In this second part of the paper we build portfolios by combining two of the factors we have already tested. Through the combination of the second factor we want to find out, using the strong factors we have already identified, if it leads to higher market outperformance more consistently.
To do this we first sorted all the companies in our investment universe by the first factor. We then selected only the companies in the first quintile, and then used only this group of companies and sorted them into five quintiles using the second factor. So the two-factors were not weighed equally. The first factor in each case had more weight as we only selected the best quintile from this factor to use with the second factor.
We also tested the same factor twice; for example, using price-to-book as the first and second factor. We did this to determine if this combination leads to higher market outperformance compared with the original one-factor tests. As explained, for the two-factor tests we did not split the universe into different market capitalization as in doing so we would not have been able to form second factor quintiles with at least 30 to 40 companies in each quintile.
Overall, what we found was that all the two-factors we tested, even the worst performing quintiles, substantially outperformed the market portfolio.