For most of the last entry, investing was a lot more art than science. People did in whatever was working based more on gut feelings than data. Portfolio management was a lot less evidence based than it is today, she.
Noted with silence.
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 Ridults, 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 best selling 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 late person. Jim, welcome to add the money. Let's start very basically define quantitative investing.
Quantitative investing, Barry is using empirical evidence that you gather over looking at how various factors like things like price to earnings ratio or earning's 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 draw down, 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.
So let's compare evidence versus the stories. When we look at history, quantitative models outperform professional investors and experts who rely on much squishier qualitative judgments. Why is that?
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 do extraordinarily well over time. The challenge is that the expert themselves often makes emotional choices,
especially during times of intense market volatility. For example, during the Great Financial Crisis, many even 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.
So you've looked at a lot of these strategies and strategists going back a century to the nineteen twenties. What kinds of approaches have consistently performed the best.
No big surprise, Barry over long periods of time. Buying stocks more cheaply priced than those that are priced into the stratosphere generally works over long periods of time. But one of the models that we've 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, even 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.
So let's break that into two half, 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 PE ratio which everybody seems to focus on. It doesn't really produce great results for investors. Explain why PE isn't the best way to measure valuation.
Well, you know, when a measurement becomes a target, it often loses its efficacy. And 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 four 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, and I think that's one of
the reasons why. Well, 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.
So let's talk about some other measures. You talked about, price to sales ratio, you talked about EBADA to enterprise value. Tell us what actually works as a way of measuring corporate value.
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. Well, 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.
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.
So momentum is really interesting because academics hate it because there is no reason underlying economic reason why it should make sense. But it does when you test it all the way back to the twenties. The rolling batting averages i e. The number of periods over one, three, five, and ten 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 twelve
month price momentum, the results are a true disaster. So essentially, it's, as Ben Graham would call it, it's listening to mister 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.
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 and Vidia, Apple, it doesn't matter. You're not saying, hey, Tuesday, March nineteenth, I'm buying my five year allowance of Nvidia. You're buying that as cash flows into your funds, you're consistently buying your favorite names kind of relentlessly over time. Is that to
pop psychology? Of an explanation for momentum or is there something too names that institutions like they tend to buy and continue to buy over time.
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 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.
So 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 five years or seven years, or sometimes even ten years. You identified that the microcaps screened for quality seem to reproduce venture capital and private equity returns but without the lock up period. Tell us about that.
Yeah, we have several papers at Shawn c Asset Management on that effect. It's really fascinating because the microcap universe is kind of this undiscovered country. Half of the names in it aren't even covered by a single analysts 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.
You can call it garbage, Jim, It's okay.
Yeah, 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 several years ago was the returns sort of are great proxy for private
equity in particular. And so if you're looking for a far less expensive way to get private equity, like returns at lower fees with no lock up, you'll want to take a look at the microcap universe sort it by these various metrics.
So in the book What Works on Wall Street you emphasize the importance of having a systematic, disciplined approach. Explain to listeners what goes into taking what is kind of used to be sort of a loose, an undisciplined approach to stock selection and turning it into something much more disciplined.
Well, I think that essentially, I'd say, would you go to a doctor who looked at you and said, hey, Barry, 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'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. You know, the 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 all 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.
So let's address that for a final question. 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 choice from the wrong place, making choices from emotional panic or greed.
Well, you know, I've often said that the four horsemen of the investment of 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 going to spend their time on. So what I concluded was probably the best thing that you can do is find yourself a 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 ninety five percent of the time they're board silly. Five percent of the time that is where they earn all their money.
Really interesting. Thanks Jim 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 to stray. 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 Ridoults. You're listening to Bloomberg's At the Money.