Wes Gray, PhD and Jack Vogel, PhD run one of the more innovative finance shops out there, Alpha Architect. Alpha Architect specializes in certain investment strategies such as value and momentum, and they are also very prolific researchers and writers. After reading their most recent book, DIY Financial Advisor (written along with David Foulke), which discusses a lot of their investment ideas and strategies, I had the privilege of doing some Q&A with Jack:
Lawrence: Many investors evaluate a stock based on commonly used metrics such as the price-to-earnings (P/E) ratio or the price-to-book (P/B) ratio. However, you identify the EBIT/EV (earnings before interest and taxes divided by enterprise value) as perhaps the best way to identify value in a company’s shares. Can you explain a bit more why this is the case?
Alpha Architect: A few years ago, Wes and I decided to test which is the “best” valuation metric to use, and published a paper in the Journal of Portfolio Management on the topic. We tested 5 measures over a 40 year period: E/P (inverse of P/E), book-to-market (B/M), EBITDA/EV (similar to EBIT/EV), free cash flow over enterprise value (FCF/EV), and gross profits over enterprise value (GP/EV). We found that EBIT/EV and/or EBITDA/EV performed the best. Specifically, the CAGR [compound annual growth rate] spread between cheap and expensive firms was the largest using EBIT/EV over a 40 year period. Some follow-on internal research showed that cheap EBIT/EV firms have a higher propensity (relative to cheap P/E firms) to be bought out (through mergers and acquisitions), which may be a reason this measure works the best. A copy of the paper can be found here, and our blog can be found here.
Lawrence: It seems counter-intuitive, but you make a compelling case that economic growth is generally irrelevant to the returns an investor can expect to receive. Can you explain why there is generally a disconnect between economic growth and equity returns?
Alpha Architect: As you point out, Jay Ritter’s academic paper shows there is virtually no relationship between stock returns and GDP growth. However, investors (and the media) are so focused on the powerful narrative that GDP growth increases corporate profits, they forget to review the underlying theory or evidence sustaining this bogus theory. First, from a firm perspective, the only way a firm increases stockholder value is by investing firm capital in positive net present value projects. And it is unclear why strong economic growth will contribute to a firm’s ability to identify more, or higher yielding, investment projects in a competitive economy. In some cases, economic growth could make this more difficult. Some examples from the paper: U.S. railroad, auto, steel, and airline industries (after initial periods of growth and profitability), show that the returns on reinvested capital (instead of being paid out) proved to be low or even negative, destroying large amounts of shareholder value, despite being high growth industries.
Lawrence: In your book, you make a good case for both value and momentum investing. For a diversified investor, would you recommend these strategies as core positions or as secondary positions (perhaps <5% of an investor’s equity exposure)?
Alpha Architect: I think it depends on the investor’s goals and more importantly how often they tend to compare their returns to a passive index. We recommend two approaches:
Core-Satellite Approach: The Core-Satellite approach is fairly simple — for the “core” of the equity portfolio (let’s assume 80%), invest in passive index funds. For the “satellite” of the equity portfolio (the other 20%), invest in highly active ETFs.
One issue with going “all-in” on actively managed ETFs is that they tend to have a large tracking error around any given benchmark index. For some investors, tracking error can cause bad decisions — “I have underperformed over the past 3 months; I need to switch strategies!” So the core-satellite approach may be optimal here, as by construction a large part of the portfolio is allocated to passive index funds. This core-satellite approach will lower tracking error of the overall portfolio. If properly constructed, an advisor/investor can create a “smart-beta” portfolio by using the core-satellite approach. We talk about this here.
High-Conviction: The high-conviction approach is the approach we believe in as long-term investors. In this approach, the passive part of the portfolio does not exist, since it “diworsifies” expected performance. We believe that value and momentum are good long-term bets for active strategies. When building the active portfolio, it makes sense to combine strategies that tend to work well at different times.
Well, value investing sounds simple — buy the cheapest highest quality stocks. This makes sense, as we all like to find a good deal. However, this strategy can underperform for long periods of time. After 6 years of underperformance, are you really going to stick with the strategy? For most investors, the answer would be NO!
So, ideally we could find strategies that work well at different times, and then allocate 50% to each of the strategies. As shown here and here, value and momentum tend to work well at different times. We we recommend investing 50% in a highly active value ETF and 50% in a highly active momentum ETF if one chooses the “high-conviction” route. We recommend an equal allocation to ensure we get exposure to both value and momentum. Fancier methodologies are often used to allocate between value and momentum, but they risk destroying the benefit of combining value and momentum. For example, a model may say 100% value, or 0% momentum, or vice versa. However, while this fancy timing system may backtest [testing how the strategy would have performed retrospectively] better, it risks losing out on the portfolio benefits of combining value and momentum.
Lawrence: Your book, DIY Financial Advisor, gives the average investor plenty of actionable information. However, the data on the average investor returns are not very good; the last I’ve seen is that the average investor has earned returns about in line with inflation over the last 20 years or so, and this despite the fact that investing has never before been so easy or so cheap. A lot of this underperformance [see chart below] can be ascribed to poor investor behavior (e.g. buying high and selling low). What gives you hope that would-be DIY investors will be have better in the future?
Alpha Architect: You are right; bad behavior by investors can lead to ugly results. A great example of this was highlighted in the Wall Street Journal in 2009. Here is a quote from the story:
“Meet the decade’s best-performing U.S. diversified stock mutual fund: Ken Heebner’s $3.7 billion CGM Focus Fund, which rose more than 18% annually and outpaced its closest rival by more than three percentage points… Too bad investors weren’t around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30 , according to investment research firm Morningstar Inc.”
We hope that all investors, especially DIY investors, learn from the example above. At our firm we put a heavy emphasis on educating our clients so they understand the systems we use. In our education, we also highlight how our model (like all models) will underperform at some point. The hope is that when the model underperforms, investors will stick with the model, which is generally a good long-term bet.
Overall, we believe that educated investors who understand the strategy will have a higher probability of sticking with the strategy.