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Review: Quantitative Value

Wesley Gray, manager of the ValueShares US Quantitative Value ETF (QVAL), may very well be the most interesting quant you’ll ever meet. Granted, the word “quant” brings to mind an old man in a white lab coat stooped over reams of data, but hear me out.

Before getting his PhD in finance from the University of Chicago, Gray did four years of service as an active-duty U.S. Marine Corps ground intelligence officer in Iraq and other posts throughout Asia. Quantitative Value isn’t even his first book. That distinction goes to Embedded: A Marine Corps Adviser Inside the Iraqi Army.

It’s hard to imagine the average fund manager crawling through the muck and gathering intelligence in Iraqi Arabic. But that is Dr. Gray, and his work is far from average. Quantitative Value, co-written by Gray and Tobias Carlisle, is a solid piece of research that combines the successful value investing framework of Benjamin Graham and Warren Buffett with the analytical rigor seen in Jim O’Shaughnessy’s What Works on Wall Street and Joel Greenblatt’s The Little Book that Beats the Market. In fact, Gray and Carlisle write extensively about Greenblatt’s “Magic Formula” and much of the book is an attempt to build the proverbial better mousetrap.

We’ll take a look at some of Gray and Carlisle’s methods and then see how they perform in the real world by tracking the returns of the Quantitative Value ETF.

The Quantitative Value screening process for stocks resembles a funnel:

Step 1: Avoid Stocks That Can Cause a Permanent Loss of Capital

This is a more elegant version of Warren Buffett’s first rule of investing: Don’t lose money. In first screening for risky stocks, Gray and Carlisle uses some of the same metrics used by short seller John Del Vecchio to identify short candidates, such as days sales outstanding. They also give special attention to accrual accounting in the hopes of weeding out earnings manipulators and run additional screens for probability of financial distress. By removing the riskiest stocks from the pool at the beginning, Gray and Carlisle are a lot less likely to get sucked into a value trap.

Step 2: Find the Cheapest Stocks

Gray and Carlisle do extensive back testing on virtually every valuation metric under the sun, including industry standards such as price/earnings (“P/E”), price/sales (“P/S”) and price/book value (“P/B”). In the end, they opt to use the same valuation metric as Greenblatt in his Magic Formula: the Earnings Yield, defined here as earnings before interest and taxes (“EBIT”) divided by enterprise value. For those unfamiliar with the term, “enterprise value” is defined here as market cap (including preferred stock) + value of net debt, or what you might think of as the acquisition price of the company.

Gray and Carlisle find that of all the assorted valuation metrics, the Earnings Yield yields the best results.

Step 3: Find Highest-Quality Stocks

This is another nod to both Buffett and Greenblatt. Buffett has repeated often that it is better to buy a wonderful business at a fair price than a fair business at a wonderful price, and Greenblatt tried to capture this mathematically by screening for companies that generated high returns on capital (“ROC”). Gray and Carlisle take it a step further by using an 8-year ROC figure.

And they don’t stop there. Gray and Carlisle run additional screens for profitability and combine the metrics into a Franchise Power score. And taking it yet another step, they combine Franchise Power with Financial Strength to form a composite Quality score.

Again, the objective here is to capture mathematically what makes intuitive sense: That companies with wide competitive moats, strong brands and strong balance sheets make superior long-term investments.

So, how does the Quantitative Value model actually perform?

In back-tested returns, it crushed the market. From 1974 to 2011, Quantitative Value generated compounded annual returns of 17.68% to the S&P 500’s 10.46%.

Of course, we should always take back-tested returns with a large grain of salt. For a better comparison, let’s see how the Quantitative Value ETF (QVAL) has performed in the wild.

We don’t have a lot of data to work with, as QVAL only started trading in late October 2014. But over its short life, QVAL is modestly beating the S&P 500’s price returns, 9.96% vs. 9.15%. As recently as April, it was beating the S&P 500 by a cumulative 4%.

Looking at the returns of a substantially-similar managed account program managed by Gray’s firm, the “real world” results look solid. From November 2012 to May 2015, the Quantitative Value strategy generated compoud annual returns of 21.1% vs. the 18.3% return of the S&P 500. The Quantitative Value strategy was modestly more volatile (beta of 1.2) and had slightly larger maxmimum drawdowns (-6.0% vs. -4.4%). But this is exactly what you would expect from a concentrated portfolio.

I look forward to seeing how QVAL performs over time, and I congratulate Gray and Carlisle on a book well written.

Note: When referring to the book, “Quantitative Value” is italicized. When referring to the ETF or to the broader strategy, it is not.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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Review of Analyze West: A Psychiatrist Takes Western Civilization on a Journey of Transformation

At one time or another, we’ve all wondered if the Western world has lost its direction.  For much of the past 100 years—and even more so since the 2008 financial crisis—the West has been riddled with self-doubt and at times, it would seem, even self-loathing.

Whether it is guilt over the past sins of colonialism and slavery, the rise of upstart economic powerhouses like China and India, or changing demographics within our borders, the West seems to have lost its mojo and a sense of its place in the world.

Enter Dr. Nicholas Beecroft.  In his latest book, Analyze West: A Psychiatrist Takes Western Civilization on a Journey of Transformation, Dr. Beecroft sits Western Civilization on the psychiatrist’s couch. “Mr. West,” the embodiment of Western Civilization, is a mildly overweight, middle-aged man suffering from panic attacks and what appears to be multiple personality disorder.  What follows as Mr. West opens himself to the psychiatrist is an entertaining and introspective examination of Western culture circa 2014.

What I found most interesting is that Beecroft—himself a respected psychiatrist—approaches the work with no obvious political or ideological agenda.  He is neither conservative nor liberal and neither traditional nor modern.  He’s a detached professional attempting to make sense of the competing and contradictory attitudes that define the contemporary West. He wants the West to be comfortable in its own skin.

Analyze West is a little hard to describe.  It’s nominally a novel, and it incorporates a love story and a rogue doctor’s struggle against a politicized and stiflingly bureaucratic medical establishment.  But it is first and foremost an exploration of contemporary (and contradictory) Western views on everything from sex to geopolitics.

As the protagonist helps West to get back on his feet, he gives his patient an exhaustive diagnosis:

You’re fit and healthy though there’s plenty of room for improvement… Economically you’re depressed. The seeds of the solutions are there if you choose to grow them. When I first met you, you had low self-esteem, low self -confidence and strong suicidal impulses. You were unconscious of your many different parts which were stuck in conflict and draining your energy. To thrive you need to draw together the best of all the parts.

Analyze West is a thoughtful book, and I woud recommend it for anyone with an interest in history, government, geopolitics and economics–and where they all intersect.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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Review: Patrick O’Shaughnessy’s Millennial Money

Note to Baby Boomers with adult children: This book review is for you.  Buy a copy for your Millennial children and encourage them to read it.  Getting started early will make an incredible difference over the course of their lives.

Most readers of financial books and news today are Baby Boomers or early Gen Xers, as it isn’t until early middle age that most Americans begin to think seriously about saving and investing for retirement.  The Millennials, at this stage of their lives, are more focused on starting their careers and paying down student loans; retirement planning is not high on the list of priorities.

Patrick O’Shaughnessy—himself a Millennial—seeks to change this generational attitude in Millennial Money: How Young Investors Can Build a Fortune.  It is an impassioned plea to start saving early and aggressively, as the Millennials will face a very different reality in their golden years than that enjoyed by their parents and grandparents.  Written by a Millennial in a voice that other Millennials will understand, O’Shaughnessy writes about “financial karma” and notes that, when it comes to money, we reap what we sow: “Building good individual financial karma is straightforward: spend less than your earn and invest a chunk of your income in the stock market every year.”

Unfortunately, as a collective, we’re looking at some very bad karma. Social Security—if it still exists in anything resembling its current form—will be far less generous, as America’s high and growing debt load makes the status quo unsustainable.  It may not be fair, but—as O’Shaughnessy notes—with the federal government’s total obligations including Social Security and Medicare approaching $222 trillion by one estimate, Uncle Sam simply won’t have the means to continue funding at current levels.  Whether they intended to or not, the Baby Boomers and their elected politicians of both parties have effectively looted the country and will bequeath an unpayable pile of debt to their children.

After driving home the need for Millennials to take retirement planning seriously, O’Shaughnessy emphasizes why it is so beneficial to start early, noting that “young money…has tremendous potential” but that “money’s potential fades with time.”

As O’Shaughnessy continues, “One dollar invested today can easily be worth $15 in forty years; but if you wait ten more years to get started, the same dollar might only grow to $7.50. Imagine how different your lifestyle would be in your later years with twice the amount of money in the bank.”

Simply investing in an index fund would get most Millennials off to a fantastic start.  But O’Shaughnessy is his father’s son, and he has a few strategies that he suggests are likely to generate far better returns.

Patrick O’Shaughnessy’s father—James P. O’Shaughnessy—is the author of What Works on Wall Street, a veritable encyclopedia of back-tested quantitative investment strategies and, in my opinion, a reference book every investor should keep at their desk.  The younger O’Shaunghnessy is continuing a family tradition when he offers his “Millennial Money Checklist” of investment criteria.  When building a portfolio of stocks, he suggest buying stocks that:

  1. Have shareholder friendly practices (i.e. pay dividends, buy back shares, pay down debt, etc.)
  2. Earn strong returns on their investments
  3. Have high-quality earnings
  4. Are attractively priced
  5. Have “improving market expectations” (i.e. stock is in an uptrend or showing momentum)

Though O’Shaughnessy takes a hybrid investing approach that includes momentum strategies, I would classify him primarily as a value investor.   A lot of Millennials will find following a value strategy to be psychologically difficult because, as O’Shaughnessy writes, “Value investing is all about buying in the face of fear, pessimism and negativity…[and] the reason it’s so difficult to be a contrarian value investor is that cheap prices result from trouble.”

The Millennials are a generation that, in their childhood, witnessed one of the biggest bubbles and busts in market history in the 1990s tech mania.  And if that didn’t sear risk aversion into their personalities, then witnessing the 2008 meltdown as young adults certainly did.  Because they’ve witnessed nothing but trouble from the financial markets, Millennials are more reluctant than past generations to invest in stocks.  O’Shaughnessy’s goal in Millennial Money is to break down this risk aversion with solid facts written in language that the average Millennial reader can understand.

If you are a Millennial—or if you are a Boomer with a Millennial child or a Gen Xer with a younger Millennial sibling—pick up a copy of Millennial Money and put its advice into practice while time is on your side.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 


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The 10 Investing Books You Should Be Reading This Summer

In honor of National Book Lovers Day this coming Saturday, Covestor put together a “top ten” list of books on investing, business and finance — as shared by portfolio managers on Covestor and members of the Covestor senior management team.

My recommendation–which is more appropriate now than ever given the recent market volatility–was The Art of Asset Allocation by David Darst:

The Art of Asset Allocation by David Darst: Selected by Charles Sizemore – CFA, RIA, and manager of the Strategic Growth Allocation portfolio on Covestor

“This is distinctly not a ‘how-to-trade-stocks’ book. As its name implies, it is a guide to building a comprehensive portfolio from the top-down. It is important to remember that, while a savvy stock pick can make you wealthy, studies have shown that more than 90% of your portfolio returns are explained by asset allocation.”

To see the full list of 10 investing books, see: The 10 investing and personal finance books you should be reading this summer.

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What to Read: Best Books for the Beginner Investor

How do I educate myself as an investor?

This is one of the most common questions I get from readers, and it’s easily the most important.  I’ll share some of my favorite investing books in a moment.  But first things first.

There is no substitute for experience. As in absolutely none.  Having your own money at risk has a way of making you focus in a way that reading a book never can.

But the problem with learning purely by experience is that it can be an expensive education when real money is involved. The market is a stern schoolmistress and one that is not averse to proverbially rapping you on the knuckles with a yardstick when you err.

You’re going to make beginner’s mistakes. It’s inevitable.  But by educating yourself beforehand, you can hopefully keep the financial pain to a minimum.

As a start, I strongly recommend you read the Financial Times (“FT”) daily and Barron’s weekly.  I consider these the absolute bare minimum of reading material for any aspiring investor.  The FT gives coverage of the global financial markets that no other newspaper—not even the Wall Street Journal—can come close to matching.  If you want to know what is driving the any stock, bond, currency or commodity market anywhere in the world, the FT is your source.  I’m a little old school and still receive a paper copy at the office every morning, but the FT has a great website and excellent phone and iPad apps as well.

Barron’s is more centered on the American markets, but I consider the two hours I spend every Saturday morning reading it cover to cover to be some of the most productive hours of my week.  In an age in which it is easy to get paralyzed with too much information, Barron’s condenses a week’s worth of data into a tidy, digestible package.  There may be days when I have to skip my morning FT reading due to time constraints.  But I never fail to read my weekly Barron’s.

Moving on to books, this is where the real education begins. Here is a shortlist of books I would recommend to any newbie to investing.  And for that matter, I would recommend them to grizzled market veterans as well.

First on the list is David Darst’s The Art of Asset Allocation. This is distinctly not a “how to trade stocks” book.  As its name implies, it is a guide to building a comprehensive portfolio from the top down. It is important to remember that, while a savvy stock pick can make you wealthy, studies have shown that more than 90% of your portfolio returns are explained by asset allocation.

I recommend that most families hire a good financial planner to help them make sense of their financial lives and to build portfolios that are appropriate given their ages, risk tolerances and special situations.  But if you are the “do it yourself” sort, Darst’s book can effectively replace your financial planner if you use it correctly.

And by the way, if you do employ a financial planner, and they have not read The Art of Asset Allocation, you should fire them.  Immediately.

Next on the list is James P. O’Shaughnessy’s What Works on Wall Street, a veritable encyclopedia of back-tested investing strategies.

Frankly, I don’t know how O’Shaughnessy finds the time to do this kind of number crunching.  What Works is over 600 pages of well-researched quantitative strategies. There is no filler here; it’s all meat.  He has sliced and diced the market in every conceivable way it can be sliced and diced: value, growth, return on equity, dividend yield, buyback yield—and the list goes on.

What I like most about O’Shaughnessy is his absolute lack of bias or dogmatism.  He does not approach the investing process with any preconceived notions, but rather lets the data do the talking.  And talk it most certainly does.

How do you use this book? As you gradually develop your own style, whether it be value, growth, or something more exotic, I recommend you use some of O’Shaughnessy’s screens as “fishing ponds.” You don’t necessarily need to buy every stock in the screen, but you can use the screen as a great starting point for further research.

I am a value investor by temperament, so no list would be complete without Benjamim Graham’s classic The Intelligent Investor.  Think of this as a less dense, more digestible version of Graham and Dodd’s Security Analysis.  (Security Analysis is considered the “Bible of value investing,” but it can be a little dense for a beginning investor.)

Benjamin Graham is considered the father of value investing and was Warren Buffett’s mentor.  Without Graham, there would have never been a Buffett, or at least not the investing legend we know and love.

Many of Graham’s specific tricks of the trade (such as buying stocks selling for less than their net current assets) are no longer usable (or at least rarely usable) in this era of instant data.  Graham had a massive informational advantage over his competition in that, in the 1930s when he really began to make a name for himself, he was the only investor with the patience and skills to pick apart a balance sheet or to calculate ratios.  Now this can be done instantly via stock screeners, making it next to impossible to “discover” a value stock the same way  that Graham would have.

Still, if you want to learn how to think as a value investor, then there is immeasurable value in reading the original text of one of the truly great minds in market history.

For a modern take on value investing, I highly recommend Mohnish Pabrai’s The Dhandho Investor.  I’m a particular fan of this book because I consider it accessible and non-technical; it’s something that doesn’t require a Harvard MBA to read and understand.

Pabrai draws inspiration from the Patels—a group of ethnic Indians who immigrated to the United States in the 1970s after being kicked out of Uganda by dictator Idi Amin—and despite starting with little capital or formal education, managed to quickly build a hotel empire in their new homeland using a simple “coin toss” rule of thumb in making investment decisions:

  1. Heads, I win.
  2. Tails, I don’t lose much.

Low risk and high potential returns: it’s the closest thing to nirvana an investor can hope to find.

Pabrai has no special metric or formula, though he does have a basic investment criteria that he shares.  If you style yourself as a value investor, like investing against the grain, and like the idea of rolling up your sleeves and doing some real research, then The Dhandho Investor is a book you should keep on your desk.

If you love market lore, then you will love The Reminiscences of a Stock Operator, a fictionalized biography of legendary speculator Jesse Livermore written by Edwin Lefevre. In addition to being wildly entertaining—it reads like a novel dictated in the first person—it’s full of “street smarts” that are as applicable today as when the book was first written in 1923.

I should be clear here: Reminiscences is not a “how to” book.  There are no formulas or screens to run.  But there is definitely a lot of trader wisdom, such as the counterintuitive maxim  of not averaging down by buying dips but rather “averaging up” into a rising market.  The best advice in the entire book—and something I recommend every investor of every stripe remember—is “Don’t argue with the tape… Quite while the quitting is good.”

But a close second concerns acting on “hot” stock tips: “Wall Street professional know that acting on ‘inside’ tips will break a man more quickly that famine, pestilence, crop failures, political readjustments or what might be called normal accidents.  There is no asphalt boulevard to success in Wall Streets or anywhere else. “

Finally, I want to leave you with a “big picture” book, Nassim Taleb’s Fooled By Randomness.  Taleb is more famous for The Black Swan, which became something of a an overused buzz word during the 2008 mortgage meltdown.  And his Antifragile, which was released in 2012, is also an insightful read.  But in my view, Fooled By Randomness is the only real “change your life” book of the three.

After reading Fooled, you will see the effects of randomness everywhere.  It can almost be a little disillusioning, as it can leave you wondering whether your own successes in life were the result of skill and hard work or simply being in the right place at the right time.

Fooled By Randomness, though it focuses primarily on the financial markets, will distinctly not teach you how to invest.  It will do much more than that.  It will teach you how to think.  I am not exaggerating when I say that you will see the world through a different lens after reading this book.

This article was first published on InvestorPlace.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. 

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