The “three factors” model developed to determine why different stocks generate different results is used by many analysts. The model considers size (small stocks vs large), value (high book-to-market ratios vs low BTM ratios) and simple market risk.

This would be the starting point for supporters of the oft-cited Efficient Market Theory, the same hypothesis that is the basis for all index investing. That theory says investors can’t consistently outperform a relatively efficient, fairly priced market by picking stocks, as their prices reflect the collective wisdom of all the participants in that market.

To get an edge, though, some traders add a fourth variable — momentum. While market capitalization shows where the market has been putting its money over the long haul, momentum reveals where it has been putting it lately. So, investors who want to build on market efficiency can start with the index and then tweak it with a dash of momentum.

The problem is that factor models have spotty records in valuing growth stocks, as evidenced by their poor performance during the technology bubble. This is not all that surprising, as the most commonly used variables rely on historical sales or earnings measures to judge companies — something many growth stocks lack, as they often have rather short histories and little or no earnings to report.

Still, investors who want to use factor analysis when searching for these growth stocks may want to consider a grading system developed by Partha Mohanram, an associate professor at Columbia University. Although his methodology may not pinpoint the next Research in Motion Ltd., it may help skittish investors stay out of the brier patch.

Mohanram developed the grading system by collecting public company reports, then screening for three measures of profitability — the ratio of net income to assets, the ratio of cash flow to assets, and the difference between net income and cash flow — as well as five secondary factors. The latter were the consistency of both sales and earnings growth, and spending in three categories: research and development, advertising and capital expenditures.

Using a database of stocks that matched the Dow Jones Wilshire 5000 index from 1979 to 2001, Mohanram’s ranking helped identify both the top and bottom performers, although it seems more useful in screening out stocks that are likely to be poor performers than in identifying those that might actually beat the market.

On average, the returns of the stocks that received the highest grades outperformed the market by roughly 3% a year. Those with the lowest scores lagged the market by an average of 17% a year, however.

In another research paper, City University professor Chensheng Lu identified a total of 16 factors, including annual asset growth rate and trading volume, that analysts might use to explain return differences, ranking their relative usefulness. His principal test was to measure returns from portfolios that were long stocks with high (top third) relative values and short stocks with low (bottom third) values. Using data for a large sample of stocks during 1963-2005 combined with current macroeconomic data, Lu concluded that liquidity was the largest contributor to any outperformance, with illiquid stocks exhibiting clearly higher returns than liquid stocks. Market return and liquidity used together explain differences in returns among most stocks, he suggests, although momentum clearly does have an impact.

Beyond this, the results for many factors correlate significantly with results for others, indicating a level of redundancy, he concludes. In addition, macroeconomic factors such as short-term interest rates or the credit spread account for asset returns during the early 1980s, but explain little in later years.

There are two separate messages to take away from these studies. First, the original three factors, when looked at together, do seem to account for most of a portfolio’s behaviour. Second, history indicates that “small value” stocks tend to deliver higher returns and higher volatility than the stock market as a whole. Assuming the trend holds, that’s the practical message for investors looking for an edge. IE