Review: Quantitative Momentum

quantitative-momentumPortfolio manager and researcher Dr. Wesley Gray is at it again, looking for ways to build that proverbial better mousetrap. I reviewed Gray’s previous book, Quantitative Value, which he co-wrote with Tobias Carlisle, and found it to be “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.”

Now, Gray’s follow-up book, Quantitative Momentum, aims to apply the same analytical rigor to momentum investing. Gray co-wrote Quantitative Momentum with Jack Vogel, with whom he published DIY Financial Advisor last year. That these gentlemen have managed to publish two well researched and highly-analytical books in back-to-back years is a feat in and of itself. But the book’s biggest contribution to the growing field of research supporting momentum investing is its assertion that momentum and value investing are essentially “two sides of the same behavioral bias coin.”

As Gray and Vogel put it, value investing works because investors systematically overreact to bad news, pushing market prices below intrinsic value. Momentum investing works because investors systematically underreact to good news. So again, both are the products of investor biases.

But if the value and momentum anomalies are rooted in well-observed biases, then why haven’t smart investors arbitraged the outperformance away? After all, that is what the efficient market hypothesis would suggest.

Gray and Vogel credit two factors:

  1. Limits to arbitrage
  2. Investor psychology

Identifying irrational prices is relatively easy. But exploiting them can be tricky due to transactions costs, hence the practical limits of arbitrage. If the cost of exploiting a mispricing is greater than the mispricing itself, the asset can stay mispriced forever.

And as for investor psychology, the problem here is best summed up with John Maynard Keynes’ observation that “The market can stay irrational longer than you can stay solvent.” Irrational traders may create mispriced assets… but because those traders are irrational and erratic, it can be hard to systematically trade against them. As Gray and Vogel write, tongue in cheek, “Day traders mess up prices, and although these people are idiots, you don’t know the extent of their idiocy, and you can’t really time the strategy of an idiot anyway, so most smart people don’t even try to take advantage of them.”

Furthermore, while value and momentum strategies have both proven to add significant alpha over the long term, they can massively underperform for years at a time, and professional money managers have careers to manage. As the authors point out, the legendary Julian Robertson was essentially put out of business in the tech bubble of the late 1990s. As a value investor, Robertson shunned the glitzy growth names driving the market higher and massively underperformed as a result. His clients jumped ship… and buried him. Warren Buffett might have suffered the same fate had Berkshire Hathaway been a hedge fund or mutual fund rather than a holding company.

So, fear of deviating too far from a “safe” benchmark like the S&P 500 prevents a lot of managers from exploiting value or momentum opportunities. But this also leaves them open for smaller or non-professional investors that don’t face the same constraints.

Momentum Investing Is Not Growth Investing

Gray and Vogel also clarify something that, for a lot of investors, might be somewhat confusing. Momentum Investing is distinctly not growth investing. Growth investing is the opposite of value investing in that growth investors buy stocks that are expensive relative to their earnings, sales, book value or other fundamental criteria. Value investors, of course, buy stocks that are cheap relative to these same fundamental factors.

Momentum investing is a different animal entirely. Momentum merely considers price movements relative to a stock’s history and relative to other stocks. Business or economic fundamentals are not considered at all. It’s pure price-based technical analysis. (This leads to other possibilities, such as combining value and momentum strategies. A stock can simultaneously be a value stock and a momentum stock if it is both cheap and showing high relative strength.)

Gray and Vogel spend much of the rest of the book testing assorted momentum strategies, and while I will spare you the pages of data tables, suffice it to say that, sliced any number of ways, momentum strategies can add serious alpha.

My compliments to Gray and Vogel. In a world in which exploitable alpha is harder and harder to find, Quantitative Momentum gives us new places to look.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital Management, an investment firm based in Dallas, Texas.

5 Books to Read Before Investing a Single Dollar


Photo credit dilettantiquity

The following is an excerpt from a piece I wrote for InvestorPlace.

A stock market education is expensive, and I’m not talking about the cost of a Harvard or Wharton MBA. Those, while pricey, can actually be cheap by comparison.

Unfortunately, there is no real shortcut here. All stock market education is, to some extent, straight from the school of hard knocks. You will make mistakes. Even legends like Warren Buffett and George Soros made horrendously bad investment moves at various points in their careers. Sure, you can spend money on investing books or even a fancy trading system. But the real cost of a stock market education is measured in money lost and profits foregone due to investing mistakes. And over a lifetime of investment, that can mean millions — if not tens of millions — of dollars.

But new investors can still give themselves a leg up by studying beforehand. Every serious investor should have a solid library of investing books.

I should be clear here; if you blindly follow a trading strategy verbatim out of an investing book, you’re likely to be disappointed with the result. Investing is often more art than science, and what worked for the author might not work for you. But by voraciously reading as much as possible, you can take the tidbits of insight that you glean from each book, and eventually cobble them into a trading style that works for you.

I’ll give you a head start with five investing books I keep in my library… and that I recommend you keep in yours.

The Intelligent Investor

I’ll start with Benjamin Graham’s classic The Intelligent Investor.

You simply have no business investing a single red cent until you familiarize yourself with Benjamin Graham. This is the man that invented the investment profession as we know it today. Graham was actively advocating a certification program for analysts in the 1940s, 20 years before the CFA program got off the ground. And he was Warren Buffett’s professor and mentor at Columbia Business School. Without Graham, there would have never been a Buffett — or at least not the investing legend we know and love.

The Intelligent Investor is a solid introduction to value investing. And while many of Graham’s specific tricks of the trade (such as buying stocks that are selling for less than their net current assets) are rarely usable in today’s more efficient market, the basic principles are as relevant as ever.

My favorite anecdote from the book is the story of the infamous Mr. Market. Graham compared investing to doing business with a wildly emotional business partner, Mr. Market, who continuously swung from extreme optimism to extreme despair and right back to extreme optimism. The analogy might actually be more applicable today than when Graham first wrote it.

Graham was a rare, independently minded genius in a field often associated with a herd mentality. Keep a copy of the Intelligent Investor on your desk. It will keep you grounded.

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Review: DIY Financial Advisor

9781119071501.pdfIt’s probably bad form of me to slander my own profession, but sometimes it is roundly deserved. So today, I’m going to share some of the insights of Wesley Gray, Jack Vogel and David Foulke in their 2015 book DIY Financial Advisor.

“DIY” stands for do it yourself, of course. And that’s what Gray and his colleagues aim to do. The book shows how retail investors can replace an expensive financial advisor – who may very well be underperforming the market and offering nothing in the way of financial advice that you can’t get elsewhere for far cheaper – with simple, repeatable investment systems.

While a good advisor is still worth every penny you pay them, Gray and his colleagues make some solid observations on why an advisor is often incentivized to give truly terrible advice:

  1. They focus on short-term rather than long-term results. All too often, investors tend to ask their advisors “What have you done for me lately.” All strategies have their down years, yet having a single underperforming year can get a manager fired. As investors, we tend to chase whatever is hot and drop whatever has recently underperformed. For this reason, a lot of professional managers feel pressure to become closet indexers, which negates their expertise.
  2. The exploit their authority to generate business. Often, a manager will rely on their credentials to demand a higher fee than their service really deserves. Again, many managers are just closet indexers. There is no reason to pay a man in a suit a fat fee to do what you could do on your own for almost free.
  3. They prefer complexity over simplicity. Complex models look impressive and help a manager justify a higher fee. But does added complexity actually make a model better? Generally, no. As Gray and his colleagues show, simple models often outperform more complex models and cost a lot less to implement.

Some of this may sound familiar to you. I reviewed Dr. Gray’s previous book, Quantitative Value, which was a case study in a simple but profitable model.

So, if you’re ready to fire your financial advisor, how do you go about it? Gray, Vogel and Foulke offer a step-by-step checklist.

Step one is to evaluate your current relationships. Does your advisor truly add value in any meaningful way, or are you paying them to do something you could do better yourself?

Step two drills down to the “FACTS”:

  • Fees
  • Access
  • Complexity
  • Taxes
  • Search

On the subject of fees, you have to ask several penetrating questions. First, what are the fees (is it transparent and straight forward?) and secondly, who is paying the advisor? Digging further into the details, is the advisor’s judgment clouded by his relationship with a fund company, or is he being incentivized by a high sales load?

Access really comes into play when looking at hedge funds and private limited partnerships. Gray and his colleagues suggest avoiding these where possible and opting for more liquid arrangement such as separately managed accounts. I agree in principle but would point out that the key words here are “where possible.” Certain strategies (such as real estate development) just don’t work particularly well in a managed account structure.

On the complexity front, keep your investments as simple as possible. The more complex a strategy is, the more likely it is to blow up under financial stress.

Taxes are a critical part of your return. It does you no good if your advisor generates 5% in alpha… only to lose 10% in extra tax costs.

Search costs are also a factor. Alternative managers might very well add value to your portfolio… but searching for them can be time consuming and expensive. And once you’ve found them, monitoring them can be a challenge, since they tend to be less highly regulated.

Once you’ve established your FACTS, you have to understand portfolio management. Gray, Vogel and Foulke break this down into three steps:

  • Asset allocation: The authors devote an entire chapter to asset allocation, and it’s much too comprehensive to try and summarize here. But in a nut shell, before you start trying to pick stocks or individual investments, you need to have an idea of what percentage of your portfolio you want allocated to the major asset classes.
  • Risk management: Again, volumes have been written on this subject, and the authors dedicate an entire chapter to it. Suffice it to say, you need to protect against large drawdowns, whether you do this with stop losses, simple moving averages or something more complex.
  • Security allocation: This is where Gray and his colleagues really shine. They go through some of their favorite value and momentum screens and offer a nice framework for further research.

The advice in DIY Financial Advisor is not for everyone. But it’s certainly recommended reading for anyone considering letting their advisor go. And even if you’re more comfortable hiring a professional, DIY will give you a nice set of criteria to grade your advisor to see if they are worth what you are paying them.

Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas.

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.

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.