Photo: IRRI Images via Flickr
There’s a war at large in the stock market today that may be hurting your portfolio returns without you even realising it. Over the last hundred years the players in the stock market have had a fairly standard approach to reaping their profit – that of the stock picking ‘hunter’.But in the last 30 years, as the technologies of data handling and computation have improved, a new breed of market player has arrived, the quantitative ‘farmer’ seeking to harvest rather than hunt profits. The last 5 years have seen such rapid advances in modern technologies that the dominance of the hunter is now seriously under threat. Financially it may pay off enormously to ask yourself whose side you are on.
The Hunter – or stock picker
Everyone loves to pick stocks – who doesn’t enjoy getting deeply ensconced in the story of a stock and seeing it multi-bag. There’s nothing as wonderful as being right and knowing that you knew it all along. And fortune has followed for the investors who’ve been skillful enough to pick and hold onto the right stocks for an entire career. Such luminaries as Anthony Bolton, Bill Miller or Warren Buffett have become legends in our time as the long term greats of the art.
The classical stock-picking ‘hunter’ will narrow the terrain down to a manageable collection of stocks and start analysing each individually. These kinds of investors have been known to “start at the A’s” and work their way systematically through the market until they find prey worthy of closer targeting. Their primary focus is on the company where they perform in-depth analysis both of its financial situation but also of more qualitative aspects such as analysis of its sector peer group, economic resilience and moat.
Frankly the majority of investors see themselves as part of this group. There is certainly a romantic ideal associated with the hunter archetype which goes so much deeper than just the sheer thrill of the chase. It goes so deep that the fund management group ‘Artemis’ used the hunter archetype as its marketing emblem for many many years.
The Farmer – or quantitative portfolio investor
There is though a rapidly growing group of investors that are far more interested in ‘characteristics‘ than companies who seek to ‘harvest’ systematic mispricings from the rough of the stock market through quantitative techniques. In a stock market that’s predominantly dominated by the far more numerous hunter, these quants have found they have a lot of easy crop. Hunters tend to be a very emotional lot prone to both chasing prey to unsustainably lofty heights and discarding them too hastily aside which allows the quants to profit from their over reaction.
While many think of quants as modern hedge fund employees even Ben Graham, the original guru of mid 20th century value investing, can be regarded as one. Graham bought up the kinds of stocks you wouldn’t even wish on your mother in law seeking safety in numbers. Individually these stocks looked like train wrecks, but collectively they offered him something special – excessively beaten down assets selling at less than their liquidation value which were in aggregate likely to be re-rated.
This approach has been mirrored far more often in recent years by a variety of quantitative techniques such as those espoused in the ‘Magic Formula’, designed to pick up good cheap companies, or the scoring techniques of Josef Piotroski which aim to highlight companies that have a high probability of turnaround. While these simple techniques can work well, hedge funds have taken the quantitative model and put it on steroids – targetting all kinds of ethereal areas to profit from that we won’t go into here.
Are the quants winning?
Recent years have seen some star fund managers come crashing down to earth. Many have had calamitous years recently some of whom have been blaming an underlying change in the market dynamic. Could it be the terrain of the stock market is being changed so much by the growing dominance of the new quants and pooled investments that its getting far less safe for the hunter?
You don’t have to be a hero…
The financial world, press and media tend to glamorise the approach of the stock picking ‘hunter’ – the Warren Buffett’s of the world – which contributes to so many individual investors over-rating their abilities and becoming easy prey of the farmers. The irony and evidence is that many investors really do not have the time nor the resources to perform the kind of analysis that can turn stock picking into a highly profitable activity in this changing market environment.
Under this canopy of persistent underperformance, the first step a recovering stock picker can take is to redefine their approach to their search process. As we should all know tips, tv and brokers tend to funnel naive investors into extremely low probability story stocks – and while this can be a fun ride it so often ends all too familiarly. A better approach is to start by applying some proven quantitative criteria to narrow the universe of stocks to a starting list to pick their stocks from and buying them as a basket.
But even then investors have to be careful. One of the findings in recent years is that individuals who buy individual stocks off these lists will time and again favour names that are familiar to them and shun the strangers. As has been highlighted by Joel Greenblatt, in general they are picking the wrong stocks! If you take the profits of any portfolio strategy, often 20% or more can be attributable to a single stock, which is regularly the least likely of the basket to be chosen by a stock picker!
James Montier, who made his name with a series of famous research papers at Soc Gen, wrote an ‘Ode to Quant’, which showed that quant models in many fields (e.g. medical science) tend to provide a ceiling from which we detract performance rather than a floor on which we build. The paper asks whether investors in aggregate might do far better in their stock picking if they essentially gave it up and deferred to the models.
Long-time readers may recall that a few years ago I designed a tactical asset allocation tool based on a combination of valuation and momentum. At first this model worked just fine, generating signals in line with my own bearish disposition.However, after a few months, the model started to output bullish signals. I chose to override the model, assuming that I knew much better than it did (despite the fact that I had both designed it and back-tested it to prove it worked). Of course, much to my chagrin and the amusement of many readers, I spent about 18 months being thrashed in performance terms by my own model.
While that may seem an extreme view, and one opposed to the activities and instincts of the vast majority of stock pickers, there’s a growing body of evidence to suggest that it could be right.
How are you adding some quant into your investing process? Let us know in the comments below – a gathering of good ideas will help to build a better toolkit for subscribers at Stockopedia PRO.
Read more posts on Stockopedia »
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.