SYSTEMATIC INVESTING

Smoke signals are sent daily from all corners of the media, which in turn creates confusion for recipients looking to gain an edge over the crowd.  Amidst the information age, investors face an immense challenge to decipher important material from the irrelevant.  Should we choose to absorb and make sense of the endless stream of news?  Conversely, would it be more beneficial to tune out the media?

Although there is no correct answer, I believe prudent investors should model investment tactical approaches like the seasoned veterans, such as Warren Buffett.  As many of our readers are aware, Buffett resides in Omaha, Nebraska because of its quiet, steady culture.  In order for our value investing community to maintain consistent and predictable, we must tune out the noise in the markets and focus solely upon the fundaments.

Furthermore, there is an extensive menu of investing tactics that eliminate emotions from the security selection process.  One of which is Joel Greenblatt’s quantitative value investment strategy of The Magic Formula.  Greenblatt generously lays out the systematic playbook in his book, The Little Book that Beats the Market.  The underlying theme of his fascinating read is to discover a method that quantifies Buffett’s stock selection motto, “purchasing good companies at a fair price.”  Therefore, Greenblatt uses the Return on Capital (ROC) calculation as the value metric and the Price to Earnings (P/E) calculation for the pricing metric.

There are a number of reasons why I prefer Toby’s strategy over Joels.  First and foremost, I believe that EV/Operating Earnings is a much more accurate pricing measurement than the P/E ratio.  In short, enterprise value is the price at which an investor would be required to pay for the company in its entirety (Market Capitalization + Preferred Equity + Non-Controlling Interests + Total Debt – Cash & Cash Equivalents).  It is also widely known that iconic activist investors, such as Carl Icahn and Bill Ackman, use the enterprise value calculation when considering the acquisition of a target firm.  Furthermore, Toby uses Operating Earnings as the denominator for his valuation technique because it minimizes the opportunity for earnings manipulation.  As illustrated in Toby Carlisle and Wesley Grey’s book, Quantitative Value, many companies are prone to earnings manipulation by means of copious, duplicitous techniques.  They also concluded that the further down the income statement you traveled, the higher the probability for the manipulation of material data.  Hence, operating earnings is much higher up on the income statement, resulting in a more representative outcome of the company’s true performance, when compared to traditional earnings.[2]  Last, Toby completed an extensive study to compare his strategy to Greenblatt’s, which concludes in Toby’s approach annually outperforming the Magic Formula for the preceding 20 years.

Instead of diving into the specifics of quantitative value investing, prospective quant investors should hone in on the process to understand why the strategy is picking up velocity.  My personal opinion is that quant investing is superior due to its ability to eliminate the human element, which allows the fundamental data to speak for itself.  The most prominent quant investors simply follow their drawn-up processes, without any hindrance of exterior forces.  As previously mentioned, quant gurus have agreed that their specified screeners act as a ceiling upon returns, as opposed to a floor.  Although this thinking appears quite counterintuitive, the backtested data and exhaustive studies conclude with the preceding results.  Furthermore, generalized quant strategies create consistency and accuracy when steadily followed.  While active investors eagerly chase returns and select positions at their own discretion according to cognitive biases, on average the results come back disappointing.  For instance, I recently spoke with an oil executive about his particular approach to diversify his personal portfolio.  He claimed to be “adequately diversified” and was confident in his approach.  Upon further examination, the individual had only engaged into positions in the energy sector, while having minimal exposure to exterior industries.  Since the individual works in the energy sector, he has a cognitive bias toward his industry because it falls within his circle of competence.  I find this story to be a reoccurring theme, not only in my own biases, but also with those I interact with.  Whether we would like to admit it or not, we all have our own preferences and biases, which tend to play a parasitical role on our investment returns.  In short, systematic quant value investing will hedge this away and allow investors to maximize potential returns.

Benjamin Graham is widely proclaimed as the “father of value investing” and has significantly influenced countless individuals in the investing arena.  He has also been endorsed by the greatest investors of all time, such as Warren Buffett.  Although Graham passed away in 1976, his legacy and profound knowledge remains though two of his greatest books, Security Analysis and The Intelligent Investor.  I highly recommend and support these timeless books because of Graham’s ingenious idea, the “margin of safety”, as well as his intensive focus upon the preservation of capital.  The margin of safety is derived through finding companies that could be purchased for considerably less than their intrinsic value.  Specifically, Graham would search for “net-nets”, which are companies priced at a 30% or more discount to their net-working capital (current assets – total liabilities).  Furthermore, Graham lived through the Great Depression and many stock market crashes, which educated him upon enduring lesson to protect your principle.  Preceding Graham’s death, he proclaimed that value investors should follow a systematic process that mindlessly follows a practice much like today’s quant value investors.  Therefore, many of the greatest and most influential investors of all time endorse the process of systematizing the strategy for quant investing.