Quantitative Value

A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors

Wesley R. Gray, Tobias E. Carlisle

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118416556
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

A must-read book on the quantitative value investment strategy

Warren Buffett and Ed Thorp represent two spectrums of investing: one value driven, one quantitative. Where they align is in their belief that the market is beatable. This book seeks to take the best aspects of value investing and quantitative investing as disciplines and apply them to a completely unique approach to stock selection. Such an approach has several advantages over pure value or pure quantitative investing. This new investing strategy framed by the book is known as quantitative value, a superior, market-beating method to investing in stocks.

Quantitative Value provides practical insights into an investment strategy that links the fundamental value investing philosophy of Warren Buffett with the quantitative value approach of Ed Thorp. It skillfully combines the best of Buffett and Ed Thorp—weaving their investment philosophies into a winning, market-beating investment strategy.

• First book to outline quantitative value strategies as they are practiced by actual market practitioners of the discipline
• Melds the probabilities and statistics used by quants such as Ed Thorp with the fundamental approaches to value investing as practiced by Warren Buffett and other leading value investors
• A companion Website contains supplementary material that allows you to learn in a hands-on fashion long after closing the book

If you're looking to make the most of your time in today's markets, look no further than Quantitative Value.

PART ONE
The Foundation of Quantitative Value

This book is organized into six main parts. Part One sets out the rationale for quantitative value investment and introduces our checklist. In it we examine several simple quantitative value strategies to illustrate some key elements of the investment process. In Part Two we discuss how to avoid stocks at high risk of sustaining a permanent loss of capital—those suffering from financial statement manipulation, fraud, and financial distress. Part Three contains an examination of the indicia of high-quality stocks—an economic franchise and superior financial strength. We go bargain hunting in Part Four, looking for the price ratios that best identify undervalued stocks and lead to the best risk-adjusted investment performance. We look at several unusual implementations of price ratios, including long-term average price ratios and price ratios in combination. Part Five sets out a variety of signals sent by other market participants. There we look at the impact of buybacks, insider purchases, short selling, and buying and selling from institutional investment managers like activists and other fund managers. Finally, in Part Six we build and test our quantitative value model. We study the best way to combine the research we've considered into a cohesive strategy, and then back-test the resulting quantitative value model.

CHAPTER 1
The Paradox of Dumb Money

“As they say in poker, ‘If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.'”

—Warren Buffett (1987)

In the summer of 1968, Ed Thorp, a young math professor at the University of California, Irvine (UCI), and author of Beat the Market: A Scientific Stock Market System (1967), accepted an invitation to spend the afternoon playing bridge with Warren Buffett, the not-yet-famous “value” investor. Ralph Waldo Gerard hosted the game. Gerard was an early investor in Buffett's first venture, Buffett Partners, and the dean of the Graduate School at UCI, where Thorp taught. Buffett was liquidating the partnership, and Gerard needed a new manager for his share of the proceeds. Gerard wanted Buffett's opinion on the young professor and the unusual “quantitative” investment strategy for which he was quietly earning a reputation among the members of the UCI community.

Gerard had invested with Buffett at the recommendation of a relative of Gerard's who had taught Buffett at Columbia University: the great value investment philosopher, Benjamin Graham. Graham had first published the value investor's bible, Security Analysis, along with David Dodd, in 1934.¹ He was considered the “Dean of Wall Street,” and regarded Buffett as his star pupil. Graham's assessment would prove to be prescient.

By the time Thorp met Buffett in 1968, Buffett had established an exceptional investment record. He had started Buffett Partners 12 years earlier, in 1956, at the tender age of 26, with initial capital of just $100,100. (Buffett joked that the $100 was his contribution.) By 1968, Buffett Partners controlled $100 million in capital, and Buffett's share of that was $25 million.² For the 12 years between 1956 and 1968, Buffett had compounded the partnership's capital at 30 percent per year before his fees, which were 25 percent of the gain over 6 percent per year. Investors like Gerard had compounded at an average of 24 percent a year. Before taxes, each original dollar invested in Buffett's partnership had grown to more than $13. Each of Buffett's own dollars, growing at the greater prefee annual rate of 30 percent became before taxes over $23. By 1968, however, Buffett was having difficulty finding sufficiently undervalued securities for the partnership, and so had decided to wind it up. This had led Gerard to find a new manager, and Gerard hoped Thorp was the man. He wanted to know if Thorp's unusual quantitative strategy worked, and so, at Gerard's behest, Thorp found himself sitting down for a game of bridge with Buffett.

Buffett is a near world-class bridge player. Sharon Osberg, international bridge player and regular professional partner to Buffett, says, “He can play with anyone. It's because of his logic, his ability to solve problems and his concentration.”³ Says Buffett, “I spend 12 hours a week—a little over 10 percent of my waking hours—playing the game. Now I am trying to figure out how to get by on less sleep in order to fit in a few more hands.”⁴ Buffett presented a daunting opponent. Thorp observed of Buffett's bridge playing⁵:

Bridge players know that bridge is what mathematicians call a game of imperfect information. The bidding, which precedes the play of the cards, conveys information about the four concealed hands held by the two pairs of players that are opposing each other. Once play begins, players use information from the bidding and from the cards as they are played to deduce who holds the remaining as yet unseen cards. The stock market also is a game of imperfect information and even resembles bridge in that they both have their deceptions and swindles. Like bridge, you do better in the market if you get more information, sooner, and put it to better use. It's no surprise then that Buffett, arguably the greatest investor in history, is a bridge addict.

Thorp was no stranger to the card table either. Before he figured out how to beat the market, Thorp wrote Beat the Dealer, the definitive book on blackjack card counting. William Poundstone recounts the story of Thorp's foray into card counting in his book, Fortune's Formula.⁶ In 1958, Thorp had read an article by mathematician Roger Baldwin, who had used U.S. Army “computers”—which actually meant “adding machines” or the people who operated them—to calculate the odds of various blackjack strategies in an effort to find an optimal strategy. Over three years, he and three associates found that by using an unusual strategy they could reduce the house edge in blackjack to 0.62 percent. Amazingly, prior to their paper, nobody, including the casinos, knew the real advantage held by the house. There were simply too many permutations in a card deck of 52 to calculate the casino's edge. “Good” players of blackjack, other writers had claimed, could get the house's edge down to 2 or 3 percent. Baldwin's strategy, by reducing the house edge to 0.62 percent, was a huge leap forward. The only problem, as far as Thorp could see, was that Baldwin's strategy still lost money. He was convinced he could do better.

Thorp's key insight was that at the time blackjack was played using only one deck and it was not shuffled between hands. In the parlance of the statistician, this meant that blackjack hands were not “independent” of each other. Information gleaned in earlier hands could be applied in subsequent hands. For example, in blackjack, aces are good for the player. If the dealer deals a hand with three aces, the player knows that only one ace remains in the deck. This information would lead the player to view the deck as being less favorable, and the player could adjust his or her betting accordingly. Thorp used MIT's mainframe computer to examine the implications of his observation and found something completely counte...

Table of contents

• Cover
• Table of Contents
• Preface
• PART ONE: The Foundation of Quantitative Value
• PART TWO: Margin of Safety—How to Avoid a Permanent Loss of Capital
• PART THREE: Quality—How to Find a Wonderful Business
• PART FOUR: The Secret to Finding Bargain Prices
• PART FIVE: Corroborative Signals
• PART SIX: Building and Testing the Model
• Appendix: Analysis Legend
• About the Authors
• About the Companion Website
• Index
• End User License Agreement