## Combining Factors

For this backtest, we first sorted our universe of stocks by earnings yield (EY), which we defined as operating income divided by enterprise value. We then took the 300 or so companies with the highest earnings yield and sorted them by the 14 secondary factors we tested.

For each of the second factors, we divided the 300 companies into five quintiles and calculated the performance of each quintile.

As you can see, using EY (valuation factor) is very effective in identifying market-beating stocks. On average, across all second factors tested, the strategy led to an average performance of just under 405% (median was 368%), substantially higher than the market portfolio return of 30.54%.

The best return of 814% was achieved by combining the earnings yield with the 6-month price index. This means a combination of price momentum and undervaluation based on earnings yield. Interesting was that the second best combination was earnings yield combined with a 12-month price index, also a momentum factor.

The worst-performing strategy was earnings yield combined with return on invested capital, which returned 143% over 12 years. Even though this strategy beat the market portfolio, it was not nearly as effective as using price momentum as a second factor. Even though the results of this two-factor strategy were good, based on the average Q1 returns, this was the sixth-best two-factor strategy we tested.