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Wednesday, March 30, 2011

Where Should the Enterprising Investor Focus These Days?

In my book "Ben Graham Was a Quant; Raising the IQ of the Intelligent Investor" in Chapter 8, I state that if Ben Graham was an active investor today, his recipe for success would probably include some other pertinent factors we should include or consider in the wake of our current economy being dominated by financial companies and the service-based sector.  Similarly, in Chapter 6, I state that “empiricism suggests the main drivers of stock returns are often market trading forces more than underlying business financials, especially in down markets when fear is leading the investment decisions rather than fundamentals.” 

Well, what I believe is probably most important to add at this time is leverage or quality ratios.  The flight from leverage in 2008 was really extreme and you saw the bounce back in 09.  Most quant models in practice, especially when predicated on regression back-tests favor value and quality (not value or quality).  Hence most traditional value investor’s holdings typically are also of higher quality and they didn’t participate in the 09 performance rebound (as much) unless they were “value only” investors of which few are.  The “value and quality” paradigm exists because value factors are so intrinsically implemented in the most quant models directly but quality simply because of its correlation with out-performance.  That is, in the cross-section of returns, those that out-perform most through time are those that tend to get the capital structure most right and those not highly leveraged are found in the top fractiles.

Secondly, Credit Default Swaps came out in 1998 I believe, and capital structure arb player Hedge Funds’s started shortly thereafter.  That has meant a slow but steady increase in correlation between the corporate bond market and equities.  Thus, it seems to me that a prescient activity for fundamental equity investors should involve getting a better understanding of the underlying debt/asset ratios and look for value predicated on the intrinsic value of the equity.  Cutting on these factors may not identify buy candidates but they will identify candidate stocks to avoid.

Now in down markets when fear is leading the charge of influence of stock return, stocks disconnect from fundamentals.  Thus, buying low volatility (low g-Factor, low Beta) stocks when the VIX is increasing is a good strategy, as long as you sell them and buy high vol (high g-Factor, high Beta) stocks when the VIX is decreasing.  Thus, working with incorporating volatility into your strategy can pay dividends when minor ELE events are happening.  I believe in addition to paying attention to the corporate debt side of the equation, a lot can be garnered by studying the implied vol of a company’s option chain.  That gives the trader’s view of where the stock is going.

In terms of their weighting?   That’s difficult to say a bit unless one spends some time modeling the factors you uncover along these lines relevant to return.  Each investor must determine that for themselves.

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