As an equity research firm we often get questions about the efficiency of a quantitative process and how that might fare against a fundamental approach to investing. This article will touch on the benefits of each, how the two can be interlinked, and why those that seek best practices should use a combination of quantitative and fundamental analysis for their investment process.
Key Factors for AFG’s Quantitative Investing
Quantitative investment practices can mean a number of things. For AFG it means a repeatable, un-biased, alpha-generating process that helps managers effectively navigate the market. Because we are using fundamental inputs – Valuation, Quality, Momentum, to drive the analysis, one could call this quantitative approach a fundamental quantitative process. For Valuation, we incorporate AFG’s proprietary metrics such as Economic Margin, Steady State Growth Rate, and Profit Decay to the traditional DCF model to estimate a company’s intrinsic value. For Momentum, we are focused on two aspects – operating momentum and price momentum.
Valuation and Momentum Working Great Together
For Momentum, we are dealing with both operating momentum and price momentum.
1. Operating momentum or what we call EM momentum, helps investors understand the company’s ability to improve their operating performance in the near term. History has shown that focusing on Valuation or EM momentum alone consistently creates alpha. However, the combination of the two variables have delivered even more consistent, and greater long term outperformance. As shown in the table below, from 1996 to 2014, going long inexpensive stocks with positive EM momentum has outperformed the two individual strategies of simply buying inexpensive stocks or buying stocks with positive EM momentum. For example, in 2007 valuation did not work but EM momentum helped managers stay afloat. The only time the combination of these two variables did not add alpha was in 1999. Following 1999, however, the valuation strategy outperformed dramatically, and so did the combination strategy.
2. Follow the wisdom of the crowd, now let’s examine the importance of price momentum. It is understandable that fundamental managers often ignore short term price momentum. In the charts below, however, you can see when valuation or price momentum delivers particularly strong returns, the other variable suffers badly. These high negative correlations are invaluable when constructing investment strategies, as they suggest taking both variables into consideration will likely help negate big ebbs and flows of returns, resulting in more consistent outperformance.
It is best to combine valuation with both operating and price momentum. With valuation being the corner stone of the quantitative strategy, analysts are able to mitigate irrational markets which are often driven by some momentum. As referenced, 1999 and 2007/2008 were historically irrational periods of the market. In 1999, we observed grossly overvalued tech companies putting up seemingly unstoppable returns. Leading up to and following the financial crisis, due to fear of balance sheet risk, investors stayed on the sidelines avoiding financials companies like epidemics. While momentum was extremely positive for tech firms in 1999 and negative for financials in 2008, valuation signals an opposite story. Following a consistent strategy that combines valuation with momentum would have prevented investors from chasing grossly overvalued tech investments leading up to the tech bubble and helped them identify the more attractive financial stocks.
Below is a quintile breakout of valuation, with the green bar being the most inexpensive group of companies and red bar the most expensive companies to invest in.
It is critically important to stick to a strategy and not waver from short term underperformance. We were right in 1999 to advise our clients to avoid overpriced tech companies, but the payoff did not come until 2000. Some of those firms that did not heed our warnings ended up becoming clients and believers of our process as they experienced firsthand the importance of a consistent process that incorporates valuation as a corner stone. Anyone remember pets.com or the collapse of Cisco?
Un-biased Quality Factors – Management and Earnings Quality
For Quality, we are talking about management quality and earnings quality. Determining the quality of a firm is not an easy task. AFG provides two key quantitative quality factors that help guide investors without the burden of listening to hours of conference calls or the unnecessary task of sifting through mountains of accounting data.
1. Management quality is quite straightforward. Companies that are earning above their cost of capital should seek positive NPV investment opportunities, while companies earning less than their cost of capital should focus on their core competencies rather than growth. By identifying companies that are investing a dollar to get a NPV return greater than zero or enjoying positive management quality, we are able to quickly eliminate companies from our focus list that fail to do so.
2. Another quality factor we have found to systematically help avoid bad companies is Earnings Quality. Earnings Quality seeks to identify the differences between Cash Flow and Net Income, or levels of accruals. Over time as Net Income approaches Cash Flow, a company with a negative difference between Net Income and Cash Flow is more likely to have positive Earnings Surprises, while a company with a positive difference is more likely to have a negative Earnings Surprise.
Factors Driving Today’s Market
Currently, investors have experienced a market which favors safety and quality. Below is a snapshot of “what’s working” in the market for the last 12 months. Factors such as high dividend yield, positive EM momentum, and good earnings quality have prevailed, at the expense of valuation. While Valuation is currently out of favor and dividend yield is the hot commodity, the story is different when examining the market using a long term lens. Looking at the factors driving the SP500 in the 10-year period, Valuation is very effective in delivering alpha while dividend yield fails to do so. AFG’s fundamental quantitative approach begins and ends with valuation because it is the most consistent of the variables in generating long term alpha, and is the cornerstone of our multi-factor model approach.
Factors Driving the Market the Last 10 years
Eventually overinvesting in these “less risky” parts of the market can create an environment where a sector or sub sector becomes overvalued. Last month we examined the Staples sector, the Economic Margin priced into the sector are roughly twice that of which the sector has been able to deliver. We continue to caution investors when investing in this sector.
The Case for a Qualitative Overlay
During irrational or exuberant markets, a fundamental approach could be largely beneficial. For example, in 2015, it would have been prudent to have carefully examined the energy sector and make adjustments to your portfolios accordingly. For those areas of the market where a quantitative model might not incorporate short term supply and demand information fast enough, analysts should make appropriate model adjustments from a fundamental standpoint. By modeling the company, analysts can get a more precise risk/reward profile which may have changed their perspective on the energy sector last year.
The point is, during volatile times, it becomes increasingly difficult to use a pure quantitative approach to value sectors such as Energy or Materials. An investment decision needs to be assisted by fundamental analysis, which requires convictions about the future moves of commodity prices. Regardless, AFG’s quantitative approach helps steer investors to the most attractive companies in any given sector, including Energy and Materials.
AFG Best Practices
AFG’s best practice research begins with a quantitative approach because it provides a number of benefits for an investment firm. To name a few, the approach is a consistent, un-biased process, and saves firms valuable time. The primary concern of a quantitative model is that it can be vulnerable to short term changes in the market. Furthermore, you must stay true to the model (buy the bucket) to produce alpha, which may create implementation challenges. That is why our investment tools allow our clients to conduct in-depth analysis of the fundamentals of a company to get a more refined answer and that is where fundamental analysis comes in.
Fundamental analysis can be key to making more refined investment decisions, but most managers don’t have the efficient tools and information to properly analyze a company. While we start with a quant process, we allow our clients to gain access to the line item forecast of every company. This is important because the analyst is now leveraging the power of sifting through large sums of data and providing a shortcut to help determine which companies to focus their attention on. By understanding the limitations of the quantitative model, the analyst can then make appropriate adjustments to focus on a single company rather than a diversified bet. With the information available today, an analyst can effectively use a quant approach with a fundamental overlay for best portfolio performance results.
APPLYING QUANTITATIVE MODELS WITH FUNDAMENTAL ANALYSIS
Begin with a Systematic Process Oriented Approach
Let’s examine how to best apply the combination of these approaches. By analyzing our quantitative Investment Grade rankings, buying A graded companies (hold them as long as they are A, B, C) and rebalancing quarterly, the portfolio would have 42% turnover and 6.5% returns above the benchmark.
*AFG International Backtest Database: Custom Screen Results from 9/30/1998 to 12/31/15
AFG’s analysts use our quantitative indicators as guidance and then do their own due diligence to make qualitative recommendations. For example, AFG has a focus list called The AFG50, a large cap focus list of 50 stocks, sector neutral to the S&P 500. With less than 20% turnover, The AFG50 focus list has delivered 40% cumulative returns above the benchmark since inception (2004).
Due Diligence and Model Refining
Let’s use one company to examine the application of a systematic, fundamental, quantitative approach to investing. Apple is a company that currently has a litany of question marks, with one being the potential short fall in demand for their new iPhone7, making it difficult to properly value the company. In addition to the sales expectation of the new iPhone7, Apple also has concerns with overseas tax issues and cash that may never make it back to investors in the US. Add heated competition, the potential for an oversaturation of smart phones, and the company’s own lack of breakthrough in innovation, investors are left scratching their head on how to value the largest company in the S&P500.
If we simply use the quantitative output Apple would be a “buy” as it is an A graded company. A graded companies are those that represent the most attractive quintile in their sector using our weighted multi-factor model. The buy recommendation for Apple is driven by its discounted price, quality of management, and current EM Momentum.
Utilizing AFG’s Value Expectations interface analysts can then take it a step further and make adjustments to reach a more refined opinion on Apple. After careful analysis, our conclusion is that Apple is still attractive relative to other tech companies but with less upside than the quantitative model suggests.
After our analysts have built in their own expectations, you can see EM levels of Apple modeled to regress over the next five years. Despite the modeled regressing in EM levels, Apple still has upside of roughly 36%. This process of modeling companies provides the flexibility fundamental managers seek while maintaining a structured discipline to invest with AFG’s quantitative factors.
We encourage our clients to begin their process with a quantitative approach, but evaluate the output of the model to ensure it accurately represents current market expectations. By using AFG’s Value Expectations interface, analysts should model companies using their own expectations to justify their holdings in any market environment.
It would be prudent for a fundamental manager to have a consistent quantitative methodology to help guide their decision making process. By applying a consistent process, firms can effectively communicate their investment thesis without significant explanation, which results in discipline among those involved in the portfolio construction and management process.
AFG’s robust process and suite of investment tools are geared to help investment professionals quickly and effectively make better buy/hold/sell decisions. Regardless of the style of investing or investment philosophy, AFG has helped managers save valuable time and improve alpha over the past 20 years. If you are looking to improve your process, we invite you to analyze your current holdings using our approach.
About Chris Austin
Partner at The Applied Finance Group
Focus areas: Portfolio Consulting, Business Development
Joined AFG in 2003
High Dividend Focus List
As we mentioned in our article on Quantitative Vs. Fundamental Investing, investors in the current market environment have been favoring safety and quality. Being that dividend yield companies have been in the spotlight and running recently we have provided a focus list of High Dividend Buy and Sell candidates. We focused on companies with a dividend yield above 2% and then overlayed AFG Company Grade and Valuation ranks into our screen. The 5 Buy candidates all look inexpensive from a valuation standpoint and earn an AFG Company Grade of A, the Sell Candidates all look expensive according to our model and earn an AFG Company Grade of F.
Howard B. Aschwald, CFA
Quantum Capital Management – Assets Under Management – $680 Million
AFG Client Since 2000
1. Can you tell us a little about Quantum Capital (Who you serve, philosophy)?
a) Quantum Capital is an independent RIA that manages assets for high net worth clients and institutional investors. We are a growth at a reasonable price investor that combines quantitative and fundamental research into high conviction, risk controlled multi market-cap equity strategies.
2. You have been a client of The Applied Finance Group (AFG) for over 15 years, what sets AFG apart from other equity research providers?
a) We were looking for a differentiator in the various investment metrics available in the equity research process. Too many standard metrics did not add stock selection value and offered little in the way of evidence to support their utilization. We initially pursued EVA (Economic Value Added) and moved quickly to adopt Economic Margin and the Applied Finance Group’s analysis framework. The AFG database and many of their unique metrics allow us to calculate a weekly scoring and ranking system which then allows our fundamental analysts to add human capital to select stocks and construct portfolios.
3. Has AFG helped you reach better investment decisions?
a) Yes – We periodically test our AFG based scoring system for efficacy and consistency. Not only do we uncover interesting ideas, but the AFG Value Expectations modeling component allows our analysts to input human judgement on key drivers to insure that we adhere to our disciplined investment process.
4. How does AFG’s research process and applications help the investment team save time?
a) Without the AFG database and time-saving modeling software, it would be extremely time consuming and much more error-prone to manually score the universe of stocks that comprise the equity strategies that we manage for our clients.
5. Any additional comments about AFG?
a) We routinely send our analysts to AFG conferences and workshops, not only as a refresher, but to make sure that analysts are on the “same page” in the language we use to communicate our investment ideas. We combine AFG metrics and language and our own proprietary methodology to create a unique research process. Over the years, we have found AFG personnel to be very engaging and helpful to all of our staff.
6. Quantum Capital has grown tremendously over the past five years, any advice you would like to share with growing firms?
a) We have discovered that institutional investors want a consistent and disciplined research process that clearly differentiates why the process has worked in the past and will continue to work in the future. With passive and multifactor investing gaining increasing AUM market share in investor portfolios, active managers must demonstrate why their investment process cannot be replicated more cheaply by software. Using AFG tools with human judgement will allow active firms to stay ahead of the growing investment automation future.
7. We are in an election year, does the outcome play a role in your investment decision process? If so, can you please elaborate?
a) This year’s politics creates much more uncertainty and the increased potential for the temporary manifestation of negative market outliers. Portfolios will do best when solid valuation is the basis for stock selection.
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