Quantitative Value, + Web Site

A must-read book on the quantitative value investment strategy

Warren Buffett and Ed Thorp represent two spectrums of investing: one value driven, one quantitative. Where they align is in their belief that the market is beatable. This book seeks to take the best aspects of value investing and quantitative investing as disciplines and apply them to a completely unique approach to stock selection. Such an approach has several advantages over pure value or pure quantitative investing. This new investing strategy framed by the book is known as quantitative value, a superior, market-beating method to investing in stocks.

Quantitative Value provides practical insights into an investment strategy that links the fundamental value investing philosophy of Warren Buffett with the quantitative value approach of Ed Thorp. It skillfully combines the best of Buffett and Ed Thorp—weaving their investment philosophies into a winning, market-beating investment strategy.

• First book to outline quantitative value strategies as they are practiced by actual market practitioners of the discipline
• Melds the probabilities and statistics used by quants such as Ed Thorp with the fundamental approaches to value investing as practiced by Warren Buffett and other leading value investors
• A companion Website contains supplementary material that allows you to learn in a hands-on fashion long after closing the book

If you're looking to make the most of your time in today's markets, look no further than Quantitative Value.

Preface xi

Acknowledgments xiii

PART ONE The Foundation of Quantitative Value 1

CHAPTER 1 The Paradox of Dumb Money 3

Value Strategies Beat the Market 9

How Quantitative Investing Protects against Behavioral Errors 23

The Power of Quantitative Value Investing 30

Notes 32

CHAPTER 2 A Blueprint to a Better Quantitative Value Strategy 35

Greenblatt’s Magic Formula 36

It’s All Academic: Improving Quality and Price 45

Strategy Implementation: Investors Behaving Badly 54

Notes 59

PART TWO Margin of Safety—How to Avoid a Permanent Loss of Capital 61

CHAPTER 3 Hornswoggled! Eliminating Earnings Manipulators and Outright Frauds 63

Accruals and the Art of Earnings Manipulation 64

Predicting PROBMs 72

Notes 79

CHAPTER 4 Measuring the Risk of Financial Distress: How to Avoid the Sick Men of the Stock Market 81

A Brief History of Bankruptcy Prediction 83

Improving Bankruptcy Prediction 85

How We Calculate the Risk of Financial Distress 86

Scrubbing the Universe 89

Notes 91

PART THREE Quality—How to Find a Wonderful Business 93

CHAPTER 5 Franchises—The Archetype of High Quality 95

The Chairman’s Secret Recipe 96

How to Find a Franchise 99

Notes 112

CHAPTER 6 Financial Strength: Foundations Built on Rock 113

The Piotroski Fundamentals Score (F_SCORE) 114

Our Financial Strength Score (FS_SCORE) 119

Comparing the Performance of Piotroski’s F_SCORE and Our

FS_SCORE 122

Case Study: Lubrizol Corporation 123

Notes 126

PART FOUR The Secret to Finding Bargain Prices 127

CHAPTER 7 Price Ratios: A Horse Race 129

The Horses in the Race 130

Rules of the Race 133

The Race Call 134

A Price Ratio for All Seasons 141

The Offi cial Winner 142

Notes 143

CHAPTER 8 Alternative Price Measures—Normalized Earning Power and Composite Ratios 145

Normalized Earning Power 147

Compound Price Ratios: Is the Whole Greater than

the Sum of Its Parts? 150

Notes 163

PART FIVE Corroborative Signals 165

CHAPTER 9 Blue Horseshoe Loves Anacott Steel: Follow the Signals from the Smart Money 167

Stock Buybacks, Issuance, and Announcements 169

Insider Traders Beat the Market 173

Activism and Cloning 176

Short Money Is Smart Money 179

Notes 182

PART SIX Building and Testing the Model 185

CHAPTER 10 Bangladeshi Butter Production Predicts the S&P 500 Close 187

Sustainable Alpha: A Framework for Assessing Past Results 189

What’s the Big Idea? 191

Rigorously Test the Big Idea 196

The Parameters of the Universe 206

Notes 208

CHAPTER 11 Problems with the Magic Formula 211

Glamour Is Always a Bad Bet 216

Improving the Structure of a Quantitative Value Strategy 218

Our Final Quantitative Value Checklist 222

Notes 228

CHAPTER 12 Quantitative Value Beats the Market 229

Risk and Return 231

Robustness 239

A Peek Inside the Black Box 249

Man versus Machine 257

Beating the Market with Quantitative Value 262

Notes 264

Appendix: Analysis Legend 265

About the Authors 267

About the Companion Website 269

Index 271

WESLEY R. GRAY, PHD, 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. Professor Gray teaches graduate-level investment management and a seminar on hedge fund strategies and operations. His professional and leadership experiences include over fourteen years building systematic trading systems, trading special situations, and service as a U.S. Marine Corps intelligence officer (Captain) in Iraq and various posts in Asia. Dr. Gray earned an MBA and a PhD 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.

TOBIAS E. CARLISLE, LLB, is the founder and managing member of Eyquem Investment Management LLC, portfolio manager of the Eyquem Fund LP, and the author of the award-winning website greenbackd.com, which covers deep value, contrarian, and activist investment strategies. He has extensive experience in activist investment, company valuation, public company corporate governance, and mergers and acquisitions law. Prior to founding Eyquem, Carlisle was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions, he has advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam, ranging in value from $50 million to $2.5 billion. He is a graduate of the University of Queensland in Australia with degrees in law and business (management).

Legendary investment gurus Warren Buffett and Ed Thorp represent different ends of the investing spectrum: one a value investor, the other a quant. While Buffett and Thorp have conflicting philosophical approaches, they agree that the market is beatable.

In Quantitative Value, Wesley Gray and Tobias Carlisle take the best aspects from the disciplines of value investing and quantitative investing and apply them to a completely unique and winning approach to stock selection. As the authors explain, the quantitative value strategy offers a superior way to invest: capturing the benefits of a value investing philosophy without the behavioral errors associated with “stock picking.” To demystify their innovative approach, Gray and Carlisle outline the framework for quantitative value investing, including the four key elements of the investment process:

• How to avoid stocks that can cause a permanent loss of capital: Learn how to uncover financial statement manipulation, fraud, and financial distress
• How to find stocks with the highest quality: Discover how to find strong economic franchises and robust financial strength. Gray and Carlisle look at long-term returns on capital and assets, free cash flow, and a variety of metrics related to margins and general financial strength
• The secret to finding deeply undervalued stocks: Does the price-to-earnings ratio find undervalued stocks better than free cash flow? Gray and Carlisle examine the historical data on over 50 valuation ratios, including some unusual metrics, rare multi-year averages, and uncommon combinations
• The five signals sent by smart money: The book uncovers the signals sent by insiders, short sellers, shareholder activists, and institutional investment managers

After detailing the quantitative value investment process, Gray and Carlisle conduct a historical test of the resulting quantitative value model. Their conclusions are surprising and counterintuitive.

This reliable resource includes a companion website that offers a monthly-updated screening tool to find stocks using the model outlined in the book, an updated back-testing tool, and a blog about recent developments in quantitative value investing.

For any investor who wants to make the most of their time in today’s complex marketplace, they should look no further than Quantitative Value.