Are Quantitative Models a Better Strategy?
Thursday, November 21, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

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Brian Peery of Hennessy Funds relies on his models to find winners.

Model Shadow Stock Portfolio Rules
The quantitative buy and sell rules for managing the portfolio.

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Do you use stock screens or other quantitative models?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 34.4%, down 4.8 points
  Neutral: 36.1%, up 2.8 points
  Bearish: 29.5%, up 2.0 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

Special note: Our offices will be closed on Thursday and Friday of next week. None of our weekly emails will be sent out, including Investor Update, the Stock Superstars Report weekly update, and the AAII Dividend Investing weekly update. We wish you a happy Thanksgiving and, to those of you celebrating the Jewish holiday, a happy Hanukkah.

In the middle, between passive (index) and active strategies, lie quantitative strategies. These strategies select stocks based on financial, valuation and momentum ratio analysis. Followers of quant strategies are not pure indexers, because they actively create models to identify and take advantage of market anomalies. They are not pure active managers, either, because they buy what their quantitative models tell them to buy.

One of the earliest proponents of using a quantitative approach was Benjamin Graham. Graham advocated buying stocks trading at low valuations. Though not traditionally viewed as a quant, Graham’s disciplined approach involved buying many stocks that exhibited large margins of safety.

Among the modern-day followers of quantitative strategies is James O’Shaughnessy. Prior to his presentation at last week’s AAII Investor Conference, Jim and I spoke about his investing style. He made two key points. First, his research shows that the numeric indicators he screens for have historically led to higher returns than the broader market. (This is known as creating alpha.) Second, he says “numbers serve to discipline rhetoric.” Rather than pay attention to the story, he focuses on what the data says about the company and its stock.

Jim is not the only proponent of using quantitative strategies. Robert Arnott of Research Affiliates is well known within the financial services industry for his use of smart-beta strategies, which are quant approaches. Our Model Shadow Stock Portfolio follows a quantitative approach that strictly governs what is bought and what is sold. Joel Greenblatt’s Magic Formula is a quantitative strategy. Even William O’Neil’s CAN SLIM methodology is mostly a quantitative model.

One of the inherent dangers of quantitative strategies, however, is that they ignore anything that is not considered by the model. O’Shaughnessy gets around this by setting up red flags to trigger sell decisions. These flags include a company not filing regulatory reports on time or significantly cutting its dividend. If an acquisition offer is made, he will sell the stock if it is trading close to the proposed takeover price. Such human intervention can help, but it is important not to stray from the parameters of a good quantitative strategy. James Montier of GMO observed that investment professionals often mess up by trying to improve upon a good quantitative model as opposed to simply relying on it.

Personally, I have yet to turn into Dr. Strangelove, or stopped worrying and learned how to love the quant models. Call it a behavioral error or blame it on my professional training as an analyst, but I like to look under the hood. I am cognizant of the risks my subjective judgments pose, however, and I do not go against the data. If the numbers say sell a certain stock or avoid buying another one, I follow the data’s lead rather than question it.

Quantitative models can make you a more disciplined investor. They can also lead you to profitable stocks you may never have considered or even heard of. Like any investment tool, quant strategies are not without weaknesses. So if you choose to fully embrace a quantitative approach, be sure to maintain proper diversification. A portfolio of 10 stocks limits the maximum stock-specific risk to 10% of your total portfolio. Owning 20 stocks lowers the stock-specific risk to 5%. Incorporating other assets, such as bonds, can also lower the portfolio’s risk. Most importantly, follow a strategy that has a sound reason for working (e.g., value has historically led to better performance) and be willing to stick to the approach, rather than rationalize why you should go against it.

On a related note, some of you have asked how to implement O’Shaughnessy’s composite factors into a stock screen. We have been in touch with his firm and plan to discuss a stock screen based on it in a future issue of the AAII Journal.

AAII Model Shadow Stock Portfolio Update: Emergency Sale

FAB Universal Corp. (FU) is a leader in digital media entertainment sales and distribution. FAB delivers media to its customers worldwide through intelligent kiosks, retail stores and franchises, and online through Apple iTunes and the Google Android Store. FAB has distributed billions of movie, music, podcast, TV show and other digital files to consumers in 240 countries through three business units: digital media services, retail media sales and wholesale media distribution. FAB Universal promotes itself as the toll booth for the world’s emerging markets through FAB’s intelligent media kiosk networks, where customers can download copyright-protected movies and music to their portable storage devices.

Allegations have been raised that FAB may have issued materially misleading business information to the investing public. On November 14, 2013, the blog issued a report asserting that FAB Universal misstated its financial performance and engaged in piracy. is owned and operated by Jon Carnes, who uses the blog to publish his investment opinions of publicly traded companies around the world, with a special focus on companies operating in China. Carnes claims on his blog that FAB’s media kiosks are loaded with pirated movies and that FAB has overstated the number of media kiosks that it deployed. He asserts that FAB’s business in China is a fraction of what it purportedly claims in its filings with the U.S. Securities and Exchange Commission.

FAB Universal denies the allegations. The company issued a press release in which it states its “vehement denial of the recent allegations raised by short-sellers in their self-serving ‘reports’ and reaffirmed its commitment to providing the company’s shareholders with accurate information. FAB’s board of directors is working expeditiously to gather all the relevant information necessary to respond to these misleading and inaccurate reports in an appropriate manner and to report back to its shareholders as quickly as possible.”

We are selling FAB Universal (FU) on an emergency basis. While there is still a lot of debate about the company, it is clear that, at the very least, the data used in the decision to buy the company was flawed and, at worst, there may be extensive fraud. The January 2014 AAII Journal Model Portfolios column will discuss this in more detail.

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The Week Ahead

The U.S. financial markets will be closed Thursday in observance of Thanksgiving. The U.S. equity markets will close early, at 1 p.m. ET, on Friday.

Just five members of the S&P 500 are on the earnings calendar: Analog Devices, Inc. (ADI), Hewlett-Packard Company (HPQ), Hormel Foods Corporation (HRL), Pall Corporation (PLL), and Tiffany & Co. (TIF). All five will report on Tuesday.

The week’s first economic report will be the National Association of Realtors’ November pending home sales index. Tuesday will feature both September and October housing starts and building permits data, the September S&P Case-Shiller Home Price Index, and the Conference Board’s November consumer confidence index. October durable goods orders and the University of Michigan’s final November consumer sentiment survey will be released on Wednesday.

The Treasury Department will auction $32 billion of two-year notes on Monday, $35 billion of five-year notes on Tuesday and $29 billion of seven-year notes on Wednesday.

AAII Sentiment Survey

Individual investors’ optimism about the short-term direction for stock prices is at a 12-week low, according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.8 percentage points to 34.4%. This is the lowest level of optimism registered by our survey since August 29, 2013. It is also the first time in six weeks bullish sentiment is below its historical average of 39.0%. Optimism has fallen by a cumulative 14.8 percentage points since hitting 49.2% on October 24, 2013.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 2.8 percentage points to 36.1%. This is the highest neutral sentiment has been since August 15, 2013. It is also the fifth consecutive week that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.0 percentage points to 29.5%. Although at a six-week high, pessimism remains below its historical average of 30.5% for the ninth time in 11 weeks.

Since the end of April 2013, neutral sentiment has been above its historical average of 30.5% during 25 out of 31 weeks. Though neutral sentiment has stayed within the typical range we have seen throughout the survey's history, the frequent above-average readings are a sign that individual investors, in aggregate, have not been exuberant about stocks. Rather, they remain both hopeful for further price gains and observant of the potential downside risks.

This week’s drop in bullish sentiment comes as the S&P 500 has declined for three consecutive days. Though many individual investors continue to be encouraged by the market’s upward momentum, earnings growth and economic growth, others remain concerned about the pace of economic growth, elevated stock valuations and the lack of a long-term fiscal solution.

This week’s special question asked AAII members if they have changed their investment style because of the magnitude of the market’s gains this year. Slightly more than half of respondents (52%) said no, they have not made any significant changes. Approximately 35% of respondents said they did make a change, but there was no clear trend in the type of changes they made to their investment strategies. More than 14% of all respondents said they have increased their cash allocations. Four percent of respondents said they have bought more large-cap stocks and an equal proportion said they have bought more dividend-paying stocks.

» Take the sentiment survey