Sophocles – Meet The Investor That “Really” Beats The S&P 500 by Tim du Toit, Quant Investing
Did you beat the S&P 500 index over the past four years?
I didn’t, BUT I found someone that has.
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Since July 2012 to January 2016 he has managed to give his clients a total return of 113.97% (after all fees) which compares very well to the 52.03% that the S&P 500 (including dividends) returned over the same period.
Luckily he agreed to the following interview.
His name is Sophocles Sophocleous (name pronounced So.fo.clees) and is based in Cyprus, really following Warren Buffett’s advice of not being too close to the investment crowds.
Now on to the interview...
Q&A with Sophocles Sophocleous
How did you get started in investing?
Sophocles: I was fascinated with the financial markets and investing from a young age.
When I was 10 we moved to the island of Cyprus and at the age of 15 I wrote letters to the Wall Street Journal (WSJ), the New York Stock Exchange (NYSE), the Philadelphia Stock Exchange and a few others asking for any information they had.
They were kind enough to send me material. Most of it was way above my head but I enjoyed it all.
I remember first reading about options from the Philadelphia Stock Exchange material and thought how easy I would be able to strike it rich.
I started reading Business Week at the library and told my dad we should buy options on a Hong Kong company.
Of course we didn’t even have a stock broker account, let alone the money. In those days there probably weren’t any options on that company anyway.
Describe your personal investment approach and how it developed over time?
Sophocles: One day in 2011 while I was working for an Emerging Markets high-yield/distressed fund, I started looking at U.S. and other equities and it looked obvious to me that there was an opportunity.
The valuations were cheap and the catalysts were there.
Historically I made some great calls but was too frugal and conservative. As a result I never invested as much as I should have in those opportunities and I was out of the market for long stretches of time.
That is not an optimal approach because even if you make 50-100% but stay out of the market your return could end-up being sub-par.
I finally realized this and decided I needed to change my style.
The big question was how do I not only make a buck but also beat the market.
You already know that most fund managers underperform the market. Most of these guys are pretty smart, so I believe it’s naïve to think that any one of us is smarter than another.
Plus most of them are supported by a team of experienced analysts and expensive tools. How could I do better, as well as outperform the market?
The way I approached the problem was to start fresh by saying to myself, “Assume you know nothing”.
So I started from working from A to Z to find what was the most success approach to investing. From both academic and practitioner evidence we find that value investing produces the highest returns with lower than expected risk.
Most of the papers are all there and available for free to any investor. There is also a whole army of value managers who have become rich and famous with Warren Buffett being the most well-known.
All this was no surprise to me as I had always been a value investor, but the confirmation solidified it.
Describe your investment philosophy?
Sophocles: The problem with value investing today is that many people consider it fashionable or marketable and like to label themselves as value investors.
The crypto-growth guys love to use PEG to put a value spin on an investment. For example, “Yeah it’s got a P/E of 35x but analysts expect 40% growth”.
But what has history and research shown us? That is the basis of my philosophy. I don’t focus on hope but evidence. And evidence shows that analysts’ high growth expectations fail and that the market prices in too much growth.
As human beings it is easy to become emotionally involved and investors find themselves looking for ways to convince themselves to buy or hold on to a stock.
So I needed a philosophy that took care of this problem. During my research I stumbled upon “What Works on Wall Street”. In the book, James O’Shaughnessy shows the results from back testing different statistics and combinations of them.
That inspired me to spend thousands of hours creating and back testing models.
My conclusion was that practically any model that has a value focus will beat the market. This can branch out into a variety of combinations such as value-growth, value-dividends, etc.
So to find investment opportunities I use quantitative value models.
What I like about that is that it solves the problem of emotion. It’s either cheap, as given by the model or it isn’t. There is no middle ground.
Furthermore, you know that the model is based on solid theory and logic and the back tested results provide some emotional comfort.
I use variables that make logical sense and am leery of quantitative machine learning investing. Most of the time, machine learning is a just a sophisticated method of curve fitting that sounds great when you are marketing.
So as you may have understood, while I use investment models, but I do not believe in using them in an automated way.
Obviously we have to correct for data errors, and believe me there are plenty that can occur.
I remember contacting Bloomberg because their output for a $35 billion US listed company gave the wrong number of shares.
But as you know you can’t model everything away. So after generating a list of potential investments, from my model, I conduct qualitative analysis.
I try to understand the story and the reason behind the stock’s cheapness.
Because if a stock is cheap there is always a reason. Most of the time I pass on the opportunity and go on to the next stock on the list.
Every now and again a theme appears.
In 2012 to 2013, it was health care and I got involved in the sector heavily. This was followed by energy but I avoided the sector as I came to the conclusion that oil could fall much further. Now, retail stories are appearing and investors should take notice. Amazon is not going to close every brick & mortar store.
This qualitative analysis has helped improve performance versus running the models in an automated fashion.
What are your ideas concerning portfolio composition and the value of individual holdings in relation to the portfolio?
Sophocles: The problem with the majority of investors is that they ask the wrong question?
Everyone is looking for the next home run.
Each individual stock doesn’t matter; it is the portfolio that matters. You have to be able to be able to answer there questions:
- What is your portfolio’s philosophy and strategy?
- Is it based on a solid foundation?
- Does each holding meet the strategy’s criteria?
It is the philosophy and strategy of the portfolio that we determine the returns and not vice versa.
Some stocks will go up and some will go down, you will be both right and wrong but if the portfolio has a solid foundation then there is little to fear.
Can you describe your top investing mistakes and what you've learned from them?
Sophocles: One thing I love about this business is that you are constantly learning and improving.
The learning never ends.
One thing I learned early on was to let some of your position ride.
I bought some hhgregg Inc. (HGG) at $6 and the stock rose to $11. Along the way I took profit and sold the position at $11. A higher valuation made no sense to me. But the market doesn’t work that way. The technicals were still strong but I ignored them. I was out as it rose to $18+.
So the lesson here is to take some profit but let some of your position ride.
Another mistake was on a short position I wanted to do on Plug Power Inc. (PLUG).
I couldn’t put on an outright short due to lack of shares or an insane borrow rate – I can’t remember precisely which one it was or both. So I decided to put on a small position in puts. I was so convinced the stock would drop. It actually dropped in half, but I lost money on my put position because it was too short dated.
There were two lessons here.
The obvious one being that regardless of story the market can be irrational for longer than we think and secondly, to pass over opportunities where you can’t put on the position you wanted to (in this case outright short).
There is always another opportunity around the corner.
How concentrated is your portfolio? Do you follow any key risk-management guidelines in managing your portfolio?
Sophocles: I believe that only through a concentrated portfolio can an investor achieve superior returns.
Both academic and practitioner evidence supports this.
Statistically you pretty much achieved almost maximum diversification benefit at 20 names, and even as few as 10-12 names can be enough.
That is also supported by the Oracle of Omaha himself, Warren Buffett.
Recent academic research showed that active fund managers are a lot better at picking stocks than people think. The problem is that their best ideas get diluted from holding too many stocks.
This happens for a variety of reasons. For example, the size of the fund may be too big or their mandate requires them to do so.
Personally I have around 20 names in my portfolio. Diversification has done more damage than good to portfolio returns.
Don’t get me wrong, you need some diversification but holding hundreds of names like most funds do just dilutes return.
You can only have so many good stocks/stories. The rest is filler.
If you have 1% in a stock and it doubles then it will make little difference, but if you have 5% then it’s a different story. This doesn’t mean more risk. Historically my portfolio has a beta (volatility) of less than 1 (less than the market) despite its concentration and value approach.
On risk management, I will take a directional bet on a sector via investing in more than one stock but at the same time I will keep this percentage below 20%.
I did this with health care. I had positions in Anthem (ex-Wellpoint), Humana, Aetna and some Cigna at one point, but as the stocks went up I took profits and kept the overall sector weight at 15 to 17%.
Recently with the drop in oil and commodities, I went to underweight in stocks that were directly and indirectly affected.
And while I believe in a concentrated portfolio, I do keep my largest holding at or below 10% to reduce potential volatility and risk.
What is your view on the use of stop-loss strategies?
Sophocles: Stop loss strategies are a must when holding short positions, because the loss is unlimited.
You see on the short side, I’m usually involved in some overvalued growth story and the stock can have a fanatical following because of the belief in what the company could become.
The stop loss levels should be based on market activity rather than a random percentage.
On the long side I have a different view.
If the story has not changed then I will not exit a position, although I may reduce my investment based on market activity.
You need to constantly monitor the story and try to understand what is going on.
Usually something is happening that pushes the stock down. It could be an earnings miss, a change in outlook, or industry-wide consequence.
Depending on what is happening you need to judge whether it justifies reducing or exiting the position or even in some cases buying more.
What do you think of short selling?
Sophocles: Essential for surviving in weak markets.
I believe an investor can enhance returns by focusing on the long side in bull markets, however when markets go down, the inclusion of shorts helps significantly.
My view is that you need to monitor both fundamentals and technicals to reach a conclusion on where the market is, because an expensive market can always get more expensive and a cheap market cheaper.
Once both fundamentals and technicals turn bearish, a market neutral strategy should be considered.
In 2015, I did some new research on the short side where I found that combing valuation with “red flags” enhances the returns from shorts while reducing risk. As a result I launched a market neutral strategy in addition to my current flagship strategy.
What is your 80/20 investment strategy or principle? (The most important 20% you must do to get 80% of the highest investment returns)
Sophocles: Focus on valuation and understand the most important drivers of the story without missing the forest for the trees.
Investors (including myself) can sometimes get trapped into spending a lot of time nit-picking on a few minor issues and miss the big picture.
Anything else you would like to mention?
Sophocles: Value investors are having a rough time as momentum stocks have outperformed recently.
I’d like to tell my fellow value investors to stick to their guns. Remember that back in 1999, Barron’s said that “Buffett may be losing his touch”, and we all know what happened.
Sophocles, thanks for your time
Your interviewing analyst
Tim du Toit