Alpha Architect On Reason, Evidence And Investing With Both Value And Momentum

Tim Melvin: We're on today with Wesley Gray of AlphaArchitect.com. Dr. Gray has written a couple of investment books. One of my favorite books of all time, he co-authored with Tobias Carlisle, that's "Quantitative Value." He just came out with The DIY Investor, which discusses the right way to manage your portfolio over your lifetime. Thanks for being on with us today, I really appreciate it. Allow us to pick your brain a little bit.

Wesley Gray: Sure, thanks for having me; I look forward to the conversation.

TM: I always thought of you as a value guy. You wrote a fantastic value investing book with Tobias that is on my "you-have-to-read-this-before-you-ever-buy-a-stock" list of books, right up there with "Intelligent Investor" and a few others. As I've tracked you over the years, and in the past few weeks, we've had a couple of conversations; you're not just a pure value guy are you?

WG: I'm not. Just from our discussions, face to face, I think we've had a similar path. I, like you, started off as a hardcore value person. I'll always be a value guy, because I'm wired to believe in that process, it's always made sense, from the minute I picked up "Intelligent Investor." But then over time, at some level, you've got to break away from the value religion and want to be an evidence-based investor. I got slammed with so much evidence with respect to momentum investing that it just became interesting, so I started looking at it myself. I think there are reasons why momentum works, and the reasons are literally the same reasons that value works. The anomaly is driven by behavior. So, I broke from the value religion and said, "Hey, I'm going to be in the religion of reason and evidence, which means I believe in value and momentum nowadays."

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TM: You expressed it great the other day; I may even have t-shirts made of the sentence that you used. You said, "Buy what's cheap, buy what's strong and forget the rest."

WG: Pretty much; that's what the evidence says. It's that easy.

TM: You've got those two little slices of value and momentum at either end of the market, and that's really where everybody should be focusing in.

WG: Exactly right. Of course, the downside is, when you focus in those areas, those strategies, like anything that works, they don't work all the time. It's really hard to be disciplined to follow them. But all the evidence is pretty clear. Buy cheap, buy strong. The rest is just a waste of time at some level if you're a long-horizon investor.

TM: That brings us to the next point. Most people, say they're in their 30s, maybe in their 20s, they've got money to invest. The first thing they do is turn to Wall Street. Good idea or bad idea?

WG: Bad idea if you don't know the incentives and the conflicts of interests of Wall Street. If you understand how the game is played, and you know how to use Wall Street to your advantage, it'll be a good idea. But for the people you're talking about, I would say that, in general, turning to Wall Street is a general bad idea. The first move should be, educate yourself, learn about the game, then go interact with Wall Street. Don't let them interact with you, because then they'll frame the discussion in a way that will be to their advantage, not to your own.

TM: You talk a lot in your book about using models and avoiding the stories. Can you expound on that? I was a broker for 20 years, and telling the story was the big deal. I worked for Shearson Lehman. They gave us scripts that had the story. So, can you talk about the difference? Why you need to not fall in love with the story?

WG: This is something that perplexed me for a long time, so I wrote this 30-page white paper where I summarize tons of studies over the past 70, 80 years where people actually look at the evidence on a simple question: How do experts, with all their stories and intuition and experience, perform relative to simple models?

And essentially, the expert hypothesis is this idea that experts are going to have more access to a lot more data. They've got their intuition, experience and they've got this qualitative edge. The assumption is that all of that stuff increases their forecast accuracy and therefore means that human experts can beat simple models.

The problem is, again, going back away from stories to evidence, all that additional data, more intuition, more experience does is increase your overconfidence in your forecast. But it doesn't actually increase your forecast ability. Of course, if you just have more overconfidence in a forecast, that's no better – that's going to lead to problems. That's just the summary of all that research.

Going back to stories and why we shouldn't believe them, well, we can look to pigeons. I don't know if you've ever read about the BF Skinner studies on pigeons where he's trying to understand the question "why do people believe in superstitions and stories so much?" He takes these pigeons and makes them hungry, puts them in a cage, and every five seconds, a piece of bird seed will pop out. A pigeon will, naturally, by randomness, kick to the left or kick to the right, see a piece of bird feed pop out. He's like, hmm, that's interesting. Keeps kicking left, right – bird seed pops out. All the sudden, these pigeons would randomly associate their action with the food, and they create a story – kick left, kick right and food pops out.

Then, what Skinner and his crew did is say, "Okay, let's try to de-train these pigeons out of their superstition." What they find is that, once a pigeon believes in a story or a framework, you can give them as much evidence as you possibly can, but it's incredibly difficult to break that.

That's why stories are so great from a sales perspective, because if you get someone believing in some train of thought, even if it's total bunk, it's so hard to un-train them, even if you overwhelm them with evidence. It's a very powerful cognitive bias. If you get wrapped in a story, there's basically no looking back, you're screwed. If someone wants to manipulate you with a story, you're going to get manipulated. Dangerous stuff.

TM: You used an example in the new book "DIY Investor" that was actually a favorite of Richard Feynmans: the cargo cult people of the South Pacific. Can you share that one? Because it's a great story and really makes the point.

WG: What happened is – and I want to clarify this story was David Foulke's find, not mine –I think it was World War II, but what they did is, the local Islanders see the American's come in…we're putting in all kinds of air bases, bringing a lot of support and resources to the natives, and we've got the war going, and all the sudden, we leave. Resources dry up. We're no longer there; no longer bringing them food and resources. They're like, hold on a second, it must have been the case that life was so good because we had all of those planes coming in here.

So what they did is they made up a mock airport with mock construction to make the planes come back, thinking that was the action that created the food and all the resources coming in, not the fact that we're at war out there and the United States is bringing in resources. People just associate incorrectly certain actions with reactions that are just not true. We do that all the time. That's why it's so important to always try to assess a correlation to understand the root cause and make sure it actually maps to the decision you're about to make.

TM: How do we avoid all these stories? Nobody tells stories better than Wall Street. I know that. I was a broker; I can still remember being a young broker, and I'll tell the story really quick. I was cold calling, because that was legal back in the days. They didn't arrest you for it. And I found a Dean Witter stock of the day. And, man, was the story good. A chain of day care centers, women going back into the workforce, the need for the two income family, the desperate search for equality. This was the greatest story in the history of the world, okay? This stock had to go to the moon.

I got everybody I knew to buy some, and then their earnings reports came out and they had insurance problems and somebody was touching people in places they weren't supposed to be touched…and the stock just exploded down. I think it fell 70 percent in an hour and a half or something. Great story, but the numbers didn't support it. So, how do we avoid the stories?

WG: There's two things you can do. One is, at all times, always focus on being an evidence-based investor. So, unless you understand the process and you can go back and ascertain whether there's any evidence that this thing works or not, that's stage 1.

Stage 2 is to never ever get overconfident in anything. Even though it's a heuristic, I would always put in a rule – no matter what the story says – "I am not going to invest over X in any single name." That could be 10 percent or 5 percent, or whatever it is. But yes, just be an evidenced-based investor and put in hard-coded rules that essentially prevent overconfidence and a belief in stories. Because, I've done it before. I've put 35 percent of my money in a story and gotten smoked out back before I became a humble quant. I've done it, and that's how I deal with it.

TM: You use models a lot too, don't you? Rules based, take the story and emotion out of the equation.

WG: 100 percent.

TM: We know momentum and value work. You're the only person I know who's a bigger geek than I am and probably reads more studies. By the way, folks, on his website, alphaarchitect.com, he's constantly posting academic studies and the results of various studies. It's a very open minded website. They cover a lot of stuff, even things that might not necessarily be in line with their core beliefs. So, it should be on your regular, I've have to check this website today. I think you can sign up and get the email, because I know I do. So, let's break it down. Let's look at what works in each segment of that right now. In value, what value strategies have you found that work over long periods of time?

WG: Sure. Just for context, to understand what universe we're talking about, when we do all of our research, we're focused on things that are tradable and liquid. Basically, what I'm saying is that all the things that I'm about to mention here don't look at micro caps and small caps or anything that could have an issue with liquidity.

Given that statement, Jack and I have written a paper where we run a horse race of every valuation metric that you could ever imagine, with the idea being, instead of us arguing whether low market-to-book stocks are better than low p/e stocks, or free cash flow yield is the answer, or maybe we should use enterprise value, look over eight years, the average earnings or whatever – let's just data mine at the outset and figure out what valuation metric has worked the best, historically. With computers these days, we can do that.

We looked at probably 1000 combinations of ways to assess "valuation." And when we data mined the entire CRSP database, what came out of it was actually ironic. We were actually expecting to find something that was super complex, but it turned out that enterprise multiples, or, perturbations on that concept, tend to be the most robust, at least from a data mining perspective, over the last 40 or 50 years.

A natural question is, okay, fine, we can go data mine anything, and that doesn't mean out of sample, or over the next 40 or 50 years enterprise multiples are going be the best. We even looked further in depth, which we haven't talked about this in any books or anything just because we haven't had time to publish it. But, we wanted to try to understand why might enterprise multiples are the most effective. One of our natural hypotheses from doing these trades and being in the business for a while is a feeling that private equity firms, a lot of times are the people that take your firm out if you're a public equity value investor, because they're like, "Wait a second, this is a really cheap public stock. Let's go buy it and take it private." And how do private equity folks look at the world? Well, they've got to buy the whole business, so they look at enterprise valuations and enterprise multiples.

What we thought is, listen, the reason these extremely cheap enterprise multiple firms maybe work better than extreme cheap, say, book to market firms, is because private equity folks are looking at enterprise multiples. Our hypothesis was that in the extreme decile of cheap firms based on enterprise multiples should have a higher propensity for private equity take out than there is among the highest decile of cheap book-to-market firms. Sure enough, after we ran the numbers and did the research, that actually is the case. So, we think enterprise multiples are empirically the best, most robust metric for a reason: Private equity is your natural outside option on a lot of these investments that you're undertaking.

TM: I noticed that you used EBIT instead of EBITDA. I assume your model showed it to be performing better. But I want to see if what a private equity guy told me one time rang true. He said, "You've got to use EBIT, not EBITDA, because the depreciation and amortization are going to very closely match your capex needed to maintain your asset base."

WG: Really, honestly, from a statistical standpoint, it'd be really hard to ascertain the difference between the two. But at the margin, yes, the EBIT/TEV metric is more effective than EBITDA/TEV. But honestly, if someone did EBITDA/TEV because that's the data you had, and you didn't want to get a Bloomberg or whatever, it's going to be 99 percent the same.

TM: So it's pretty close.

WG: Very close. Honestly, all these things are really close. What we're talking about is "at the margin" effects. Of course, "buy cheap stuff," as a general rule is fine.

TM: Now I'm going to ask you a very self-serving question. Let's say I don't need scale. I'm an individual. I have 500,000 in my IRA, 401k and assets, and I'm looking to fund up. Can I gain additional edge by using smaller, less liquid stocks in the value strategies?

WG: Definitely. I think you can, but you have to go in with eyes wide open that, implicitly, you're taking on some kind of a liquidity premium. So, clearly, if it's in an IRA that's going be taken out in 20, 30 years from now, and you've dealt also with the tax problem of having to rebalance every so often, yes, I think an individual can probably gain some edge there, because you can eat the liquidity premium, and, at the margin in those smaller names where all the best poker players aren't playing, you're going to find probably a little more inefficiency than you would in, say, large cap value.

TM: Let's go back to the enterprise values, because I used the word private equity mindset constantly when I'm talking and writing about the markets. Thinking like a private equity investor, using these enterprise value multiples, how has it worked over time?

WG: It's like all value strategies. They all work over time. But the devil is in the details, because when you look at them year-to-year, and especially on a relative basis to the S&P 500, which unfortunately is what a lot of people think as the relative benchmark, you're not going to win all the time. In fact, they're going to lose for extensive periods. So, it's just like any value strategy.

TM: You mean like right now?

WG: Yes, right now, exactly. Value over the last two or three years, especially in the past three or four months, especially small value, has gotten absolutely destroyed. But the poor results – in a sick twisted way – are actually what you want to see, because if a strategy works all the time and beats the pants off the market, everyone would start doing it. But that's not what we want. We want to be able to exploit our edge as an individual with long horizon, which is an ability to career risk. We're just going to have to deal with the short-term pain for long-term gain.

TM: One question you addressed in your book, but I have to ask it because you're about to play Myth Busters here: Does Warren Buffett, in fact, outperform Benjamin Graham by adding his more qualitative factors to the portfolio?

WG: Before I even make comments, I'll reference a few things that people should read. One is a paper called "Buffett's Alpha." The authors actually do a quantitative assessment of what Buffett's track record looks like, and what factors drive it. It's essentially cheap, high quality, low beta, with a strong emphasis on cheap. Warren Buffett, despite all the stories that he abandoned a Ben Graham "pure cheap" strategy, is a cheap stock investor. We've all heard the story that he bought Coca Cola at 25x PE, and that was a great "value investment" because it had quality and cheapness; but frankly, when you look at his entire record, it's pretty clear that he's primarily a cheap investor who adds a quality layer on that. So, he's still more Ben Graham than people want to believe.

From an empirical standpoint, the Graham Strategy of "buy cheap issues that everyone hates" and what Warren Buffett actually does, which is buy cheap stuff that everyone hates but make sure it's high quality, they're not too different. But in general, let's take the anecdote of what Warren Buffett does. He's not just a pure cheap investor like Ben Graham is. He's kind of cheap, but he wants to incorporate quality as a huge component of investments, so he can get, like, See's Candy, or Coca Cola or what have you.

That's fine if you're Warren Buffett, and you could pick those one or two names that, in theory, are able to stomp the market. But in general, if you're an evidence-based investor, you want to do what Graham says. Buy cheap stocks, period. Then, within cheap, at the margin, we can look for high quality versus low quality.

But what we don't want to do is, at the outset, weigh quality and cheapness on equal footing, because the quality of a company, in general, is a priced factor. And that makes a lot of sense. Everyone knows that Google is a great company. Everyone knows that Proctor and Gamble is probably not going bankrupt. So we've got to ask ourselves, "What's the edge in buying quality companies at the outset?" The answer is, there isn't one. Whereas, the edge is in the cheap, distressed things that everyone is throwing bananas at on CNBC every day. That's where you're going to have the edge. Not in quality, per se.

TM: I've always maintained that Warren's switch from a true Ben Graham style investor had much more to do with scale than anything else. He was too big to be messing around with the micro-cap companies. And the Phil Fisher story just made a really nice cover.

WG: Yes, that's also true. You got it. When you add in quality, two magical things happen: You gain scale and you lower career risk, because quality has less tracking error, or deviations from, say, the S&P 500. It's a great way to stay employed longer than just being a pure cheap stock value investor, which is deadly from a career perspective and has limited scalability.

TM: Everybody, even today, has the Coke story wrong. Because Coca Cola was in quite a state of turmoil when Warren started buying the stock in ‘90 and ‘91. He may have added on over the years at different prices, but it was actually a cheap stock when he was buying size.

WG: You got it. Perfect example is IBM in today's terms. That's a classic Buffett value stock. It's really cheap, and everyone hates it because they're going to get destroyed by Google, but it's also high quality from a quantitative perspective. It's really cheap and high quality, and Buffett is buying it. But I think Ben Graham would probably buy it too, because it's one of the cheapest securities in the market right now. Our quantitative value algorithm also agrees.

TM: Right. So, enterprise value is what we want to look for. We want to look for the lowest decile. Let's jump into momentum for now and talk about what the best momentum strategies are.

WG: Sure. In momentum, real high-level, what I'm talking about is what they call stock selection momentum, or, in academic parlance, cross-sectional momentum. We're going to rank a basket of securities on momentum, which is basically their past performance, and we want to buy those securities that have done really well relative to the other securities. That's really high level, the momentum that we're talking about here. It's not market timing momentum.

Within that, the classic, academic way of doing that is, we sort securities on their past 12-month cumulative returns, and we skip the first month, because the first month is what they call mean reverting. So, you just want to look at months two through 12. That's what everyone quotes as the momentum anomaly.

The question is, how do we improve on that in a robust way? Jack and I are actually writing a book about this. Really, after reverse engineering probably a hundred studies and thinking about it, it boils down to two elements. One, the path dependency of how you got your momentum. For example, if you have two stocks that are both up 100 percent, you could have a biotech that was wiggling along, that goes up 100 percent today because of an FDA approval. That would be jumpy momentum.

Then, you have another security that went up over 50 bips a day for the last 12 months. So these two stocks are both up 100 percent, and they're both classified as momentum stocks. However, how they got their momentum, it turns out, has everything to do with whether that momentum will continue into the future. That slow and steady momentum type stock, that IS the momentum anomaly, whereas those securities like that crazy biotech, they're basically priced efficiently. We want to focus on the path dependency of how a security achieves its momentum as the big muscle movement in momentum investing. It's kind of like cheapness in a value investing context.

The second big element, and this is really applicable in U.S. stocks, is seasonality. There's a thing in mutual fund land called window dressing, where a mutual fund manager, as sick as this sounds, every quarter and every year, they've got to post their book to the world, and they're going to send this out to all their clients. Well, when the clients look at their statements to see what's in their portfolio, they don't want to see the [less-than-ideal] stock that the manager actually bought that went down a lot, they want to see hot stocks. The managers want to flip into these high momentum, high performing stocks, so when they post their reports to clients they look good.

Anyways, that is related to momentum because momentum stocks, right at quarter ends, can have their best performance, where, when you look outside of quarter ends, the momentum effect is pretty mundane. It's basically not doing anything. Seasonality, or basically the timing of when you want to rebalance momentum, in an important element to consider when trying to exploit momentum.

To summarize, anyone who builds a momentum strategy, should consider path dependency, because that's a really big muscle movement, akin to, again, buying cheap in value. Then, the second movement out there – that's more marginal, but also important – is this seasonality component. An analogy in value would be using quality, given you're in the cheapest securities. Those are the two things, path dependency and seasonality.

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TM: How has it done over the years relative to the market and other strategies?

WG: Momentum strategies, just generically, have way more mojo than value. Let's say the market over the past 90 or 100 years has earned 9 or 10 percent a year. Maybe a deep value strategy is going to be in the 15, 16 range. These momentum strategies get upwards of 18, 19, 20 percent, but it's not a free lunch.

Momentum strategies are way more volatile than value strategies, and value strategies are more volatile than the generic market when you run them pretty concentrated. So it's a cost benefit analysis. You're going to have higher expected returns doing momentum trading, but you're going to get more volatility. From a risk-adjusted perspective, momentum is still a good bet, but it is going to be hair-raising. Obviously, it's important for people to know that if they're going to do hardcore momentum strategies.

TM: What I've noticed and all the momentum strategies, pure momentum, that I've looked at, is if the market gets toppy, be prepared to take a beating.

WG: Yes. This year is actually a perfect example. As you know, value has totally been destroyed. Momentum has actually done pretty well year-to-date. But, what people don't understand is, that looks good on paper, but how did it actually work in practice?

Well, momentum was really killing it up until June. It was up 10, 15 percent, However, momentum was totally destroyed in the last few months. On net, it's still up a few percentage points, and it's still doing better than the S&P. But living through that volatility in real time was not fun, because you were up 20 percent, and now you're only up a few points. Momentum is a different beast.

TM: We've got these two slices of the market. Everyone else is mucking around in the middle, telling stories and not really achieving their goals. We know most investors underperform, even the professionals. They're stuck in the middle, we're out here on the edges. Can we combine these two to gain any further advantage?

WG: You've got it. That's frankly where most of the magic happens. Value is a pretty reasonable strategy, but has a lot of vol. Momentum's a pretty reasonable strategy, but has a lot of vol. So combine the two religions. But most people won't do that because, most people are either value people or they're momentum people—they don't like to mix the two.

Well, it turns out, if you're a person that believes in evidence and wants to make money, combine the two things, because the two religions are opposite sides of the spectrum and they're not very correlated. When you pool them together, you get great diversification benefits. I think it's a great idea.

TM: So, 50 percent in a value strategy, 50 percent in a momentum strategy. How often do we want to rebalance these?

WG: Honestly, you don't need to do the rebalance too frequently because we always have to consider frictional costs and tax. I think once a year, you reassess and get value and momentum back in line so you don't end up being all-in momentum or all-in value. That's probably, for an individual investor, totally reasonable.

TM: You've got something in your book you call "robust asset allocation." Can you talk about that a little bit?

WG: Stepping back, "Quantitative Value" is a book about the following question: How do I exploit the value anomaly in a systematic way and make it the most effective approach possible? "DIY Financial Advisor" is answering a different question. At the outset, we say, listen, financial advice is too complex and not transparent at all. We can make it transparent and simple, and it'll be very effective in expectation.

Once we get through that and highlight that's the case, and people are like, "Oh yeah! Got it." Next, we outline a system that one could use as an application of these ideas of transparency and simplicity, and it's called robust asset allocation. It's really three pieces. The first piece is, how do we access global risk premiums in the simplest way possible? We borrow an idea from Meb Faber, who wrote this great book called "The Ivy Portfolio." He highlights that with five simple core asset classes – domestic equity, international equity, REITs, commodities and bonds – simply equal waiting that portfolio, annually rebalancing, we can recapture 90 to 95 percent of endowment returns. We can basically capture the world's returns. That's awesome, super simple, super easy, super low fee – great.

Step two is, how do we improve upon that without making it so complex that we're now back to being Wall Street again? Well, as we've been discussing here, within equities, there's pretty clear evidence that if you have horizon and you're not beholden to a lot of career risk, that value and momentum makes sense. Instead of doing domestic equity, international equity, we'll just pass and buy and hold Vanguard funds, maybe we should focus on tilting towards value and momentum equities within those exposures. If people believe in that, they can add that level of complication, simply replace passive equities with value momentum equities.

Then, finally, the third piece, which, again, dependent on what religion you're talking to, they could consider you a heretic, is market timing and trying to preserve capital using trend-following. This took me about five or six years to finally come around to, just because I came out of Chicago School, and I really respect the efficient market