To attain knowledge add things every day. To attain wisdom subtract things every day.
To attain knowledge add things every day. To attain wisdom subtract things every day.
by Ray Kroc, with Robert Anderson, published 1992
Reading through the stories of great entrepreneurs, business people and politicians like Cornelius Vanderbilt or Warren Buffett, it is easy to find a sentiment much like this one from Ray Kroc:
Ethel [his wife] used to complain once in a while about about the amount of time I spent away from home working. Looking back on it now, I guess it was kind of unfair. But I was driven by ambition.
I find this sentiment remarkable for a few different reasons.
The first is how common it is. It seems to suggest that achieving “great things” in a particular field of enterprise is not possible without neglecting one’s family and other personal relationships in favor of the “productive” relationships and activities.
The second is how little awareness of this tradeoff many such people seem to possess, at least until they reach the end of their life and all their glory has already been gotten. Then, as they contemplate their state of affairs, either looking back on the empire they built or ruminating regretfully now that they are deposed (violently or voluntarily), they seem to re-evaluate how they spent their time and decide they came up short in considering family time less important than it should have been. They also seem to be either disconnected from the damage they do to their children and their psyches, or else try to evade such recognition– I think Ray Kroc mentioned his daughter all of two times in this 200 page telling, and while his daughter may not have been critical to the story of building McDonald’s, you’d think she would’ve provided enough value and motivation in Kroc’s life to merit more than a couple passing mentions!
The third is how excusable such high achievers seem to find their behavior to be in retrospect. “But…” is a permission word. It negates what comes before and offers cover. Yes, Ray Kroc was unfair, but… It suggests a different moral framework for studying life or a particular circumstance, one in which the rules don’t really apply and the ends justify the means.
The fourth is what a temptation these great projects must’ve provided to these people, to ignore their family, their health or any number of other values. If I was a successful paper cup salesman but stumbled upon the idea of McDonald’s myself, could I have resisted the temptation to build it and in the process knowingly give up my family, friends, physical well-being, etc.? It is perhaps easy to sit in judgment of another person’s efforts and decisions when the attraction of my own responsibilities is relatively less compelling. It’s easy to go home to my family at the end of the day as they typically offer me more interest and excitement. But would that be the case if millions of dollars and a global business organization hung in the balance? That I don’t know for sure, and perhaps you can’t know until you’re tempted with it.
But that leads to the fifth point, which is to consider whether a story like Kroc’s and McDonald’s could be told any other way. What if in the first 27 pages of the story of this business the quote above was not to be found, nor anywhere in the 173+ pages that followed? What if Kroc didn’t get divorced (twice), didn’t have a string of health issues along the way, came home and kissed his wife and daughter on the forehead five nights a week and spent most of each month at home and around town rather than around the country? What choices would’ve needed to be made differently to support that outcome, and how would the company look different either internally or competitively if that had been the case? How big would Berkshire Hathaway be if Buffett had raised his own children and loved his first wife more considerately instead of reading so many damn books and annual reports?
To ask may be to answer, but it’s frightening (hopeful?) to think otherwise.
Besides neglecting important obligations and personal considerations, what else do stories like these seem to tell us about those who achieve outsize success?
Incredible stamina seems to be part of it. They don’t just work hard, they work all the time. But again, it’s hard to know if this is part of the person, part of the responsibility and opportunity, or both. How would a person not work hard and often at something they didn’t love to the point they were mesmerized by it? Enthralled is a good way to describe the state of mind in relation to the idea of the thing being pursued here.
Also, simplicity. Maybe it’s the bad ghostwriting designed to break the story down for a lowbrow audience but the way these people talk about what it is they did, they rarely come across as great geniuses, though they’re often wits (Buffett is a notable exception here, and Vanderbilt was clearly “sharp”, a word for cunning back then, though it wasn’t clear he was necessarily “intelligent”, while it was clear he was no buffoon). The grand strategy and complexity is often seen in hindsight, knowing how the story ends and having years and years to tell it and thus accumulate various trappings which may or may not be integral to the success. In Kroc’s own words, it was all about Quality, Service, Cleanliness and Value and then spreading it across the land. Their financing was complicated, but it’s not clear it needed to be, especially if the company was less levered and less insistent on growing as fast as it did. Being focused seems obvious, yet important enough to mention it.
Where does that leave me? If there’s a way to build a legacy that doesn’t involve neglecting one’s family and health, perhaps by being more patient, moving more slowly or being less obsessed about the outcome, that is the kind of legacy I want to build. And I have to wonder what kind of personal insecurity or individual idiosyncrasy or whatever it is, that I seem not to have, that would not allow a person to make that choice given the alternative.
But if the only way to make things great is to trash some other part of your life and leave a smoking crater behind, a crater that’s especially painful in the vulnerability of old age, then I guess I better prepare myself mentally for more humble achievements. I’m just not interested in those kinds of tradeoffs and I don’t understand how such achievements could be satisfying without a family to enjoy them with and the sound mind and body necessary to experience it all.
Simplicity is the ultimate sophistication.
~Leonardo Da Vinci
by Wesley R. Gray and Tobias E. Carlisle, published 2012
The root of all investors’ problems
In 2005, renowned value investing guru Joel Greenblatt published a book that explained his Magic Formula stock investing program– rank the universe of stocks by price and quality, then buy a basket of companies that performed best according to the equally-weighted measures. The Magic Formula promised big profits with minimal effort and even less brain damage.
But few individual investors were able to replicate Greenblatt’s success when applying the formula themselves. Why?
By now it’s an old story to anyone in the value community, but the lesson learned is that the formula provided a ceiling to potential performance and attempts by individual investors to improve upon the model’s picks actually ended up detracting from that performance, not adding to it. There was nothing wrong with the model, but there was a lot wrong with the people using it because they were humans prone to behavioral errors caused by their individual psychological profiles.
Or so Greenblatt said.
Building from a strong foundation, but writing another chapter
On its face, “Quantitative Value” by Gray and Carlisle is simply building off the work of Greenblatt. But Greenblatt was building off of Buffett, and Buffett and Greenblatt were building off of Graham. Along with integral concepts like margin of safety, intrinsic value and the Mr. Market-metaphor, the reigning thesis of Graham’s classic handbook, The Intelligent Investor, was that at the end of the day, every investor is their own worst enemy and it is only by focusing on our habit to err on a psychological level that we have any hope of beating the market (and not losing our capital along the way), for the market is nothing more than the aggregate total of all psychological failings of the public.
It is in this sense that the authors describe their use of “quantitative” as,
the antidote to behavioral error
That is, rather than being a term that symbolizes mathematical discipline and technical rigor and computer circuits churning through financial probabilities,
It’s active value investing performed systematically.
The reason the authors are beholden to a quantitative, model-based approach is because they see it as a reliable way to overcome the foibles of individual psychology and fully capture the value premium available in the market. Success in value investing is process-driven, so the two necessary components of a successful investment program based on value investing principles are 1) choosing a sound process for identifying investment opportunities and 2) consistently investing in those opportunities when they present themselves. Investors cost themselves precious basis points every year when they systematically avoid profitable opportunities due to behavioral errors.
But the authors are being modest because that’s only 50% of the story. The other half of the story is their search for a rigorous, empirically back-tested improvement to the Greenblattian Magic Formula approach. The book shines in a lot of ways but this search for the Holy Grail of Value particularly stands out, not just because they seem to have found it, but because all of the things they (and the reader) learn along the way are so damn interesting.
A sampling of biases
Leaning heavily on the research of Kahneman and Tversky, Quantitative Value offers a smorgasbord of delectable cognitive biases to choose from:
The authors stress, with numerous examples, the idea that value investors suffer from these biases much like anyone else. Following a quantitative value model is akin to playing a game like poker systematically and probabilistically,
The power of quantitative investing is in its relentless exploitation of edges
Good poker players make their money by refusing to make expensive mistakes by playing pots where the odds are against them, and shoving their chips in gleefully when they have the best of it. QV offers the same opportunity to value investors, a way to resist the temptation to make costly mistakes and ensure your chips are in the pot when you have winning percentages on your side.
A model development
Gray and Carlisle declare that Greenblatt’s Magic Formula was a starting point for their journey to find the best quantitative value approach. However,
Even with a great deal of data torture, we have not been able to replicate Greenblatt’s extraordinary results
Given the thoroughness of their data collection and back-testing elaborated upon in future chapters, this finding is surprising and perhaps distressing for advocates of the MF approach. Nonetheless, the authors don’t let that frustrate them too much and push on ahead to find a superior alternative.
They begin their search with an “academic” approach to quantitative value, “Quality and Price”, defined as:
Quality, Gross Profitability to Total Assets = (Revenue – Cost of Goods Sold) / Total Assets
Price, Book Value-to-Market Capitalization = Book Value / Market Price
The reasons for choosing GPA as a quality measure are:
Book value-to-market is chosen because:
The results of the backtested horserace between the Magic Formula and the academic Quality and Price from 1964 to 2011 was that Quality and Price beat the Magic Formula with CAGR of 15.31% versus 12.79%, respectively.
But Quality and Price is crude. Could there be a better way, still?
Marginal improvements: avoiding permanent loss of capital
To construct a reliable quantitative model, one of the first steps is “cleaning” the data of the universe being examined by removing companies which pose a significant risk of permanent loss of capital because of signs of financial statement manipulation, fraud or a high probability of financial distress or bankruptcy.
The authors suggest that one tool for signaling earnings manipulation is scaled total accruals (STA):
STA = (Net Income – Cash Flow from Operations) / Total Assets
Another measure the authors recommend using is scaled net operating assets (SNOA):
SNOA = (Operating Assets – Operating Liabilities) / Total Assets
OA = total assets – cash and equivalents
OL = total assets – ST debt – LT debt – minority interest – preferred stock – book common equity
STA and SNOA are not measures of quality… [they] act as gatekeepers. They keep us from investing in stocks that appear to be high quality
They also delve into a number of other metrics for measuring or anticipating risk of financial distress or bankruptcy, including a metric called “PROBMs” and the Altman Z-Score, which the authors have modified to create an improved version of in their minds.
Quest for quality
With the risk of permanent loss of capital due to business failure or fraud out of the way, the next step in the Quantitative Value model is finding ways to measure business quality.
The authors spend a good amount of time exploring various measures of business quality, including Warren Buffett’s favorites, Greenblatt’s favorites and those used in the Magic Formula and a number of other alternatives including proprietary measurements such as the FS_SCORE. But I won’t bother going on about that because buried within this section is a caveat that foreshadows a startling conclusion to be reached later on in the book:
Any sample of high-return stocks will contain a few stocks with genuine franchises but consist mostly of stocks at the peak of their business cycle… mean reversion is faster when it is further from its mean
More on that in a moment, but first, every value investor’s favorite subject– low, low prices!
Gray and Carlisle pit several popular price measurements against each other and then run backtests to determine the winner:
the simplest form of the enterprise multiple (the EBIT variation) is superior to alternative price ratios
with a CAGR of 14.55%/yr from 1964-2011, with the Forward Earnings Estimate performing worst at an 8.63%/yr CAGR.
Significant additional backtesting and measurement using Sharpe and Sortino ratios lead to another conclusion, that being,
the enterprise multiple (EBIT variation) metric offers the best risk/reward ratio
It also captures the largest value premium spread between glamour and value stocks. And even in a series of tests using normalized earnings figures and composite ratios,
we found the EBIT enterprise multiple comes out on top, particularly after we adjust for complexity and implementation difficulties… a better compound annual growth rate, higher risk-adjusted values for Sharpe and Sortino, and the lowest drawdown of all measures analyzed
meaning that a simple enterprise multiple based on nothing more than the last twelve months of data shines compared to numerous and complex price multiple alternatives.
But wait, there’s more!
The QV authors also test insider and short seller signals and find that,
trading on opportunistic insider buys and sells generates around 8 percent market-beating return per year. Trading on routine insider buys and sells generates no additional return
short money is smart money… short sellers are able to identify overvalued stocks to sell and also seem adept at avoiding undervalued stocks, which is useful information for the investor seeking to take a long position… value investors will find it worthwhile to examine short interest when analyzing potential long investments
This book is filled with interesting micro-study nuggets like this. This is just one of many I chose to mention because I found it particularly relevant and interesting to me. More await for the patient reader of the whole book.
Big and simple
In the spirit of Pareto’s principle (or the 80/20 principle), the author’s of QV exhort their readers to avoid the temptation to collect excess information when focusing on only the most important data can capture a substantial part of the total available return:
Collecting more and more information about a stock will not improve the accuracy of our decision to buy or not as much as it will increase our confidence about the decision… keep the strategy austere
In illustrating their point, they recount a funny experiment conducted by Paul Watzlawick in which two subjects oblivious of one another are asked to make rules for distinguishing between certain conditions of an object under study. What the participants don’t realize is that one individual (A) is given accurate feedback on the accuracy of his rule-making while the other (B) is fed feedback based on the decisions of the hidden other, invariably leading to confusion and distress. B comes up with a complex, twisted rationalization for his decision-making rules (which are highly inaccurate) whereas A, who was in touch with reality, provides a simple, concrete explanation of his process. However, it is A who is ultimately impressed and influenced by the apparent sophistication of B’s thought process and he ultimately adopts it only to see his own accuracy plummet.
The lesson is that we do better with simple rules which are better suited to navigating reality, but we prefer complexity. As an advocate of Austrian economics (author Carlisle is also a fan), I saw it as a wink and a nod toward why it is that Keynesianism has come to dominate the intellectual climate of the academic and political worlds despite it’s poor predictive ability and ferociously arbitrary complexity compared to the “simplistic” Austrian alternative theory.
But I digress.
Focusing on the simple and most effective rules is not just a big idea, it’s a big bombshell. The reason this is so is because the author’s found that,
the Magic Formula underperformed its price metric, the EBIT enterprise multiple… ROC actually detracts from the Magic Formula’s performance [emphasis added]
Have I got your attention now?
The trouble is that the Magic Formula equally weights price and quality, when the reality is that a simple price metric like buying at high enterprise value yields (that is, at low enterprise value multiples) is much more responsible for subsequent outperformance than the quality of the enterprise being purchased. Or, as the authors put it,
the quality measures don’t warrant as much weight as the price ratio because they are ephemeral. Why pay up for something that’s just about to evaporate back to the mean? […] the Magic Formula systematically overpays for high-quality firms… an EBIT/TEV yield of 10 percent or lower [is considered to be the event horizon for “glamour”]… glamour inexorably leads to poor performance
All else being equal, quality is a desirable thing to have… but not at the expense of a low price.
The Joe the Plumbers of the value world
The Quantitative Value strategy is impressive. According to the authors, it is good for between 6-8% a year in alpha, or market outperformance, over a long period of time. Unfortunately, it is also, despite the emphasis on simplistic models versus unwarranted complexity, a highly technical approach which is best suited for the big guys in fancy suits with pricey data sources as far as wholesale implementation is concerned.
So yes, they’ve built a better mousetrap (compared to the Magic Formula, at least), but what are the masses of more modest mice to do?
I think a cheap, simplified Everyday Quantitative Value approach process might look something like this:
I wouldn’t even bother trying to qualitatively assess the results of such a model because I think that runs the immediate and dangerous risk which the authors strongly warn against of our propensity to systematically detract from the performance ceiling of the model by injecting our own bias and behavioral errors into the decision-making process.
Other notes and unanswered questions
“Quantitative Value” is filled with shocking stuff. In clarifying that the performance of their backtests is dependent upon particular market conditions and political history unique to the United States from 1964-2011, the authors make reference to
how lucky the amazing performance of the U.S. equity markets has truly been… the performance of the U.S. stock market has been the exception, not the rule
They attach a chart which shows the U.S. equity markets leading a cohort of long-lived, high-return equity markets including Sweden, Switzerland, Canada, Norway and Chile. Japan, a long-lived equity market in its own right, has offered a negative annual return over its lifetime. And the PIIGS and BRICs are consistent as a group in being some of the shortest-lifespan, lowest-performing (many net negative real returns since inception) equity markets measured in the study. It’s also fascinating to see that the US, Canada, the UK, Germany, the Netherlands, France, Belgium, Japan and Spain all had exchanges established approximately at the same time– how and why did this uniform development occur in these particular countries?
Another fascinating item was Table 12.6, displaying “Selected Quantitative Value Portfolio Holdings” of the top 5 ranked QV holdings for each year from 1974 through 2011. The trend in EBIT/TEV yields over time was noticeably downward, market capitalization rates trended upward and numerous names were also Warren Buffett/Berkshire Hathaway picks or were connected to other well-known value investors of the era.
The authors themselves emphasized that,
the strategy favors large, well-known stocks primed for market-beating performance… [including] well-known, household names, selected at bargain basement prices
Additionally, in a comparison dated 1991-2011, the QV strategy compared favorably in a number of important metrics and was superior in terms of CAGR with vaunted value funds such as Sequoia, Legg Mason and Third Avenue.
After finishing the book, I also had a number of questions that I didn’t see addressed specifically in the text, but which hopefully the authors will elaborate upon on their blogs or in future editions, such as:
There’s also a companion website for the book available at: www.wiley.com/go/quantvalue
I like this book. A lot. As a “value guy”, you always like being able to put something like this down and make a witty quip about how it qualifies as a value investment, or it’s intrinsic value is being significantly discounted by the market, or what have you. I’ve only scratched the surface here in my review, there’s a ton to chew on for anyone who delves in and I didn’t bother covering the numerous charts, tables, graphs, etc., strewn throughout the book which serve to illustrate various concepts and claims explored.
I do think this is heady reading for a value neophyte. And I am not sure, as a small individual investor, how suitable all of the information, suggestions and processes contained herein are for putting into practice for myself. Part of that is because it’s obvious that to really do the QV strategy “right”, you need a powerful and pricey datamine and probably a few codemonkeys and PhDs to help you go through it efficiently. The other part of it is because it’s clear that the authors were really aiming this book at academic and professional/institutional audiences (people managing fairly sizable portfolios).
As much as I like it, though, I don’t think I can give it a perfect score. It’s not that it needs to be perfect, or that I found something wrong with it. I just reserve that kind of score for those once-in-a-lifetime classics that come along, that are infinitely deep and give you something new each time you re-read them and which you want to re-read, over and over again.
Quantitative Value is good, it’s worth reading, and I may even pick it up, dust it off and page through it now and then for reference. But I don’t think it has the same replay value as Security Analysis or The Intelligent Investor, for example.
One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity.
Perfection is not when there is no more to add, but no more to take away.
~Antoine de Saint-Exupery
It is vain to do with more what can be done with less.
~William of Occam
The only art is to omit.
~Robert Louis Stevenson