- All investors are susceptible to behavioral mistakes that then leads to poor returns. Gray and Carlisle create a quantitative value strategy that exploits the typical investors’ flaws while building temperament into their model.
- “While the term quantitative likely conjures images of complex equations churned by powerful computers, it’s best understood as the antidote to behavioral error.”
- Price and value are distinct but intrinsic value is less easy to define. It can only be estimated through some valuation model using past information to make future projections. Changing the projections changes the intrinsic value. In theory, investors can twist valuation models to their will by tweaking the inputs…and they often do.
- The behavioral argument for value: investors project recent poor earnings into the future, stock prices fall with the projections and overreaction to bad news, until selling drives stocks to be undervalued. Value investors best against the overreaction to bad news and assumed continued poor performance, by buying underpriced stocks that go on to beat the market. To most investors, value stocks appear to be riskier than they really are.
- Ben Graham’s Simple Quant Strategy:
- “What’s needed is, first, a definite rule for purchasing which indicates a priori that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally, you need a very definite guide for selling.” — Ben Graham
- Portfolio with a minimum of 30 stocks
- P/E < 10
- Debt-to-Equity < 50%
- Sell each stock after a 50% return or after 2 years, whichever comes sooner.
- Graham estimated a 15% annual return (backtested from 1976 to 2011 exceeded Graham’s estimates by about 2%).
- But why? Because the strategy was followed — absent fear and greed, during years of underperformance — consistently to the letter. Temperament is built into the model.
- “Systematic behavioral biases create opportunities for investors who can find a way to control their innate weaknesses.”
- Studies show that experts underperform or can do no better than simple models.
- All investors are biased in some way. Rather than trying to correct the flaws, why not build a strategy that protects from the flaws. The same strategy can also be built to exploit the flaws of others, providing the necessary edge to outperform.
- “Even once we are aware of our biases, we must recognize that knowledge does not equal behavior. The solution lies in designing and adopting an investment process that is at least partially robust to behavioral decision-making errors.” — James Montier
- Gross Profitability (GPA)
- A proxy measure for Quality
- GPA = (Revenue – Cost of Goods Sold)/Total Assets
- “The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability. For example, a firm that has both lower production costs and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales through aggressive advertising, or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income below that of its less profitable competitors. Similarly, if the firm spends on research and development to further increase its production advantage, or invests in organizational capital that will help it maintain its competitive advantage, these actions result in lower current earnings. Moreover, capital expenditures that directly increase the scale of the firm’s operations further reduce its free cash flows relative to its competitors. These facts suggest constructing the empirical proxy for productivity using gross profits.” — Robert Novy-Marx
- The rest of the book is a good example for thinking about how a quant value strategy might be structured.
- Avoid Permanent Loss of Capital
- Remove companies with the potential for earnings manipulation and fraud.
- The first place to look is accruals used to manipulate earnings to look better than reality. The goal is to avoid stocks showing the illusion of quality earnings.
- “Interestingly, simply measuring net income against cash flow captures many of the earnings manipulations, and, as it turns out, is predictive of future returns.”
- Beneish M-Score looks at manipulation from the view of probability based on characteristics found in past financial manipulators.
- Remove companies with a high chance of distress or bankruptcy.
- Altman Z-Score uses a combination of five ratios to determine a likelihood of bankruptcy (a score below 1.81 = bankrupt, above 1.81 = not bankrupt).
- The Z-Score was built for manufacturing companies, showing a need for a model that adjusts for industry accounting conventions.
- “…stocks with higher leverage, lower profitability, lower market capitalization, lower past stock returns, more volatile past stock returns, lower cash holdings, lower price-to-book ratios, and lower prices per share are more likely to file for bankruptcy, be delisted, or receive a “D” rating… Investors should be aware that stocks with a high risk of failure tend to deliver particularly poor returns, and at heightened risk.”
- Find Cheap Quality
- Buffett’s “wonderful business” presents a high return on capital in excess of market rates of return and over an extended time.
- Gross Profitability or GPA = (Revenue – Cost of Goods Sold)/Total Assets
- Return on Capital or ROC = EBIT/Capital
- Two above measures of quality don’t account for price. That introduces a problem — mean reversion. 1) It confused stocks at the peak of a business cycle with franchises. 2) Businesses with high returns on capital draw competition. In both cases, high returns erode and mean revert.
- One way to filter out franchises from companies at peak business cycle is to look at metrics averaged over the long term — long enough to account for a full business cycle. Franchises should show more consistent stable returns over the full cycle.
- “A consistently high, stable profit margin indicates the presence of a franchise.”
- Piotroski F-Score looks for cheap but financially strong companies — looking at 1) profitability, 2) leverage, liquidity, and funding source, and 3) operating efficiency — where higher F-score = higher financial strength. Piotroski found that eliminating financially weak companies improved overall returns (the weakest, underperformed the market). The F-Score tends to produce more small and mid-cap stocks than large caps.
- Find Cheap Price
- Several ratios can be used as a proxy for value: E/P, EBIT/EV, EBITDA/EV, FCF/EV, Gross Profits/EV, B/M were backtested in the book. EBIT/EV, EBITDA/EV, and GP/EV were the most robust.
- The cheapest decile of each outperformed the market. The most expensive decile of each performed the worst.
- Normalizing the “earnings” in the ratios over multiple years, versus the single year, didn’t produce better results.
- A composite of all the ratios is another idea, reducing the chance of any single ratio lagging over a longer period.
- Find Supporting Signals
- Buyback Yield = companies that reduced outstanding shares the most in a year, outperformed the market. Companies issuing the most shares in a year underperformed the market.
- Insider Transactions = there’s only one reason insiders buy, but many reasons insiders sell. But its more nuanced than that. “Opportunistic” (i.e. irregular compared to “routine” trades) insider buying generated market-beating returns for the insider. Other things to look for are larger purchases on an absolute basis, or multiple irregular purchases over several months, or purchases while the company is buying back stock, or purchases in “value” stocks. Each could be a sign of higher conviction.
- Activists = stocks targeted by activist investors tend to beat the market, after the initial Schedule 13D notice. The outperformance may last into the second year, possibly because management agrees to the activist’s recommendations.
- Cloning is another option where you basically, ride the coattails of other successful investors by following them through 13F filing. But, you have to be able to find skilled investors who will continue to beat the market.
- Short Interest = a basket of lightly shorted stocks outperformed the market, highly shorted stocks fell short of the market. Avoiding highly shorted stocks, in a long-only portfolio, is another filter to consider.
- Follow the K.I.S.S. method (Keep It Simple, Stupid) when building a strategy. More information is likely to increase confidence more than accuracy. The end result is overconfidence not better performance.
- “As investors, we should favor simplicity over complexity, but as humans, we seem behaviorally destined to prefer complexity.”
- “Did you like what the model said or did you not like what the model said? That is a hard thing to backtest. If you are going to trade using models, you just slavishly use the models; you do whatever the hell it says no matter how smart or dumb you think it might be at that moment.” — Jim Simons
Quotes
“As investors, we should favor simplicity over complexity, but as humans, we seem behaviorally destined to prefer complexity.”
“Did you like what the model said or did you not like what the model said? That is a hard thing to backtest. If you are going to trade using models, you just slavishly use the models; you do whatever the hell it says no matter how smart or dumb you think it might be at that moment.” — Jim Simons
“A consistently high, stable profit margin indicates the presence of a franchise.”
“Interestingly, simply measuring net income against cash flow captures many of the earnings manipulations, and, as it turns out, is predictive of future returns.”
“While the term quantitative likely conjures images of complex equations churned by powerful computers, it’s best understood as the antidote to behavioral error.”
“What’s needed is, first, a definite rule for purchasing which indicates a priori that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally, you need a very definite guide for selling.” — Ben Graham
“Even once we are aware of our biases, we must recognize that knowledge does not equal behavior. The solution lies in designing and adopting an investment process that is at least partially robust to behavioral decision-making errors.” — James Montier
“The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability. For example, a firm that has both lower production costs and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales through aggressive advertising, or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income below that of its less profitable competitors. Similarly, if the firm spends on research and development to further increase its production advantage, or invests in organizational capital that will help it maintain its competitive advantage, these actions result in lower current earnings. Moreover, capital expenditures that directly increase the scale of the firm’s operations further reduce its free cash flows relative to its competitors. These facts suggest constructing the empirical proxy for productivity using gross profits.” — Robert Novy-Marx