Speaker 1: For most of the last entry, investing was a lot
Speaker 1: more art than science. People did in whatever was working
Speaker 1: based more on gut feelings than data. Portfolio management was
Speaker 1: a lot less evidence based than it is today, she.
Speaker 2: Noted with silence.
Speaker 1: As it turns out there are ways you can use
Speaker 1: data to your advantage even if you're not a math wizard.
Speaker 1: I'm Barry Ridults, and on today's edition of At the Money,
Speaker 1: we're going to discuss how to use what we've learned
Speaker 1: about quantitative investing to help us unpack all of this
Speaker 1: and what it means for your portfolio. Let's bring in
Speaker 1: Jim O'Shaughnessy. Jim is the former chairman and founder of
Speaker 1: O'Shaughnessy Asset Management, which was sold to Franklin Templeton a
Speaker 1: couple of years ago. He is also the author of
Speaker 1: the New York Times best selling book What Works on
Speaker 1: Wall Street, now in its fourth edition. What Works on
Speaker 1: Wall Street was the first quantitative equity investing work, more
Speaker 1: or less for the late person. Jim, welcome to add
Speaker 1: the money. Let's start very basically define quantitative investing.
Speaker 2: Quantitative investing, Barry is using empirical evidence that you gather
Speaker 2: over looking at how various factors like things like price
Speaker 2: to earnings ratio or earning's growth rate, and testing them
Speaker 2: over as many market cycles as you can. That gives
Speaker 2: you information that you simply couldn't have without such a test.
Speaker 2: For example, you can see what's the biggest draw down,
Speaker 2: how long did it last? How long and how often
Speaker 2: did a strategy beat its benchmark and by what magnitude.
Speaker 2: It's essentially like a very long term study just looking
Speaker 2: at the evidence as opposed to stories.
Speaker 1: So let's compare evidence versus the stories. When we look
Speaker 1: at history, quantitative models outperform professional investors and experts who
Speaker 1: rely on much squishier qualitative judgments. Why is that?
Speaker 2: Primarily the old Pogo cartoon We've met the enemy and
Speaker 2: it's us succinctly points out the reasoning here. Essentially, when
Speaker 2: we model great investors and look at the underlying factors
Speaker 2: of their portfolio, they do do extraordinarily well over time.
Speaker 2: The challenge is that the expert themselves often makes emotional choices,
Speaker 2: especially during times of intense market volatility. For example, during
Speaker 2: the Great Financial Crisis, many even quantitative investors emotionally overrode
Speaker 2: their models, so making decisions consistently according to a process
Speaker 2: that you've tested, sort of saves you from your own
Speaker 2: emotional problems.
Speaker 1: So you've looked at a lot of these strategies and
Speaker 1: strategists going back a century to the nineteen twenties. What
Speaker 1: kinds of approaches have consistently performed the best.
Speaker 2: No big surprise, Barry over long periods of time. Buying
Speaker 2: stocks more cheaply priced than those that are priced into
Speaker 2: the stratosphere generally works over long periods of time. But
Speaker 2: one of the models that we've found that actually performed
Speaker 2: really well over a variety of market cycles was essentially
Speaker 2: buying cheap stocks as measured by things like price to
Speaker 2: cash flow, even to enterprise value, etc. That are on
Speaker 2: the men that have turned a corner and are showing
Speaker 2: some good price momentum. Cheap stocks on the mend is
Speaker 2: a really interesting way to look at the market, because
Speaker 2: essentially the market is saying, yeah, that stock is very,
Speaker 2: very cheap, but we think it's probably too cheap. They're
Speaker 2: putting their money where their mouth is and buying it.
Speaker 2: That's a great strategy overall.
Speaker 1: So let's break that into two half, starting with valuation.
Speaker 1: One of the things that struck me the first time
Speaker 1: I read what works on Wall Street was the price
Speaker 1: to earnings ratio, the PE ratio which everybody seems to
Speaker 1: focus on. It doesn't really produce great results for investors.
Speaker 1: Explain why PE isn't the best way to measure valuation.
Speaker 2: Well, you know, when a measurement becomes a target, it
Speaker 2: often loses its efficacy. And you know, there's the old
Speaker 2: joke about the company hiring a new CFO and they
Speaker 2: only ask them one question, what's two plus two? And
Speaker 2: everyone answers four except for the person they hire, whose
Speaker 2: answer was what number did you have? In mind? Earnings
Speaker 2: are much easier to manipulate than things like revenue and
Speaker 2: other measurements of value, and I think that's one of
Speaker 2: the reasons why. Well, it worked very very well before
Speaker 2: all of our innovations and computer databases, etc. Once it
Speaker 2: became a target for people to pick things on, it
Speaker 2: started getting manipulated at the corporate level.
Speaker 1: So let's talk about some other measures. You talked about,
Speaker 1: price to sales ratio, you talked about EBADA to enterprise value.
Speaker 1: Tell us what actually works as a way of measuring
Speaker 1: corporate value.
Speaker 2: Specifically, we like to look at a composite of various
Speaker 2: value factors, several of which you mentioned. One of my
Speaker 2: rookie mistakes in the first version of the book was
Speaker 2: simply looking at the data and saying, well, price to
Speaker 2: sales has done the best of any single measurement. Well,
Speaker 2: it was a rookie mistake because I was measuring it
Speaker 2: over a specific period of time. As we improved our
Speaker 2: process of testing, we found that using rolling rebalances and
Speaker 2: multiple value factors, it alone was outperformed by a value composite.
Speaker 1: And let's talk a bit about price momentum. That has
Speaker 1: been a robust factor for strong performance, especially as you mentioned,
Speaker 1: when you combine momentum with value metrics give us an
Speaker 1: explanation for how we should be looking at momentum.
Speaker 2: So momentum is really interesting because academics hate it because
Speaker 2: there is no reason underlying economic reason why it should
Speaker 2: make sense. But it does when you test it all
Speaker 2: the way back to the twenties. The rolling batting averages
Speaker 2: i e. The number of periods over one, three, five,
Speaker 2: and ten years where it beats its benchmark is extremely high.
Speaker 2: And that's sort of the wisdom of crowds working there.
Speaker 2: I believe when people have very differing opinions on a stock.
Speaker 2: They have heterogeneous opinions, right, as long as those opinions
Speaker 2: remain heterogeneous, the price movement is an excellent indicator of
Speaker 2: the net net net sentiment of investors. When it's going
Speaker 2: much much higher, obviously, that's positive. When it's going negative,
Speaker 2: that's very negative. If you invert momentum and look at
Speaker 2: buying the stocks with the worst six month or twelve
Speaker 2: month price momentum, the results are a true disaster. So essentially, it's,
Speaker 2: as Ben Graham would call it, it's listening to mister market,
Speaker 2: and they're putting their money where their mouth is. And
Speaker 2: that's why I think it's such a strong and robust
Speaker 2: indicator over a huge number of market cycles.
Speaker 1: You know, it's interesting you say that. I always just
Speaker 1: assumed that if you're a big fund manager and you're
Speaker 1: buying fill in the blank, Microsoft and Vidia, Apple, it
Speaker 1: doesn't matter. You're not saying, hey, Tuesday, March nineteenth, I'm
Speaker 1: buying my five year allowance of Nvidia. You're buying that
Speaker 1: as cash flows into your funds, you're consistently buying your
Speaker 1: favorite names kind of relentlessly over time. Is that to
Speaker 1: pop psychology? Of an explanation for momentum or is there
Speaker 1: something too names that institutions like they tend to buy
Speaker 1: and continue to buy over time.
Speaker 2: Yeah, that's the persistent underlying bid theory, and I'm sure
Speaker 2: that there is an effect when institutions continue to pour
Speaker 2: money into their favorites on a buy list. But I
Speaker 2: think that the reason momentum really works is those names
Speaker 2: that you just mentioned. They do have positive momentum most
Speaker 2: of the time, but the fact is they probably aren't
Speaker 2: qualifying for the list of the stocks with the biggest
Speaker 2: change in prices. Those names tend to be very, very
Speaker 2: different than institutional favorites. So having an underlying persistent bid
Speaker 2: from institutions yeah helpful. But a lot of those names
Speaker 2: don't actually make the cut when you're sorting on your
Speaker 2: final factor being momentum.
Speaker 1: So let's talk about a fascinating piece of research you did.
Speaker 1: I believe is also referenced in the book. People like
Speaker 1: things like private equity and venture capital, but they're not
Speaker 1: thrilled with being locked up for five years or seven years,
Speaker 1: or sometimes even ten years. You identified that the microcaps
Speaker 1: screened for quality seem to reproduce venture capital and private
Speaker 1: equity returns but without the lock up period. Tell us
Speaker 1: about that.
Speaker 2: Yeah, we have several papers at Shawn c Asset Management
Speaker 2: on that effect. It's really fascinating because the microcap universe
Speaker 2: is kind of this undiscovered country. Half of the names
Speaker 2: in it aren't even covered by a single analysts and
Speaker 2: when you use quality, momentum, etc. To sort it out,
Speaker 2: because warning, the universe itself is pretty not a great,
Speaker 2: not a great universe.
Speaker 1: You can call it garbage, Jim, It's okay.
Speaker 2: Yeah, okay, all right, So the universe itself is garbage,
Speaker 2: but there are a lot of hidden gems there and
Speaker 2: the ability to sort out those hidden gems that are
Speaker 2: little covered or not covered at all. Basically, what we
Speaker 2: found in a paper that we published several years ago
Speaker 2: was the returns sort of are great proxy for private
Speaker 2: equity in particular. And so if you're looking for a
Speaker 2: far less expensive way to get private equity, like returns
Speaker 2: at lower fees with no lock up, you'll want to
Speaker 2: take a look at the microcap universe sort it by
Speaker 2: these various metrics.
Speaker 1: So in the book What Works on Wall Street you
Speaker 1: emphasize the importance of having a systematic, disciplined approach. Explain
Speaker 1: to listeners what goes into taking what is kind of
Speaker 1: used to be sort of a loose, an undisciplined approach
Speaker 1: to stock selection and turning it into something much more disciplined.
Speaker 2: Well, I think that essentially, I'd say, would you go
Speaker 2: to a doctor who looked at you and said, hey, Barry,
Speaker 2: I just got these little yellow pills and they look
Speaker 2: appealing to me, and I think they might work for
Speaker 2: what's wrong with you? I don't think you would, right,
Speaker 2: I think you'd say, well, where are the studies, where's
Speaker 2: the evidence? Where is the long longitudinal studies to prove
Speaker 2: the efficacy of this little yellow pill? Right? That's really
Speaker 2: what we're doing with factor or quantitative investing. We are
Speaker 2: looking historically at ideas that make economic sense, right, don't
Speaker 2: pay the moon by momentum, et cetera. But then this
Speaker 2: is the key important part. We're turning it into a
Speaker 2: process that we run time and again and don't override.
Speaker 2: You know, the in basketball to investing, the process is
Speaker 2: much more important than the either intuitive ooh I should
Speaker 2: jump on this name or the terror Oh my god,
Speaker 2: the name is collapsing.
Speaker 1: I've got to.
Speaker 2: Jump out of it. It really brings a rigor and
Speaker 2: a discipline to approaching the market that is really hard
Speaker 2: to duplicate without that process underlying the quantitative methodology not impossible,
Speaker 2: but willpower dissipates very very quickly, especially in times of
Speaker 2: either exuberance right during a bubble or despair during a
Speaker 2: bear market. Following the process through thick and thin, which
Speaker 2: you're all always trying to improve, by the way, but
Speaker 2: following that process without making any additional emotional overrides, has
Speaker 2: proven itself to be quite effective at getting rid of,
Speaker 2: or at least neutralizing some of the very famous behavioral
Speaker 2: biases that we all have as humans. Right, we're all
Speaker 2: running human operating system and helping us avoid the pitfalls
Speaker 2: is really what the underlying process does, and does very
Speaker 2: very well.
Speaker 1: So let's address that for a final question. One of
Speaker 1: the things you have discussed previously is some of the
Speaker 1: biggest challenges investors face is avoiding emotional decision making. What
Speaker 1: are the tools you recommend for making sure that the
Speaker 1: average mom and pop investor doesn't succumb to their own
Speaker 1: emotional limbic system and making choice from the wrong place,
Speaker 1: making choices from emotional panic or greed.
Speaker 2: Well, you know, I've often said that the four horsemen
Speaker 2: of the investment of apocalypse are fear, greed, hope, and ignorance,
Speaker 2: and ignorance is the only one that is really correctable
Speaker 2: by studying. It's very, very difficult, especially as you note,
Speaker 2: for retail investors who look they have other interests, they
Speaker 2: have other things that they're going to spend their time on.
Speaker 2: So what I concluded was probably the best thing that
Speaker 2: you can do is find yourself a good financial advisor
Speaker 2: who could sort of serve as your wingman. The thing
Speaker 2: that advisors are able to do because of a lot
Speaker 2: of reasons, right it's not their money. They can be
Speaker 2: much more dispassionate about it, they can be much more
Speaker 2: professional about it, and then they can help their client
Speaker 2: during those tough times. It's like the old joke about
Speaker 2: anesthesiologists ninety five percent of the time they're board silly.
Speaker 2: Five percent of the time that is where they earn
Speaker 2: all their money.
Speaker 1: Really interesting. Thanks Jim for all these insights. So to
Speaker 1: wrap up, quantitative investing provides an enormous advantage to investors.
Speaker 1: It's specific, it's evidence based, it uses data, and it
Speaker 1: avoids the emotional decision making that leads investors to stray.
Speaker 1: If you want to apply some quantitative strategies to your portfolio,
Speaker 1: consider looking at the combination of momentum and low price
Speaker 1: stocks or microcaps that have been screened for quality and value.
Speaker 1: I'm Barry Ridoults. You're listening to Bloomberg's At the Money.