It seems that almost every investor today is a value investor. Since Value Investing is such a broad term, the ways to employ a value investing strategy are endless.
The definition of Value Investing is investing in stocks in which their market price is lower than their intrinsic economic value, and holding them until the price vs. valuation gap is closed, hopefully by the appreciation of the stock’s price. Value is thus subjective. It relies on an investor’s assessment of an issue’s intrinsic value, based on her subjective valuation of its tangible and intangible assets, future earning power and growth expectations. Graham taught us that growth is an inherent element of value investing, as an issue’s intrinsic value is dependant on a company’s growth expectations. Discretionary investors, those who select stocks manually, may develop different opinions on the stock stocks at a given price. As such, one investor may see Apple stock (AAPL) as over-valued at $160 a share, while another investor may see it as a steal. Both may regard themselves as value investors. Strangely, both may be right. The stock may fluctuate for years in the range of $130-$160, confirming the bearish investor’s views, but then jump to $220, confirming the opinion of the bullish investor.
In contrast to making discretionary stock selection decisions, quantitative investing requires that selection is based purely on figures. The subjective view is limited to the conception of the investment strategy, the recipe. Yet even the investment recipe relies on quantitative truths, which we refer to as Factors. Those factors are:
- Valuation – how low the price is, compared to its trailing Sales, EBIT, EBITDA, net earnings, assets or a combination of the above.
- Quality – how profitable the company were in recent years; how solidly it is financed
- Volatility – how volatile has been its stock price in recent years
- Momentum – To what extent has the stock price appreciated or depreciated in a recent period
- And more.
The most common quantitative value strategies can be consolidated into the following four buckets:
- “Quantitative-Value” (QV)-like* Strategy, investing in the highest-quality among absolutely cheap stocks
- Deep Value, investing in stocks with the lowest absolute valuation, regardless of quality
- Magic Formula – stocks with combination of value and quality
- Systematic Safe & Cheap – investing in the cheapest among high-quality stocks
*The name is inspired by the book “Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors” by Tobias Carlisle and Wesley Grey.
In this website, we intend to provide the necessary tools for investors to implement each of the strategies independently. We will provide stock screens which the investor can control for a particular style, market cap, number of holdings and rebalancing periods. As we build the website, we intend to provide past performance results and essential statistical information.
The first and second strategies can be constructed using the “Quantitative Value Stock Screen.” The third strategy should be constructed using the “Magic Formula Stock Screen” (future). The fourth strategy will have its dedicated stock screen.
The first strategy, investing in the Highest-Quality among Cheap Stocks, is based on the premise that cheap stocks outperform, but you must also control for quality. The strategy is inspired by Tobias Carlisle and Wes Grey’s book “Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors.” The strategy earns very high average annual returns with relatively little volatility. It works well with small caps, which is consistent with AQR’s finding that the Small-Firm Effect is real if you control for quality. In our implementation of the QV-like strategy, we have introduced enhancements to Grey and Carlisle’s model which further improves risk-adjusted returns and reduce asset turnover, for reduction of tax liability and trading costs.
One of those improvements which we would like to highlight here is using a composite valuation formula to rank stocks for their cheapness. While Grey and Carlisle use EV/EBIT, we have found that using an average of several valuation metrics (EV/Sales, P/E, P/B, EV/EBITDA and others) yielded better results in the last 20 years. The concept of using a composite value screen was inspired by James O’Shaughnessy’s seminal book “What works on Wall Street.”
The second strategy, Cheapest Stocks – Deep Value, is based on Graham and Dodd’s teaching. It is also highlighted in Tobias Carlisle’s book “Deep Value,” and his blog acquirersmultiple.com. This strategy selects the ultimate cheapest stocks in the universe without any control for quality. It earns high average returns, especially with small cap stocks, but it is very volatile.
The third strategy, Magic Formula, is an implementation of Joel’s Greenblatt’s “The Magic Formula” strategy, inspired by his book “The Little Book That Beats The Market,” and his website magicformulainvesting.com. The strategy earns market-beating returns (over the long term), but not quite as good as the others. Through using our “Magic Formula Stock Screen,” an investor can tweak the desired market capitalization, number of stock holdings and rebalance periods to suit his style and preferences. We also introduce a few enhancements which improve returns, lower volatility, and lower asset turnovers, for reduction of tax liability and trading costs.
The fourth strategy, Systematic Safe & Cheap, is inspired by the teachings of Graham and Dodd, and the work of Walter Schloss. In contrast to the first group of strategies, we first build a universe of quality stocks by eliminating the ones with may be riskier. We then choose cheap stocks among the quality ones using a proprietary method. The strategy results in very high returns with the lowest volatility of all four categories. Not only we invest a significant portion of our own capital in it, but we also intend to make it available for investors through managed accounts.
The last category of quantitative value investing strategies is that which blends value with momentum. We will write on it we continue developing this website.
For each fundamental Quantitative Value strategy, we have tested the performance of a portfolio with various levels of diversification, market capitalizations and rebalance frequencies. Where we were able to find enhancements which both work well and based on sound economic theory, we indicated those and compared them to the generic strategies.
All strategies were built with the individual investor in mind – no restriction made on owning small cap stocks, minimization of asset turnover to reduce tax liability and trading costs, and an effort to reduce volatility as it is the primary factor preventing many investors of confidently weathering periods of underperformance.
“Investing is Simple, but it’s not easy” — Warren Buffett
We could not agree more.