By Jack Forehand (@practicalquant) —
Within the past year, I have been fortunate to interview some of the smartest minds that I know in investing for our Five Questions series. I was able to talk to Alpha Architect founder Wes Gray about quantitative value investing. I talked Daniel Crosby about behavior in investing. I spoke to Ben Hunt about how things have changed in the market and why we may not be able to rely on past data as much as we used to. I was even to able to spend ninety minutes talking to Jim O’Shaughnessy for the two-part interview we began publishing this week.
When you talk to investors of this caliber, there are many similarities you notice right away. They all rely on evidence to make their decisions. Their opinions are all well thought out. And they all recognize that despite their wealth of knowledge, they still have a lot to learn.
There is also another thing you notice when you interview great investors, though: they sometimes disagree with each other. We all want to think that there is one answer to the most important questions we face as investors. We want to believe that if we think hard enough and spend the time to do the detailed research, the right answer will be clear to us. But that just isn’t the way it works.
There are many questions in investing that even the smartest investors will disagree on. And that puts those of us who aren’t in the pantheon of elite investors in a challenging situation. If two people who we respect come down on opposite sides of the same issue, it can be difficult to figure out what to do. And with something as complex as investing, this can happen often. In fact, in a few of the interviews I have done, some of the smartest people I know have said the exact opposite things.
So how should an investor navigate these disagreements among the best investors? I am certainly not the one to provide all the answers, but I have found breaking these disagreements into three groups can be very helpful.
 The Things That Don’t Matter
Some topics in investing that are the subject of vigorous debate among the best investors are better off left to them. For example, you will hear lots of debate about where the market is going in the next year. You will hear compelling arguments on both sides that make you want to believe what they are saying. They may even make you want to make adjustments to your portfolio based on them. But for long-term investors, these types of debates are nothing but noise. And it isn’t just where the market is going. There will be many debates about the short-term movements of the economy, or the price of oil or even the short-term prospects of individual stocks. We haven’t gotten into these type of debates in our interviews because we don’t think they are useful, but you will hear smart investors debate them all the time. These debates may be very interesting, but they should not affect how you manage your portfolio.
 The Questions That Have No Answer
Despite the fact that all of us want them to, some questions just don’t have one right answer. Sometimes it is possible for smart people to look at all the evidence and to end up drawing different conclusions.
Let me give you an example from some of the interviews I have done.
There is significant debate among factor investors about which factor to use. Some have a specific factor they prefer, while others will combine them together into a composite.
Back in December, I spoke to Wes Gray about this topic. Wes has a specific metric he prefers over the others that are available and a good reason why. Here is how he explains it:
To us, value investing is best when it is most businesslike (stealing a phrase from Ben Graham). And when we started this journey many years ago, the most “businesslike” and simplest way to assess the value of an enterprise is to figure out what the firm generates in operating income (~Revenue minus costs of goods sold and SGA), and then figure out how much it would cost to buy all the assets that generate this operating income. This is how private equity buyers look at firms because it helps untangle the complexity associated with different capital structures. We also like measures that appeal to private equity investors (i.e., “business-buyers”) because we think the private/public market arbitrage is one of the reasons cheap public stocks earn excess returns – you can “free ride” on the private equity buyers arbitrage activity. Some of our internal research suggests that this benefit is highest for cheap EBIT/TEV firms, versus other valuation metrics.
This week I spoke to Jim O’Shaughnessy of O’Shaughnessy Asset Management, who looks at this issue in a different way. Jim explains why OSAM uses a value composite instead of individual factors.
You yourself mentioned that if we just use my book What Works on Wall Street as our guide post here, in the first one I was a little wet behind the ears and called price to sales the king of value factors. Well of course, that was before I took the time to think that really it depends on what kind of timeframe are you looking at to determine who’s going to be the king or the queen. If you were looking at it maybe 10 years earlier, it might’ve been EBITDA to enterprise value.
Looking at it 10 years later, it might be price to free cash flow. And that is where we kind of alighted on this idea of, well, you know, why not all of them? Every factor has its own strengths and own liabilities. Why not come up with a composite that combines all of these various factors, that cover different strengths, different liabilities, but also, for example, on the value composite side, cover more parts of the balance sheet. After doing that research, we found that yes, that insight was correct. We found it far more efficacious to use a composite of value factors because (a) when you’re looking at single factor performance, it’s always going to be a horse race with a different winner depending on what year you end and begin in. And secondly (b), the idea that you’re getting a much better sense for the overall value when you look at a variety of the factors than if you look at just one made both intuitive sense and then obviously our final test, which is the make it or break it one, it met all of our empirical tests as well.
So who is right? In my opinion, they both are. Wes argues that one factor trumps the others because it makes the most sense when valuing a business. If you think one factor is superior to the others, it certainly makes sense to use it. Jim, on the other hand, doesn’t have that level of conviction in any individual factor, so he uses all of them. Both approaches make sense. Both approaches are based on long-term data.
This is a great example of the fact that not all questions are going to have one answer. When two people as experienced and intelligent as Jim and Wes come down on opposite sides of an issue, and both of them can back up their opinions with evidence, it is probably safe to say that there is no one correct answer.
 The Answers That Are Context Dependent
All investors are different. And that means that sometimes the correct answer for one investor can be completely different than the correct answer for another. In my interview with Jim O’Shaughnessy, we discussed the fact that investors face two major points of failure. The first is that they will sell when the market is down. The second is that they will sell when they underperform the market.
But which one is worse? The answer to that depends on factors that are unique to each person.
In the second part of my interview with Jim that will be published next week, we discussed trend following. Trend following is a system that will move a portfolio to cash when the market is in a downtrend in an effort to preserve capital. Trend following systems help with the first point of failure by limiting losses. But that can cause an issue with the second point of failure because they can sometimes be caught in cash during market rallies. This January was a great example. Most trend systems were taken out of the market by the December decline and missed much of the rally early this year before getting back in. That underperformance can lead some investors to abandon them.
Many quant firms run trend following systems because of their ability to limit losses, but OSAM isn’t one of them. The reason is that second point of failure. It can be really hard to stick with them during periods where their signals are wrong.
Jim explained his views on trend following in this way:
I’ve always been enamored with trend following systems. I have studied as many of them as I could get my hands on. I mean as many of the reasonable empirically realistic ones that I could find that you yourself may deploy. We don’t offer a trend following system. And that is because for the most part, what we found is that the number of false positives that they give leads to exactly the type of behavior that you’re talking about, which is, you get a false positive like you got in January. You get a
So does trend following make sense? It all depends on the person who is following it. For investors who are more susceptible to the first point of failure and are loss averse, it can make a lot of sense. For investors who are more negatively affected by underperformance, it makes much less sense. The right answer is completely dependent on the context.
The Bucket Approach to Expert Advice
By taking the opinions of those I respect in investing and putting them into one of these three buckets, it makes is easier to figure out how to process it. Then I can decide whether that opinion should impact what I am doing with my investment portfolio. We live in a time where we have more access to the opinions of the world’s best investors than we ever have. If that advice is used properly, it can make us all better investors. But if it isn’t, it can also be counterproductive. The key is developing a process to differentiate the two.