What is Quantitative Value Investing? How it Works, Pros and Cons

Quantitative-Value-Investing
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When you want to make an investment in a company, industry, or organization, analyzing the data you get from them is important. However, there are diverse ways of analyzing this data and quantitative value investing is one of them.

new study in the CFA’s Financial Journal showed the underperformance/diminishing alpha of stocks chosen purely based on their quantitative value and this explains why value factors taken alone aren’t great indicators.

So, while this article will basically focus on explaining the concept of quantitative value investing, you will get to learn the pros and cons involved in this investment strategy so you know when to use them.

What is Quantitative Value Investing?

According to Wikipedia, Quantitative value investing also known as Systematic value investing is value investing that analyzes fundamental data such as financial statement line items, economic data, and unstructured data in a rigorous and systematic manner.

Practitioners often employ quantitative applications such as statistical/empirical finance or mathematical finance, behavioral finance, natural language processing, and machine learning.

Benjamin Graham and David Dodd were the two professionals who introduced this financial concept through their book “Security Analysis”. It came as a substitute for the traditional form of financial computing by eliminating biases that lead to poor investment indecisions in any market.

How Does Quantitative Value Investing Work?

This form of investing takes many shapes as individuals can tailor it to their own specifications.

Joel Greenblatt‘s magic formula investing is a simple example of a quantitative value investing strategy and this investing formula encourages you to purchase cheap stocks from about 30 “working companies” with a high return on capital and great earnings yield.

He created a book to support his theory which he titled “The Little Book that Beats the Market” and he claims the theories in his book have yielded him a 17-year annual return of 30.8%.

The quantitative value investing school of thought works when you;

  • Build a strategy
  • Test the strategy
  • Follow your strategy

I get that sounds somewhat universal, so I will quickly break it down so you can get a concrete understanding of the subject at hand.

Build a Strategy

Building a strategy has to deal with two core aspects; risk framework and stock selection method.

In risk framework, you diversify portfolio and rebalance methodology. You select your stocks by using a great ranking system that focuses on the companies you’re interested in.

In stock selection method, you rank the market and set your buying/selling rules. After you’ve created these rules using results from your analysis,, they become a guiding rule for you and other throughout your investment time frame.

Test the Strategy

Building a strategy is a good start, however, testing the effectiveness of any strategy is tested by its workability. Test this your new formula on about six markets and the results will help you identify the strengths and flaws.

Follow your strategy

In building your strategy, introducing a way to track your stocks entering and leaving your portfolio is a necessity. A good strategy would be to introduce a tracker that gives you an update on daily market movements while giving you an opportunity to compare all performances.

Conclusively, following the magic formula investing model, QVI demands you:

  • Establish a minimum market capitalization (usually greater than $50 million).
  • Exclude utility and financial stocks.
  • Exclude foreign companies (American Depositary Receipts).
  • Determine the company’s earnings yield = EBIT / enterprise value.
  • Determine company’s return on capital = EBIT / (net fixed assets + working capital).
  • Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  • Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
  • Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  • Continue over a long-term (5–10+ year) period.

Quantitative Value Investing |Pros & Cons

As a system of investment, there are always pros and cons you will see. In QVI, some of these pros and cons include:

ProsCons
Lower volatilityBulging number of incorrect data
Unemotional InvestingInability to measure qualitative aspects
Improves Market DisciplineStocks can get undervalued
Diversification and Asset Allocation

Conclusion

In investing, there’s no one strategy or method to success, however, there are great hacks that can help you starve against loss of every kind while building your profit at a marginal level.

Leveraging quantitative value investing is important when building your portfolio, it has a system that helps you keep track of your securities and you get alerted about huge shakes in the market on the go.

References

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