhere" (Asness, Moskowitz, Pedersen) and "Factor Momentum Everywhere" (Ehsani and Linnainmaa), which showed a time-series factor momentum portfolio combining timing strategies earns an annual Sharpe ratio of 0.84.
Earnings Growth: The Primary Long-Term Driver
Over the last 50 years, the S&P 500 compounded at 11.1% annually. The decomposition reveals earnings growth as the dominant force:
| Driver | Annual Contribution | Share of Total |
|---|---|---|
| Earnings Growth | 6.7% | 60% |
| Dividends | 2.9% | 26% |
| Multiples Change | 1.6% | 14% |
Earnings growth had 1.4x the impact of dividends on index gains over the last century. Importantly, earnings are rarely negative over a 10-year period, making them the most reliable component of total return.
The Role of Sentiment and Multiples
The Shiller CAPE ratio (Cyclically Adjusted Price-to-Earnings) captures market sentiment. High multiples consistently portend lower future returns — CAPE predictions are accurate within ±1.37% of actual returns 67% of the time for 10-year forward returns.
As Morningstar research notes, differences in stock valuations are primarily about expected returns, not future earnings growth. Price primarily predicts future returns — a subtle but crucial distinction.
Implications for Investors
This research has direct implications for portfolio construction:
- Factor diversification works: Combining value, momentum, and quality — which have low inter-factor correlations — provides the most robust approach
- Earnings quality matters more than growth: Sustainable, high-quality earnings drive long-term returns more than aggressive growth
- Valuation sets the starting line: Buying at lower multiples systematically improves forward returns
- Patience is required: Any single factor can underperform for years — value suffered for over a decade (2007–2020)
At Blank Capital Research, our 6-factor quantitative model is built on these exact principles — systematically capturing quality, momentum, value, investment, stability, and short interest factors across 9,000+ stocks. Explore the full rankings to see these factors in action.