At the Money: Benefits of Quantitative Investing (March 20, 2024)
Throughout history, investing has been a lot more “Art” than “Science.” But today, data is widely available and it’s a key tool you can use to enhance your portfolio returns.
Full transcript below.
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About this week’s guest:
Jim O’Shaughnessy, former chairman and founder of O’Shaughnessy Asset Management (now part of Franklin Templeton) and author of the New York Times bestselling book, “What Works on Wall Street” — the first quantitative investing book available to the general public.
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For most of the last century, investing was a lot more art than science. People did whatever was working based more on gut feelings than data. Portfolio management was a lot less evidence-based than it is today.
As it turns out, there are ways you can use data to your advantage, even if you’re not a math wizard. I’m Barry Ritholtz, and on today’s edition of At The Money, we’re going to discuss how to use what we’ve learned about quantitative investing.
To help us unpack all of this and what it means for your portfolio, let’s bring in Jim O’Shaughnessy. Jim is the former chairman and founder of O’Shaughnessy Asset Management, which was sold to Franklin Templeton a couple of years ago.
He is also the author of the New York Times bestselling book, What Works on Wall Street, now in its fourth edition. What Works on Wall Street was the first quantitative equity investing work, more or less for the layperson.
Jim, welcome to At The Money. Let’s start, very basically, define quantitative investing.
Jim O’Shaugnessy: Quantitative investing is using empirical evidence that you gather over looking at how various factors, like things like price to earnings ratio or earnings growth rate, and testing them over as many market cycles as you can. That gives you information that you simply couldn’t have without such a test.
For example, you can see what’s the biggest drawdown, how long did it last, how long and how often did a strategy beat its benchmark, and by what magnitude. It’s essentially like a very long-term study, just looking at the evidence as opposed to “stories.”
Barry Ritholtz: So let’s compare evidence versus stories. When we look at history, quantitative models outperform professional investors and experts who rely on much squishier qualitative judgments. Why is that?
Jim O’Shaugnessy: Primarily the old Pogo cartoon? We’ve met the enemy and it’s us succinctly points out the reasoning here.
Essentially when we model great investors and look at the underlying factors of their portfolio, they do perform extraordinarily well over time. The challenge is that the expert themselves often makes emotional choices, especially during times of intense crisis. market volatility. For example, during the great financial crisis, many quantitative investors emotionally overrode their models.
So making decisions consistently according to a process that you’ve tested sort of saves you from your own emotional problems.
Barry Ritholtz: So you’ve looked at a lot of these strategies and strategists going back a century to the 1920s. What kinds of approaches have consistently performed the best?
Jim O’Shaugnessy: No big surprise: Over long periods of time, buying stocks more cheaply priced than those that are priced into the stratosphere generally works best over long periods of time.
But one of the models that we found that actually performed really well over a variety of market cycles was essentially buying cheap stocks as measured by things like price to cash flow, EBITDA to enterprise value, etc., that are on the men that have turned a corner and are showing some good price momentum.
Cheap stocks on the mend is a really interesting way to look at the market because essentially the market is saying, “Yeah, that stock is very, very cheap, but we think it’s probably too cheap.” They’re putting their money where their mouth is and buying it. That’s a great strategy overall.
Barry Ritholtz: So let’s break that into two halves, starting with valuation. One of the things that struck me the first time I read “What Works on Wall Street” was the price to earnings ratio, the P/E ratio, which everybody seems to focus on. It doesn’t really produce great results for investors. Explain why P/E isn’t the best way to measure valuation.
Jim O’Shaugnessy: When a measurement becomes a target, it often loses its efficacy.
You know, there’s the old joke about the company hiring a new CFO and they only ask them one question. What’s two plus two. And everyone answers for, except for the person they hire, whose answer was, what number did you have in mind?
Earnings are Much easier to manipulate than things like revenue and other measurements of value. I think that’s one of the reasons why it worked very, very well before all of our innovations and computer databases, etc. Once it became a target for people to pick things on, it started getting manipulated at the corporate level.
Barry Ritholtz: Let’s talk about some other measures. You talked about price to sales ratio;
You talked about EBITDA to enterprise value. Tell us what actually works as a way of measuring corporate value.
Jim O’Shaugnessy: Specifically, we like to look at a composite of various value factors, several of which you mentioned. One of my rookie mistakes in the first version of the book was simply looking at the data and saying, “Well, price to sales has done the best of any single measurement.”
It was a rookie mistake because I was measuring it over a specific period of time. As we improved our process of testing, we found that using rolling rebalances and multiple value factors — . It alone was outperformed by a value composite.
Barry Ritholtz: And let’s talk a bit about price momentum. That has been a robust factor for strong performance, especially as you mentioned, when you combine momentum with value metrics, give us an explanation for how we should be looking at momentum.
Jim O’Shaugnessy: Momentum is really interesting because academics hate it because there is underlying economic reason why it should make sense – but it does.
When you test it all the way back to the 1920s, the rolling batting averages, i. e. the number of periods over one, three, five, and 10 years where it beats its benchmark is extremely high.
And that’s sort of the wisdom of crowds working there, I believe when people have very differing opinions on a stock, they have heterogeneous opinions, right? As long as those opinions remain heterogeneous, the price movement is an excellent indicator of the net, net, net sentiment of investors.
When it’s going much, much higher – obviously that’s positive. When it’s going negative. That’s very negative. If you invert momentum and look at buying the stocks with the worst six month or 12 month price momentum, the results are a true disaster.
So essentially it’s as Ben Graham would call it, it’s listening to Mr. Market and they’re putting their money where their mouth is. And that’s why I think it’s such a strong and robust indicator over a huge number of market cycles.
Barry Ritholtz: You know, it’s interesting you say that. I always just assumed that if you’re a big fund manager and you’re buying, fill in the blank, Microsoft, NVIDIA, Apple, it doesn’t matter, you’re not saying, Hey, Tuesday, March 19th, I’m buying my five year allowance of NVIDIA. You’re buying that as cash flows, into your fund. You’re consistently buying your favorite names, kind of relentlessly over, over time.
Is that too pop psychology of an explanation for momentum? Or is there something to names that institutions like they tend to buy and continue to buy over time?
Jim O’Shaugnessy: Yeah, that’s the persistent underlying bid theory. And I’m sure that there is an effect when institutions continue to pour money into their favorites on a buy list.
But I think that the reason momentum really works is those names that you just mentioned, they, they do have positive momentum most of the time. But the fact is, they probably aren’t qualifying for the list of the stocks with the biggest change in prices. Those names tend to be very, very different than institutional favorites.
So having an underlying persistent bid from institutions, yeah, helpful, but a lot of those names don’t actually make the cut when you’re sorting on your final factor being momentum.
Barry Ritholtz: Let’s talk about a fascinating piece of research you did, I believe is also referenced in the book. People like things like private equity and venture capital, but they’re not thrilled with being locked up for 5 years or 7 years or sometimes even 10 years.
You identified that the microcaps screened for quality seem to reproduce venture capital and private equity returns, but without the highs costs and lock up period. Tell us about that.
Jim O’Shaugnessy: We have several papers at, OSAM Asset Management on that effect.
The microcap universe is kind of this undiscovered country. Half of the names in it aren’t even covered by a single analyst. And when you use quality, momentum, etc., to sort it out, because warning, the universe itself is pretty, not a great, not a great universe.
Barry Ritholtz: You can call it garbage, Jim. It’s okay.
Jim O’Shaugnessy: Okay. All right. So the universe itself is garbage. But there are a lot of hidden gems there and the ability to sort out those hidden gems that are little covered or not covered at all. Basically what we found in a paper that we published uh, several years ago was the returns sort of are a great proxy for private equity in particular.
If you’re looking for a far less expensive way to get private equity like returns at lower fees with no lockup, you’ll want to take a look at the microcap universe sorted by these various metrics.
Barry Ritholtz: So in the book, What Works on Wall Street, you emphasize the importance of having a systematic disciplined approach.
Explain to, to listeners, what goes into taking what is kind of – used to be sort of a loose and, and undisciplined approach to stock selection – and turning it into something much more disciplined.
Jim O’Shaugnessy: Essentially, would you go to a doctor who looked at you and said, “Hey, I just got these little yellow pills and they look appealing to me and I think they might work for what’s wrong with you.”
I don’t think you would, right? I think you’d say, well, where are the studies? Where, where, where’s the evidence? Where is the long longitudinal studies to prove the efficacy of this little yellow pill, right?
That’s really what we’re doing with factor or quantitative investing. We are looking historically at ideas that make economic sense, right? Don’t pay the moon by momentum, et cetera.
But then this is the key important part. We’re turning it into a process that we run time and again and don’t override. In basketball to investing, the process is much more important than the either intuitive – Ooh, I should jump on this name, or the terror Oh, my God. The name is collapsing. I’ve got to jump out of it – It really brings a rigor and a discipline to approaching the market that is really hard to duplicate without that process underlying the quantitative methodology.
Not impossible. But willpower dissipates very, very quickly, especially in times of either exuberance right during a bubble or despair during a bear market, following the process through thick and thin, which you’re always trying to improve, by the way.
But following that process without making any additional emotional overrides has proven itself to be quite effective at getting rid of or at least neutralizing some of the very famous behavioral biases that we all have as humans, right? We’re all running human operating system and helping us avoid the pitfalls is really what the underlying process does and does very, very well.
Barry Ritholtz: So let’s address that for our final question, uh, one of the things you have discussed previously is “Some of the biggest challenges investors face is avoiding emotional decision making.”
What are the tools you recommend for making sure that the average mom and pop investor doesn’t succumb to their own emotional limbic system and making choices from the wrong place? Making choices from emotional panic or greed?
Jim O’Shaugnessy: I’ve often said that the four horsemen of the investment apocalypse are fear, greed, hope, and ignorance. And ignorance is the only one that is really correctable by studying. It’s very, very difficult, especially as you note for retail investors who look, they have other interests, they have other things that they’re gonna spend their time on.
So what I concluded was probably the best thing that you can do is find yourself Good financial advisor who could sort of serve as your wingman. The thing that advisors are able to do because of a lot of reasons, right? It’s not their money. They can be much more dispassionate about it. They can be much more professional about it, and then they can help their client.
During those tough times. It’s like the old joke about anesthesiologists. 95 percent of the time they’re bored, silly. 5 percent of the time that is where they earn all their money.
Barry Ritholtz: Really interesting. Thanks Jim, for, for all these insights.
So to wrap up. Quantitative investing provides an enormous advantage to investors.
It’s specific, it’s evidence-based, it uses data, and it avoids the emotional decision-making, that leads investors astray.
If you want to apply some quantitative strategies to your portfolio, Consider looking at the combination of momentum and low-price stocks, or microcaps that have been screened for quality and value.
I’m Barry Ritholtz. You’re listening to Bloomberg’s At The Money.
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