How to Be Active?

On November 9th, the CFA NY Society and Harding Loevner cosponsored an event at HL’s corporate offices entitled How to be Active?

The format was a roundtable discussion of roughly 40 participants with Tim Kubarych of Harding Loevner moderating.  After the predetermined questions were exhausted, the debate grew organically before the event concluded with a reception to allow for smaller scale discussions.  Chatham house rules were in effect.

DISCLAIMER: These statements do not represent the views of CFANY or Harding Loevner.

Investment Approach

What’s the rationale for your Investment Process?

The bottom-up fundamental research can generate about 2-5% annually of outperformance.  Rational, educated effort combined with some skill of an analyst can provide outperformance relative to a benchmark.  This task involves a basic understanding of the company, the industry, and then a reasonable approach to valuation. The need to make difficult decisions and avoid emotions from clouding your judgment is of paramount importance.  If you’re skillful, you may be right roughly 55% of the time.  You can’t assume that any single decision will be right given that ratio, but you can build a process around people that are more often right than not.

Organizations sometimes have poorly designed incentive structures that can lead analysts to highlight a suboptimal subset of their ideas.

Our Quantamental investment approach is active, concentrated and fundamental. Most succinctly defined, we are rules based.  Security selection follows a sequence of rules to filter out stocks that have characteristics of quality, growth and momentum.  We don’t think we can pick the best stocks, but attempt to create filtering rules that on average produce an outperforming portfolio.
Is a quantitative approach inherently backward looking?

As factor investors, we don’t project future cash values.  The underlying assumption is to take bets on securities that have a “value” or “momentum” style.  If you have stocks with specific characteristics, you can capture those style premia.

Do you trust your data? What about accounting gimmicks applied by companies?

One way to avoid worrying about data is through portfolio construction. You can equal weight the portfolio because you admit that you just don’t know.  There’s evidence that you can add some incremental value above standard Fama French factors.  Our research shows that broad factor exposures are more important than optimizing within a factor. There’s little benefit to refining within a characteristic. If you look at EV/EBITDA, you don’t get much of an advantage to adjusting that EBITDA yourself.  Error terms average out.

Are quantitative ranking systems worth refining for fundamental investors?

Occasionally we combine quantitative methods with fundamental signals.  However, there’s too much promising data of our fundamental analyst approach for our firm to move away from our process.  Also, there is considerable market cyclicality to style.  The bottom-up approach hasn’t failed us. If you’re dependend heavily on a particular style, it may work well over time, but introduces a cost of higher Tracking Error.

Considerations of the Investment Time Horizon                    

Asset Allocation and Factor Selection.

It’s rare to do factor timing when doing bottom-up stock selection only. Most people invest for a year. As you move out on the horizon scale, mean reversion happens with different periodicity depending on what you are talking about.  You can have regions/industries at the 3-5 year scale, or asset classes at 7-10 years. You could partially mitigate this by being diversified within a product.  You must ask the question: what are the natural time scales of what you’re investing in?

Time Horizon of your Investment Process?

There’s a balance between how often you update/rebalance your portfolio and the trade implementation costs. More updated data can achieve better factors, but you incur trading costs and those of market impact. You have to review estimated trading costs and make a cost/benefit analysis when you are looking to rebalance your portfolio. We operate a market neutral Hedge Fund and look for signals that are not quickly erased by competition. Some sources are common – like value/growth – but others are more nuanced and esoteric. We always need to evaluate whether signals still work.  Also, we only invest in mis-pricings that are bound by economic principles, while monitoring price movements and questioning the magnitude.

So much money in the past 5 years has flowed into quantitative strategies.  How does that affect your ability to generate alpha? Do you have to be quicker?

One has to identify the time scale that fits with the investment resources; be humble and recognize where others have a competitive advantage. Also, one must be skeptical about how long a certain advantage can last in a given area.

Are fundamental investors at a disadvantage by not using “big data”?

In theory, a democratic 3rd party research budget allows analysts to self-select what’s most important to them. To be long-term fundamental investors, it’s more proper to focus on slower frequency signals. Ayn Rand provides an allegory in the Fountain Head: “Sound perception of an ant does not include thunder”.  Daily news is noise to long-term investors, but could be a signal to other market participants also. Industry seems to be moving to shorter-term signals, which leaves less competition for longer-term-wave-length-type investors.