Competing with the Quants

I was having a drink a while back with my friend and fellow Rich Investor contributor John Del Vecchio, and we were reminiscing about how much this business has changed since we started our careers.

John is a forensic accountant who knows exactly where to look in the financial statements for accounting shenanigans; where “the bodies are buried,” so to speak. I call him the “Horatio Caine of finance” after David Caruso’s character on CSI: Miami. John has the same no-nonsense demeanor.

The late 1990s were a fantastic time to be a short seller. With the internet bubble entering the final blow-off stages, a disciplined forensic account had an almost unlimited supply of short candidates.

But you had to know what warning signs to look for. This often meant spending hours digging through the footnotes of a company’s income statement, cash flow statement and balance sheet.

Back then, John spent 10 hours per day on the LexisNexis database, pouring over every line of a short candidate’s financial statements. And often, it would all be for naught. Not every investigation ended with a perp walk.

Today, John presses a button and his system does the heavy lifting for him in a matter of seconds.

When the system finds irregularities, John still has to roll up his sleeves, put on the green visor, and dig into the books. But his quantitative system saves him hours (if not days) of exhausting research.

And the 1990s weren’t all that long ago. Let’s go a little further back in time.

Benjamin Graham – Warren Buffett’s mentor and the man that invented value investing as a discipline – made a fortune in the 1930s and 1940s by doing painstaking research.

He’d dig through the financial statements and calculate valuation ratios (price/earnings, CAPE, etc.) by hand.

As early as the 1950s, after Wall Street had starting hiring armies of analysts to do the same work, Graham had started to question whether he could still find bargains using his old methods.

By the 1970s, Graham has more or less given up and converted to an efficient market advocate.

Warren Buffett is most famous for owning large positions in household names like Geico and Coca-Cola. But earlier in his long career, Buffett literally walked door to door in Omaha asking little old ladies if they were interested in selling their paper stock certificates to him.

In today’s world of instant stock trading on your smartphone, that seems ridiculously quaint and old timey.

Fundamental investors have flocked to quantitative tools to help them pick through mountains of data faster than their competitors.

Forbes even coined a term for it – “quantimental” investing.

But is more data always better?

That’s a lot less certain. Last week, Bloomberg reported that quant funds are “reeling from the worst run in eight years.” AQR – considered one of the best quant managers in history – is down nearly 9% this year in one of its flagship funds after suffering a miserable June.

There are so many points to be made here, it’s actually hard to know where to start. But here we go…

1. You can’t realistically invest today without using at least some basic quantitative tools.

There are simply too many stocks to research and not enough hours in the day. Not all of us are crunching numbers using computers designed for NASA, of course. But even something as basic as a simple screen or ranking system can narrow your universe to a manageable size.

If Ben Graham were alive today, he wouldn’t be calculating ratios by hand after digging the numbers out of a quarterly report. It’s also highly unlikely he’d be using the same screening criteria that he recommended using in the 1930s.

Graham was a smart guy, and he would have evolved with the times, probably coming up with new ratios we’ve never heard of.

2. You’re never going to be able to compete with the big boys in technology investment. 

The biggest Wall Street banks and hedge funds really do use computers that were designed for NASA and have teams of PhD eggheads to run them. You can’t realistically compete with that, so you have to play a different game.

Look for opportunities in small- and medium-sized companies that the big boys can’t realistically touch. (A large fund can’t take a meaningful position in a smaller company without moving the market.)

3. Beware of false correlations. 

I wrote a couple months ago that butter production in Bangladesh was statistically proven to be the best predictor of U.S. market returns.

Now, this is obviously a quirky coincidence. No rational human being would really believe that dairy production half a world away makes a dime’s bit of difference to the stock market here.

But quantitative investing is full of little traps like these. So before you trade, your screen needs to pass a “smell test.”

If the criteria seems farfetched (seriously, Bangladeshi butter?) it’s likely that you’re mistaking statistical noise for worthwhile information.

 

 

This article first appeared on Sizemore Insights as Competing with the Quants