This article is an excerpt from the ebook How To Invest In Stocks Quantitatively: A Quant Toolbox User Guide which is available for FREE download on the Quant Toolbox Page.
If you’re reading this article, there is a good chance that you are a Value Investor. To use Buffett’s cliché, you understand that Price is what you pay, and Value is what you get. Namely, that discrepancies between Price and Value can be exploited to generate outsized returns. Yet there are two primary schools of thought when it comes to the mechanics of investing and building a portfolio.
The first group of investors, whom I call Discretionary Investors, study and analyze securities manually, prior to adding them to their portfolios. Typically, discretionary investors read SEC filings, conference call transcripts, and analysis papers to ascertain a stock’s level of under-valuation, the quality of the underlying company, and its future prospects. After developing sufficient knowledge of the stock and the situation, and having confidence in their investment thesis, they invest a relatively sizable sum in the company, building a portfolio of as little as ten stocks or as large as 30 stocks. There is a limit to how many stocks a human being can realistically monitor and keep acquainted with, hence that number. While not having the statistics, I believe that most investors fall into that category.
The second category of investors, whom I call Quantitative Investors, are those that make Buy and Sell decisions solely based on computerized algorithms, such as the outputs of screeners. Following an initial effort of crafting an algorithm, or a screener, based on well-defined Valuation, Quality & Momentum rules, those investors follow those rules mechanically, without further judgment. If an algorithm tells you to buy a stock, you simply buy it. No questions asked. If the algorithm tells you to sell a stock, you sell, no debate.
While to some, such an approach may sound unintelligent; in fact, it has a clear rationale. The set of rules used are crafted based on elaborate research and tested in back-testing simulation to result in over-performance. Useful algorithms or screeners are subjected to rigorous statistical due diligence. Most importantly, following an algorithm or a screener mechanically eliminate cognitive biases which lead to ill decisions. The quantitative investor is thus not subjected to her own fear or greed, not to the inclination to hold losing positions in the hope of recovering losses and not avoiding stocks because of unexplained fears. It has been shown that in most cases, where human judgment is involved, results suffer. Quantitative portfolios take much less time to monitor and maintain, as there is no point in analyzing any specific security in depth. The algorithm or screener is doing that for us. As such, typically, quantitative portfolios contain tens of stocks (at least 30). The most common example of such an algorithm/screener is The Magic Formula, popularized by Prof. Joel Greenblatt in his best-selling book The Little Book That Beat the Market. Another example is Tobias Carlisle’s The Acquirer Multiple. On our website, TalDavidson.com we include the most successful screeners known today, some of which are based on our proprietary research. Our screeners benefit both types of investors. Naturally, Quantitative Investors can use the screeners to build and maintain complete stock portfolios. All they need to do is follow our instructions and use the screeners to make buy/sell decisions. Discretionary Investors will use the screeners as a source of investing ideas. Our screeners’ results serve as the best starting point for investment ideas, as the highlighted stocks already meet the quantitative measures that correlate with over-performance. A good value screener is the best pond to fish for new investments. Quantitative Screeners thus serve two purposes. The first is boosting potential returns by focusing on discretionary investors’ efforts on the stocks with the most potential for overperformance. Secondly, saving valuable search time by providing a focus list for further investigation.