In the coming weeks I will spend some time discussing parts of the book Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Wesley Gray and Tobias Carlisle (2013). Many elements in the book already have been discussed on this website. Since investors invariably fall victim to the same behavioral mistakes I am convinced it makes for a good exercise to go through the most important parts of the book.

One of the four pillars of this website is Old-School Value Investing: Psychology. The pillar emphasises the critical role of psychological factors in our investment decision processes. Remember: “Intelligent investing is a mental approach.” As part of this pillar we referred to the example given by Joel Greenblatt (2011) in his book The Big Secret for the Small Investor. Greenblatt indicates that the best mutual fund over the 2000-2009 period realised an annual return of +18%. Yet the average investor in this fund lost 11% annually. On page 23 of the book by Gray and Carlisle we find some further details about this example. In 2007 the concerned fund surged 80%. Investors subsequently poured in $2.6 billion. In 2008 – the year of the so-called Great Recession – the fund sank almost 50%, which is not abnormal considering the stock market crash in 2008 and the beginning of 2009. Investors pulled out more than $750 million. Said Heebner, fund manager, gave the following comment:

A huge amount of money came in right when the performance of the fund was at a peak. I don’t know what to say about that. We don’t have any control over what investors do.

Seth Klarman’s 2021 Letter: Baupost’s “Never-Ending” Hunt For Information

Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More

In other words the average investor in the fund has consistently bought on high levels and sold on low levels. We all know that this is the perfect road to extremely low or subpar investment returns. Nevertheless investors keep making the same mistakes.

Let’s reflect for a moment on the irrational behavior of the investors. At the end of 2007 the investors who entered the fund clearly believed that the investment manager would be able to repeat the strong performance (+80% in 2007) in subsequent years. They also – most likely implicitly – assumed that the assets selected by the fund manager would continue their extraordinary performance without fully realising that the valuation of those same assets had experienced a dramatic increase, the result of which were significantly lower expected future returns. In 2008 investors left the fund believing that the return of minus 48% was representative for the future. At the same time they did not realise that the assets in the investment fund could be bought at a discount of almost 50% compared to the beginning of 2008.

The graph below shows the performance of value investing in emerging Asia over the 1995-2012 period. Over this period investors in Asian value stocks realise a compound annual return of 17.1% (before transaction costs), consistent with the results of quantitative value investing in other parts of the world over a sufficiently long period of time. Nevertheless, the period was very turbulent with subpar investment returns for the 1995-2000 and 2007-2011 periods. The graph clearly shows – consistent with other studies – that value investing requires the adoption of a long-term time horizon, implying that the approach is definitely not suited for all investors. This point was also made by Benjamin Graham (1976) in one of his latest interviews (emphasis added):

The investor needs the patience to apply these simple criteria consistently over a long enough stretch so that the statistical probabilities will operate in his favor.


The above example illustrates that investors focus on completely irrelevant aspects when making investment decisions. They focus on past returns and/or price movements as the critical and almost only factor in their investment decisions, which Benjamin Graham (1949) warned us about in The Intelligent Investor In this seminal work we find at least three warnings in relation to this issue (emphasis added):

The third form of endeavor – the famous buy-cheap-sell-dear principle commonly ascribed to the original Rothschild – may seem at first blush to be only a special case of trading in the market. Actually it differs in a fundamental sense from what we have just been discussing, because this approach lays its first emphasis on value received rather than on the expected next movement of the market.

By shifting his emphasis from price movements as such to their effect on the level of values the investor can retain his original and proper status as the buyer of sound securities and at the same time react intelligently to the recurrent fluctuations of the stock market.

He must deal in values, not in price movements. He must be relatively immune to optimism or pessimism and impervious to business or stock-market forecasts. In a word, he must be psychologically prepared to be a true investor and not a speculator masquerading as an investor. If he can meet this test, he will be a member not of the public at large but of a specialized and self-disciplined group.

The example above clearly illustrates that investors’ investment decisions mainly are influenced by price movements, not by the underlying valuations. Otherwise they would show the opposite behavior, they would buy at low valuations and/or sell at high valuations. Is there a way out of the problem? Yes, we are convinced there is, and the answer is provided by Benjamin Graham in the above statements – a systematic focus on value rather than price movements.

Value investors should build a systematic investment system around focusing on value. The need for a quantitative system is summarised by Gray and Carlisle in their book as follows:

The power of quantitative investing is in its relentless exploitation of edges. The objective nature of the quantitative process acts both as a shield and a sword. As a shield, it serves to protect us from our own cognitive biases. We can also use it as a sword to exploit behavioral errors made by others. It can give us the confidence to sit down at the poker table and know we’re not the patsy.

The investment system should consist of at least the following elements:
(a)    a quantitative stock selection model with a focus on value and safety, consistent with the investment philosophy of Benjamin Graham and with a solid and proven historical track record;
(b)    a system of rules in order to determine when additional investments will be made.

Part (b) of the investment system forces investors to consider value investing as a long-term savings plan instead of a one-time (hopefully lucky shot) investment. This point will be elaborated on in a later article.

As regards part (a) the book of Gray and Carlisle can help investors developing their own quantitative value investment methodology. In Value Investing: Tools and Techniques for Intelligent Investment, James Montier (2009) distinguishes three types of fundamental risks: valuation risk, business risk and financial risk. In Quantitative Value by Gray and Carlisle valuation risk is dealt with in Chapters 7, 8 and 11. Business risk is treated in Chapters 5 and 8. Financial risk is considered in Chapter 3 with the PROBM-score, in Chapter 4 with the Altman Z-score and the score developed by Campbell et al. (2008), and in Chapter 6 with the F-SCORE measure developed by Piotroski. I’m convinced that most investors need some further assistance in selecting their own quantitative value investing methodology. As a consequence, in the next contributions I will spend some time discussing the various quantitative chapters of the book.

By Steven De Klerck

Updated on

No posts to display