In an interesting deep value investing forum I follow one of the participants asked an interesting question:
“Most quant strategies produce a high turn-over. Can you point me to quant (value/quality) strategies with a very low turn-over and a holding time of more than 3 years?”
This is something I have given a lot of thought, mainly because of the 25% capital gains taxes (payable even if you hold the investment for only one day) here in Germany.
The following is the best strategy we have come up with, and is something I use myself.
Value effect works for 5 years
Does a quantitative value investing strategy work if you have a holding period of up to five years?
James Montier in a paper he wrote in September 2008 called Going global: Value investing without boundaries found that the value effect (undervalued companies outperforming the market) continued for up to 5 years.
It may even be longer but the paper only included results for a holding period up to five years.
He found that a quantitative value investing strategy worked, outperforming the market 12% in the third year followed by 8% in the fourth year, continuing in the fifth year.
You can read more in this article: Are you fishing in a pond that is just too small? Global value investing proven
This means that if you implement a deep value quantitative investment strategy you can easily hold the investments for up to 5 years.
The 80/20 principle of quantitative value investing
What strategy should you use, you may be thinking?
The 80/20 principle applied to quantitative value investing, that numerous researchers found, is to buy companies with a high Earnings Yield (EBIT to Enterprise Value).
It is because this simple ratio uses profs (EBIT) before interest and taxes. This allows you to compare companies worldwide with different interest rates as well as tax rates with one another.
Also, because it uses Enterprise Value which takes the capital structure (equity, debt and cash) of the company into consideration.
This is an even better strategy
An even better strategy, and one I prefer, is a valuation ranking system that uses a few valuation measures. You can read all about it here: This outperforms all other valuation ratios (14 year back test result)
You can use any value investing strategy
But you do not have to EBIT to Enterprise Value as long as you buy undervalued companies you can use any quantitative value strategy that has been proven to work over long periods of time and lets you sleep comfortably every night.
If you are looking for an investment strategy take a look at the best strategies we've tested here: Quant Investing best strategies
Be careful of low price to book value companies
That said I would be careful of a low price to book ratio strategy because of this research: Be careful of this time tested value ratio.
Make sure you limit your losses
As this is a quantitative strategy with you not doing a lot of research I suggest that you include a system to limit losses.
Use a trailing stop-loss system with a 20% limit that you look at once a month (not every day); this keeps your transactions costs low.
You can read more about this stop-loss system, as well as how to implement it, here: Truths about stop-losses that nobody wants to believe.
For those of you that do not like a price driven stop-loss system, here is a great suggestion by a friend and long-term subscriber to the screener.
Inspired by Warren Buffett
He said he got the idea from an article where Warren Buffett mentioned that he did not care what had happened to a company’s share price as long as operationally the company was still doing well.
Quantitative fundamental stop loss
So how can you easily find out if a company’s operations are deteriorating without doing a lot of research?
My friend does this by selling an investment if the company’s Piotroski F-Score falls below 5, replacing it with one of the best picks from his favoured screen.
Piotroski F-Score summarised
The Piotroski F-Score is calculated with the use of the following 9 ratios:
1. Return on assets (ROA)
2. Cash flow return on assets (CFROA)
3. Change in return on assets
4. Quality of earnings (accrual)
5. Change in gearing or leverage
6. Change in working capital (liquidity)
7. Change in shares in issue
8. Change in gross margin
9. Change in asset turnover
Good or high score = 8 or 9
Bad or low score = 0 or 1
You can read more about the Piotroski F-Score here: This academic can help you make better investment decisions – Piotroski F-Score
Why you should take a serious look at a stop-loss system
Whenever I bring up stop losses in a value forum it is always a hot topic of discussion.
But you must keep in mind that this is a quantitative value investing strategy where the whole idea is not to do a lot of research.
If you do a lot of research you can argue that the price is now even less than the intrinsic value of the company and the investment has become more attractive. But even this has not led to a lot of well-known value investors riding value trap companies all the way to the bottom.
I have also made this mistake, more than once, that's why I now like working with a stop-loss, especially with the quantitative part of my portfolio. And I have also started applying it to my value investing portfolio.
Psychological benefit of a stop-loss
The other benefit of a stop loss is psychological. Because it helps you avoid large losses you have less of “burned on the stove” problem of investing again after large losses.
If you theoretically think about investing this may not seem like a problem but it is very hard to get back into the market if you have lost 30% to 50% or even more of your capital.
Back testing this is not easy
I can unfortunately not give you any back tested results of this strategy because testing a stop-loss system is not easy.
To test it you have to monitor the portfolio on a monthly basis to see if the stop-loss has been reached and, once a position has been sold, you have to reinvest it in the same strategy. This means you don't just look at re-balancing the strategy on a yearly basis but you now have to do it monthly.
I have however extensively tested a low EBIT to Enterprise Value strategy against the world’s best value investors with surprising results.
Click the following link to read the full article: How a simple ratio beats the world’s best value funds.
Quant value investing strategy summarised
In summary this is what the long term Quant Value investing strategy looks like:
- Search for and invest in undervalued companies worldwide
- Use a 20% trailing stop-loss strategy OR
- Use a fundamental stop-loss with the Piotroski F-Score
- Hold investments for up to 5 years
- If an investment is sold because of the stop-loss or after five years invest the proceeds in new undervalued companies you have identified.
PS Everything you need to implement a quantitative investment strategy in your portfolio can be found here.