Dr. Wesley Gray on Quants, Irrationality, and The Marines

This is a Q&A with the author of the recent book Quantitative Value, Wes Gray. Dr. Gray is a member of the SumZero community and his bio follows:

WESLEY R. GRAY, Ph.D., is the founder and Executive Managing Member of Empiritrage, LLC, an SEC-Registered Investment Advisor, and Turnkey Analyst, LLC, a firm dedicated to educating and sharing quantitative investment techniques to the general public. He is also an Assistant Professor of Finance at Drexel University’s LeBow College of Business, where his research focus is on value investing and behavioral finance. Dr. Gray’s professional and leadership experiences include over fourteen years building systematic trading systems and trading special situations, and four years of service as an active-duty U.S. Marine Corps ground intelligence officer (Captain) in Iraq and various posts in Asia. Dr. Gray earned an MBA and a Ph.D. in finance from the University of Chicago Booth School of Business. He graduated magna cum laude with a BS in economics from The Wharton School, University of Pennsylvania.

Nicholas Kapur, SumZero: Wes, thanks for joining us for this Q&A. Your new book, Quantitative Value, is about reducing subjectivity in the value investing process. Let’s begin with that.

Wes Gray: Nick, thanks for the invite. I’ve been a SumZero user since the very founding, conducted research on the value of the users’ recommendations, and simply love what you guys are doing. I’m a huge fan and am honored to be here. Also, I would like to point out at the outset that the book is a joint venture with Toby Carlisle. Our partnership was fairly transparent: I provided the good looks, he provided the content.

So yes, the book…Stepping back a bit, ask yourself, “What makes a good investor?” We’ve all heard Warren Buffett’s pitch: buy firms below their intrinsic value. Heck, Buffett even spells out his purchase criteria. Is a simple set of criteria all it takes? Probably not. It is unlikely that Buffett’s value-add is his ability to read SEC documents faster than the rest of us and proclaim that he wants to purchase cash-generating firms at a good price. His economic moat is his ability to think like a computer--calculated, hyper-rational, and without emotion. Paradoxically, the world’s greatest investor spells out his edge (ability to act without emotions bungling the outcome) in his 1987 Chairman’s Letter, and simultaneously heckles the use of computer programs (systems that ensure emotions can’t bungle the outcome) in the investment process:

[..."In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace."]

In the end, we simultaneously agree and disagree with Buffett. We agree that successful investing requires one to be completely rational and objective, but we disagree that computers are a poor tool to facilitate rational behavior for us mere mortals that suffer from innate bias on a daily basis.

Nicholas Kapur: You have an interesting (awesome) background. How’d you get into investing to start with? And then, what turned you to the dark-side, aka, quant?

Wes Gray: My late grandmother was a hardcore Graham/Buffett fan and she gave me two books for my fifteenth birthday: The Intelligent Investor and Buffetology. I spent the next ten years enamored of the idea that I could simply “do my homework,” be disciplined, and become fabulously wealthy. I raised $250,000 while I was an undergrad at Wharton and started a little LP. We were just coming out of the Internet bubble, and small-cap value stocks were on fire. Ben Graham net-nets were falling into my lap, we were making huge returns, and I thought I was a hero.

Then, in 2002 I entered the PhD program in finance at the University of Chicago. Eugene Fama and Dick Thaler -- an odd combo -- both advised my research. My early experiences at Chicago really made me think hard about market efficiency and behavioral finance. In 2004, I passed my PhD comprehensive exams, but I wasn’t happy. I was burnt out on finance. Competing with my finance PhD peers, who all seemed to be Russian and Chinese mathematics champions, was humbling and utterly exhausting. I needed a change. I decided to join the Marines. Crazy idea, but what the hell?

While serving, I had the opportunity to live and operate in many countries: Japan, Iraq, Philippines, etc. I learned a lot about human behavior and how organizations operate. My experiences in the military, and the Iraq war in general, left me with enough empirical evidence to proclaim without a shadow of a doubt that humans--to include myself--are diseased with irrational decision-making skills.

After the Marines, I returned to my PhD program with vigor for finance like no other. Human behavior was fascinating, quantitative tools were fascinating, and not getting shot at was fascinating--it was a brand new lease on life.

Nicholas Kapur: Hah. Can’t say my immediate reaction to war would be to go ‘quant’, but there you go. You recently led an exhaustive analysis on the SumZero community itself and some of the unusual outperformance we are seeing within it. Did this work have any impact on the work you did on Quantitative Value?

Wes Gray: We conducted a large-scale examination of ideas submitted to SumZero (http://goo.gl/IhNNg), ran them through the academic “empirical torture chamber” and found that, on average, the recommendations on SumZero add value. The effects are especially pronounced in smaller firms, where the market is presumably less efficient. Having read every submission submitted to SumZero, I was able to garner a sense for how successful buy-side analysts conduct their analysis. Many of the tools, techniques, and procedures identified in SumZero reports ended up being incorporated into the Quantitative Value system.

Nicholas Kapur: So with all this knowledge, please enlighten us: What are the metrics that really matter when it comes to value investing?

Wes Gray: Ben Graham was way ahead of his time. In the end, the key driver for returns is price--cigar-butts, garbage-bin buys, Mr. Market’s lost children--whatever you want to call them, the empirical evidence is clear: cheapness matters. Let me be clear, by “cheapness” I am strictly talking about price alone, regardless of quality. Think trash stocks with P/Es of less than 5--I’m not referring to very high quality firms that look undervalued at 20. This statement contradicts the wisdom of Warren Buffett’s advice to purchase “wonderful companies at a fair price,” or Joel Greenblatt’s elegant “Magic Formula” concept of combining price and quality into a single metric that spits out great investments across the cheapness spectrum.

Our research shows that returns drop the minute one ventures into high-price firms. Warren Buffett is a clear exception to this empirical finding, but let’s be honest, none of us is Warren Buffett. The data also suggest that the Magic Formula system is a flawed framework, because it equally weights quality and price aspects. In many instances, investors weighing quality and price equally are sometimes “forced” to pay a high price for an asset that is considered very high quality.

At the face of it, paying higher prices for higher quality makes sense, but empirically, this simply detracts from performance. The same flaw is found in investment firms that require specific exposures to certain industries: in some industries, the cheapest firm is actually expensive on an absolute price basis. In the end, any system or searching algorithm that doesn’t focus on cheapness at the outset, will suffer, on average. I know this is potentially a controversial claim to many value investors, but what I’ve stated is not a hypothesis, it is an empirical fact. Moreover, as we point out in the book, it is not the case that quality does not matter, however, it IS the case that price matters a heck of a lot more. In summary, if one is trying to design an effective search algorithm they are best served by screening on an absolute price metric first, and then focusing on the identification of the highest quality assets within the garbage heap of the cheapest stocks. Our book is dedicated to cooking up the most effective search algorithm.

Nicholas Kapur: Fascinating. You also identify “5 Signals” that the smart money sends to the market when good opportunities are available. Please elaborate.

Wes Gray: One aspect of our quantitative value algorithm is incorporating “smart money” signals in the marketplace. The five signals we highlight in the book will be very familiar with your audience:

*Stock buybacks and Issuances
*Insider Trades
*Activist Investor Tracking (13D)
*Legendary Investor Tracking (13G)
*Short Interest

These signals have significant potential to enhance returns. For example, if a searching algorithm identifies that XYZ Corp. is the highest quality stock among a bucket of really cheap stocks, we know at the outset that, on average, this firm will generate high risk-adjusted returns. But we might be especially interested in this stock if the firm is buying back stock, management is buying, Bill Ackman owns it, Warren Buffet owns it, and short interest is at 0%.

Nicholas Kapur: So, using your toolset, what opportunities are looking especially ripe right now in the market?

Wes Gray: I had one of our associates run a fresh screen yesterday--so this is hot off the press. There are a lot of interesting names popping up in the algorithm. Some names of the names that pop up at first seem to be in the “why in the world would anyone own that” bin: Dell (Nasdaq: DELL), Devry (NYSE: DV), and Gamestop (NYSE: GME).

But other entrants were surprising to me, in the sense that they jump out at me as top-tier firms: Apple (Nasdaq: AAPL), Lockheed Martin (NYSE: LMT), and Guess (NYSE: GES). Now, before anyone automatically adds Apple, Lockheed and Guess and disregards Dell, Devry, and Gamestop, remember that the true contrarian is not the investor who buys the perceived high-quality value stocks, but the investor who buys the value stocks that all the value guys are shorting! In the end, as a quant, I would buy all the names and hold them as a basket.

Nicholas Kapur: Thanks, Wes. We’ll leave it at that. Appreciate you taking the time to speak with us and best of luck with the book.

Check Out Quantitative Value Right Here