19 January 2017

Although Preston and Stig are hardcore value investors, sometimes it’s important for individuals to challenge their beliefs. As a result, TIP has invited leading expert Dr. Wesley Gray onto the show to discuss the concept of momentum investing. Although growth investing is a common term for many individuals in finance, momentum investing is less understood. The difference between the two approaches is that growth is primarily based on a company’s exploding fundamentals. For example, if the revenue is growing at a rapid pace and the company has prospects for further expansion, then the business might fit into the classical definition. This is different from momentum because the only variable considered is price of the security. Now, this might seem like there’s something missing from the description, but there is no mistake. The only thing that’s considered with momentum investing is the price.

Through research and much back testing, Dr. Gray has found that a hybrid approach of momentum investing and value investing has provided the most comprehensive returns. To learn more about this unique and mysterious way of investing capital be sure to check out our interview with Dr. Gray.

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  • Why momentum investing is not the same as growth investing.
  • Why value investor should consider a momentum strategy in their portfolio.
  • Why investing is like poker, where the best players win over time.
  • Ask the Investors: What do you look for in a 10K?


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Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:05  

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Intro  0:29  

Broadcasting from Bel Air, Maryland, this is The Investor’s Podcast. They’ll read the books and summarize the lessons. They’ll test the waters and tell you when it’s cold. They’ll give you actionable investing strategies. Your hosts, Preston Pysh and Stig Brodersen!

Preston Pysh  0:52  

Hey, how’s everybody doing out there? This is Preston Pysh. I’m your host for The Investor’s Podcast. And as usual, I’m accompanied by my co-host Stig Brodersen out in Seoul, South Korea. 

We have an exciting interview for you today because we have one of our good friends, Wesley Gray, with us today. If you haven’t heard our previous episode with Wes, you’re in for a treat because he is insanely bright, and you’re gonna find that out real soon as we start asking him some amazing questions. 

So Wes, got his undergrad at Wharton. He went to Chicago Booth. He has a PhD and he’s written four books. Last time he was here we were talking a little bit more about his book, “Quantitative Value.” But today, Wes has a new book that has recently come out and we talked about this just a little bit on the first episode about mixing momentum investing with value investing. And Wes, correct me if I’m wrong, but I would say that you have your roots in value investing. Is that a correct statement?

Wesley Gray  1:54  

Hundred percent correct. I’m a Ben Graham “Intelligent Investor” bible thumper, originally. I still am to this day. You got it.

Preston Pysh  2:04  

But so you run in this crowd with Patrick O’Shaughnessy and a couple others. I know James is big on this. I know Toby’s big on this. Toby Carlisle who’s in our MasterMind Group that you’re mixing this value investor, Warren Buffett-Benjamin Graham approach, but you’re slightly mixing it with a little bit of momentum investing because when you’ve done all this back testing, you’ve been able to prove that you can actually get a better result by having this blend. And correct me if I’m wrong, the blend is, you know, off the top of my head, I’m thinking to around 70% value to 30% momentum. Is it somewhere around in that figure would you say?

Wesley Gray  2:41  

Yeah, I mean, it really depends on on how you want to slice and dice it but the basic idea is, value works basically an overreaction to the bad news. Momentum works, it’s under action, good news. And they’re kind of like yin and yang because they’re like two religions. So the value guys think, “Oh, momentum is stupid.” The momentum guys think value guys are stupid, and so they’re actually natural complements. 

If you believe it all in portfolio theory, and you understand value investors rightly, don’t believe in a lot of it. But the basic idea of pulling things that are kind of yin and yang makes a lot of sense if both things are high expected return and high volatility. If you can pull those two together, and they kind of cancel each other out and value is doing bad and the momentum is doing great. I mean, that’s a good thing from kind of a risk management standpoint.

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Preston Pysh  3:37  

So before we dive into the first question, so everyone who’s listening to this show, this is what this episode is all about. Most of our audience are value investors, like Stig and myself. So we like talking about macro. We like talking about these other things because they’re interesting topics. But at the end of the day, we are hardcore value investors that really don’t exercise a lot of momentum investing. So I think that this is going to be a fantasticeEpisode for people out there listening. 

This is the direction we’re going. We’re going to be talking about momentum investing, and how you can maybe augment or include a small portion of this in your portfolio to increase your returns. And Wes can talk the stats on this. He is a data-driven kind of person, so he can get into the nitty gritty details of that as we go through the rest of the interview. 

Before we jump into the first question, I’m kind of curious, where you kind of discovered this approach. How did you come across this, Wes?

Wesley Gray  4:29  

Well, basically, I start off doing the value investor thing, because that just makes a lot of sense. Like, look at firms as a business, buy them cheap, buy a margin of safety, etc. Great. And then what’s really nice about that kind of story is there’s actually a lot of evidence backing it up. When you look at value investing, you can ask, “Well, why is this actually work?” And I think we talked about it on the last podcast, but really any investment strategy works to the extent that you could essentially frontrun future expectations. 

So value works because when you buy cheap stuff that everyone hates, it tends to be the case that in the future expectations tend to get revised in your favor. And by simply buying cheap stuff that everyone hates, you can kind of front run that, right? And so now you make sense, the data is there., and from an expectation front-running standpoint, it’s a great trade. The whole thing’s, you know, got a good mojo to it. 

Well, turns out that when you look at momentum, it’s the same thing. It’s all about a way to frontrun expectation changes. And so any strategy where you’re able to do that, you’re going to make money, right? Because value investing will not make your money because if you just buy cheap stuff, and no one ever agrees with you, i.e. expectations never change to be in favor of what you think like this is a cheap stock. You’re just gonna always own a cheap stock, right? And so you always need even value investors need to rely on the fact that at some point, expectations change, and the value investor viewpoint fundamentals matter. So eventually it’ll drag the expectation out in that direction. But that’s an assumption that expectations will go to that. 

It turns out to be a good assumption but I think that seems the logic of, “Okay, how are we going to frontrun other market participants get ahead of that game?” Well, momentum tends to be a great signal to do that, and arguably, what’s not even an argument, like the data is more strong for momentum than value that just from a straight like evidence-based standpoint.

Stig Brodersen  6:43  

Perfect introduction, Wesley. And before we dig into the first question, we probably said that a few times before we begin to the first question. I just want to add one thing more guys, we had Wes on episode 48 and 49. We’ll make sure to link to those episodes in the show notes because we talked a few times about, Well, you’ve been on a podcast before we discuss some of that. But we definitely see this episode as a continuation of those episodes. But clearly, we also go on to talk about some of the standard elements and explain the concept in this episode as well. 

But Wes, I would like to turn the very first question into a brief history lesson. So in your new book, “Quantitative Momentum,” you described the birth of technical analysis, and you talk about how it was developed in the Netherlands, later in Japan, and how billionaires like George Soros and Druckenmiller and Paul Tudor Jones later become very successful with the approach. Could you please take us back in history and talk about the modern technical analysis approach?

Wesley Gray  7:43  

Sure. So I mean, I can only take you back as far as like documented history that we could find and will take us. We get back around the 1600s and talk about de la Vega, where he’s in the Netherlands, basically mentioning behavioral finance and how people participate in markets. And a lot of times, it’s all about the technicals. It all boils down to what my old roommate tells me: high prices attract buyers, low prices attract sellers. And this guy’s retired already. He’s market maker for Deutsche Bank for like 10 years, and he’s basically explaining momentum. 

So I think this is something that you can look way back. A lot of people have been doing this for a long time and what’s interesting is when you start getting into formalized research, it’s like anything, there’s always seems there’s a dark age. 

So momentum in this specific application that we talked about in our book, and what is under discussion here is using momentum to select stocks. This idea was originally taught like Gary Antonacci talks about the Colin Jones paper in 1937. It’s kind of more of a trend fall thing but kind of hints on momentum. 1937, that was a long time ago. Robert Levy, 1967, publishes a paper on relative strength strategies in stocks in the Journal of Finance, for God’s sake, the top tier academic journal. Okay? 

What happens also about that time? Well, Eugene Fama publishes his dissertation in 1965. And all the sudden, you get the efficient market mafia kind of starts controlling the thought. It’s all about math, it’s all about modern portfolio theory. This 1967 paper that basically shows that you can just use simple price patterns to beat the market. 

You know, these guys get buried, and they’re not allowed to basically talk for another 30 years. And then you got Jagadish and Tippmann, in 1993, who a lot of people say is like, quote-unquote, when momentum was found. Well, I just talked about a paper that was published 30 years prior to that and another paper published 30 years prior to that. 

And so, everyone’s been saying momentum is a new thing. It’s going to get our doubt. Kinda everyone knows about it, you know, recently, everyone’s was saying all momentum is dead. Well, there’s my old boss, *Chris Gates, he has a paper where they got data from 1800 to 1927. So basically 120 years out of sample data, and guess what momentum works just as well then as it did in the last hundred years. However, just like value, you get your face ripped off sometimes, and that’s why it works.

Preston Pysh  10:33  

So well without jumping into questions later on for a person who’s hearing that response. I think the thing that immediately jumps into your head is how do you protect yourself from that event that you just described as being just totally cataclysmic event as you’re implementing this momentum strategy, and it just totally does not work. How does a person mitigate that risk from happening?

Wesley Gray  10:58  

Sure. So the best way someone described momentum investing to me was actually from a value investor this guy, Charles Mizrahi. He says momentum investing is like this. Value investing you drive in a slow, boring car in the slow lane. You kind of grind it out here the friars pass you by and you always look stupid. You know a lot you kind of grind it. Sometimes your car breaks down and you’re screwed and you lose a lot of money, but whatever. It’s just kind of a grinder strategy. 

Like momentum is basically strategy where you’re always in the fast lane, going 100 miles an hour. And the minute that lane ahead of you start slowing down, you switch lanes. Value is kind of a long term hold grinded out type strategy. Momentum, necessarily, it is momentum. 

So the minute something starts losing momentum, you got to get out of that thing. Get out of that lane. So it’s just a total different way of an approach but that’s how you can protect yourself in momentum is the minute there isn’t momentum. Get out and move to what has momentum. And that tends to historically give you a lot of bang for the buck. It has a lot of ball just like value. But it’s not just like writing these things down to zero, because mechanically you’re going to get out and  move behind momentum.

Preston Pysh  12:18  

And when we talk about the things you’re really paying attention to, it’s all price action, right? It’s just all the price that’s being paid for the security, nothing else?

Wesley Gray  12:26  

Yeah, and that’s a proxy for what a lot of people argue is related to fundamental action. Basically, underaction. So like guys can basically map there’s *inaudible paper that does it essentially where if you look at earnings releases, right? There tends to be for a reason like underaction, these earnings releases so people release unexpected positive earnings. You’d expect the stock to move to the quote-unquote, fundamental value. It never does, it moves up and then it kind of drifts. Momentum is a way just using the price you essentially capture that as well but people can map prices, the price appreciation to fundamentals releases of information that for whatever reason, anchoring biases, what have you? The market just doesn’t react fast enough for some reason. It’s unclear why that is. But it just it is. 

So even though you use price as the proxy or returns, it’s not like it’s just that’s it. A lot of times does map back to like a fundamental element there, which basically overreaction to good news is I think what most of the evidence suggests.

Stig Brodersen  13:33  

Just very briefly, for people out there listening and thinking, “I heard about this. I have a really good understanding of value investing is.” Could you just briefly explain momentum investing? It’s like, if you have a stock, call it $10 and it drops to five as a value investor, you’d be thinking, “Hmm, this might be now trading at a lower price. There might be some value there I can gain.” Whereas that’s not what you’re looking for at all as a momentum investor. You’re looking for that stuff, going from five to 10 bucks and saying that there might be a strong indication that it might continue. Is that basically what you’re saying?

Wesley Gray  14:04  

Yes. So value investing in a traditional sense is basically buy cheap stuff, right. And that’s great. Got it. Momentum investing is basically buy relative strength. So when we talk about stock selection, there’s there’s two types of momentum. There’s your kind of trend following momentum, or what they call time series momentum. That’s like looking at a stock at a current point in time relative to its history, and making a decision based on that. So it’s in isolation. 

What we’re talking about here, the geek term is called cross sectional momentum, or the practitioner term is relative strength. So here, we don’t really care if you’re up 10%, or even down 10% as long as you’re relatively doing well to other securities in your universe. So if you’re negative 10, but the other guys are negative 50. The evidence is pretty clear that the negative 10 guy will continue to have strong relative performance than the negative 50 guy. But it’s not about just we’re talking about the absoluteness of it. It is not what we’re looking here is the relative momentum that is really the document effect for stock selection.

Preston Pysh  15:11  

Now, when you say relative momentum relative to other companies in that industry is what you’re comparing them to?

Wesley Gray  15:17  

Yeah, you can do that. Or you just do it across all securities, people do it within industry, like, it doesn’t matter. But as long as it’s in a relative is what matters. So as long as you have momentum relative to whatever universe you’re operating in, that is the signal that seems to kind of drive this empirical phenomenon that’s been around forever.

Preston Pysh  15:37  

Very interesting. So Wes, could you explain the concept of behavioral finance and why it hints at the framework for being a successful active investor? And I know in your book, you provide a poker analogy. So could you kind of give our audience a glimpse of that?

Wesley Gray  15:52  

Yeah, sure. So this framework, which I’ll outline to you guys, we call it the sustainable act investing framework. This is a framework through which you can review any strategy, value investing, momentum investing, big board investing or whatever. The idea is, if you can’t map it into this framework, and identify the edge, it’s not real. It’s data mining. 

So essentially, it works in this is really just academic behavioral finance. But most people think that behavioral finance is about behavior. So understanding how investors have all kinds of weird psychology problems, they make bad decisions, and then they do stupid things in the market. But that’s not really interesting because if it was only about behavior, and if there was one really smart person, they would just go get billions of dollars and exploit all those people and it wouldn’t matter because they would just arbitrage them away, like ASAP.

 But in order to make behavioral finance interesting, you need to identify one decision making errors. So why do people do stupid stuff in the first place and sell stocks too cheap or whatever. But then also, why in the hell aren’t the arbitrage guys taking advantage of it? Only then we actually see these effects in the data because if it’s driven by a behavioral issue, and then we also understand the market frictions, or why other smart people aren’t doing it, now we have like, real effect that we could actually see in the data and try to understand it. 

And so essentially, what the sustainable act of framework suggests is, we got to answer two questions whenever we’re doing any sort of long term investment strategy that purports to have any sort of edge over just buying a Vanguard Fund, which is amazing, right? Because it’s cheap, tax efficient, and you own everything. Incredible. 

The first question is, you know, use the poker table analogy. Who are the bad poker players at this table that I’m sitting at here? And that’s where we get into the behavioral stuff right? Like who’s the idiots that are, you know, selling these great companies that crazy PE ratios, you know, because they got overreaction biases representativeness or whatever it is. We need identify what is the underlying psychological problem with people that are investors out there making decisions, because that’s going to create this sort of additional mispricing. 

So you’ve identified the bad poker players at the table. But we don’t operate in a world where it’s only bad poker players. We operate in a world where there’s people with PhDs in physics and math, people that got 30 years of stock picking like Warren Buffett type. So we need to understand what are the best poker players at the table doing? And if we identify situations like value investing, okay, we kind of understand the behavioral reasons why these opportunities exist. You know, it’s really hard to do. It’s really painful strategy. Like, that’s great because the best poker players have a friction. They can’t just easily explain this, and so value works like that. 

Let’s think about momentum. Well, you the behavioral core behavioral bias, arguably is overreaction to bad news, right? People throw the baby out the bathwater. You know, that’s a simple way of saying it. Great. Why don’t the best poker players do it? Because it’s painful as hell and they will lose job, right? Who wants to do that? If you do like active value investing.

Well, what’s momentum? arguably the behavioral bias is there. This is an underreaction to fundamental good news that price signals are telling us, in fact, they’re yelling at us that this is the case. And yet people react to that price signal because they’re overconfident in their own information set. 

So that’s kind of the one of the core leading theories about the behavior that drives them. And then well why don’t all the best poker players do it? Well, just like value, if you do momentum strategies, you are going to look like the biggest idiot in the entire planet for potentially 5 to 10 years stretches. That’s great, because that means it’s sustainable. You can’t be like a pop shop lever the strategy up and arbit away immediately. 

And so, bottom line is, there’s two questions. Who are the bad poker players? Great. We need that because they cause mispricing. Second question. Why isn’t Warren Buffett or why aren’t like all the other smart people managing billions of dollars doing it? If we understand their limitations, now we have a real kind of sustainable opportunity. And I just have the belief that value and momentum fit in that framework pretty effectively.

Stig Brodersen  20:31  

Very, very interesting, Wes. I think this is a really good transition into the next question, because one of the ideas that I got from you by following your research and reading your blog and your work is that you have explained about an investment style box or if I should just explain this. 

So traditionally, when we have an investment style box, it’s usually a three by three. So it’s divided into three rows with big mid and small cap, and then three columns. columns with value blend and growth. And this is like the way that we usually see this box. So whenever you’re looking at an ETF, for instance, it will be in one of those nine squares in terms of explaining what time of ETF it is. Now, you suggest that perhaps we should replace growth with momentum. Could you please explain why we might need to rethink growth and replace it with momentum in the future?

Wesley Gray  21:28  

Sure. So it depends on your objective function, if you’re trying to closet index, and minimize track *inaudible, growth is great. If you’re trying to maximize expected return, and play the buckets that the evidence suggests, will actually, you know, generate excess return over long periods of time, you don’t want to think in terms of growth, because growth without momentum is a sucker bet. It’s what every value investor in the world knows is a bad idea overpaying for hype, buying the latest and greatest scheme out there that the streets pumping the newest IPO, like basically expensive stocks, right? That we already know, all the investors know total sucker bet.

But momentum is not growth or it is not expensive stocks. Momentum is momentum. Momentum is what is your performance relative to other securities in universe independent of fundamentals? You could be a high flying hundred PE stock and have high momentum. You could also be like recently because you guys appreciate this like I do, small cap value has been face rip and rockin. A lot of those stocks are momentum right now. 

So you could actually have a circumstance right now where you can be value and you could be momentum. But the key is you don’t want to buy expensive stuff which is growth. What you want to buy as you want to buy value, and then momentum where momentum is high relative strength, not growth. Growth means expensive hundred PE securities. Momentum can be that, but doesn’t necessarily have to be that. 

So the idea is if you want to maximize expectation, and not just worry about trying to cover all the buckets of the market, you know, value is one area you want to focus and momentum is another. And those are the two spectrums you want to be in, at least from what the evidence suggests, if you actually care about, quote-unquote, trying to beat the market or generate risk premiums in excess instead of ,buying the vanguard fund.

Preston Pysh  23:39  

So Wes, I’m curious if you could dig into a little bit more defining the difference between growth and momentum because I think the typical person listening right now, they haven’t made that difference yet. So let me just try to put it in my own terms and then you kind of self correct off of what I’m saying here. 

So when you’re talking growth, you’re talking about, call it like an Amazon company where you’re looking at the top line revenues, you’re seeing them grow at a rapid pace. And you’re expecting that to just go off into oblivion and just keep shooting into the stratosphere. That would be more of what we commonly refer to as a growth pick. 

Now, when you’re talking about momentum, you’re really looking at just the price action of the stock. So let’s say it’s Amazon again, and you saw compared to other tech companies, or was to say the S&S 500, in general. You’re seeing that price action, and it’s moving twice as fast as any other stock out there. We would label that momentum. Is that a correct interpretation of this? And if not just kind of hit the…

Wesley Gray  24:40  

Yeah, that’s really good and let me go really slow here because this is like a nuance point. That matters so much. So let’s go back to the value anomaly as it’s documented. It basically says let’s just take PE ratio. You got 1000 stocks, the value anomalysays that if we simply buy the cheapest 100, and we compare the performance on that to the most expensive 100, you get this huge spread, depending on the size cuts or whatever. Let’s say it’s 5%, or anywhere from 2% to 8%, depending on what you know the size levels are. But it’s huge, right? That’s a massive difference over 100 years of 2% to 4% kind of spread. 

The low PE stocks are called value in academic research behind PE stocks are considered growth or glamour or what have you. Good. Got it. Momentum says we’re not looking at any E. We’re looking at P. That’s it. And we’re not looking at P. We’re looking to how P compares to the other Ps in the market, ie *inaudible the price. 

So with momentum, you say okay, now we got 1000 stocks. We’re gonna rank them on their last one year performance, and we’re going to sort them. The top 100, they’re going to probably have you know, 15% or 60% returns. The bottom 100 we’re gonna have by whatever negative 10, negative 20. The spread between those top 100 and those bottom 100 is like double value premium. 

So value depend on how you cut the size is two to four, you know, a minimum is going to be four to eight. So just the absolute spread there’s different and the key differentiation is growth. It’s about P ti E, expensive stuff. Momentum is about relative strength, price movement. And that little difference matters so much, because if you have a growth stock, ie expensive security, if it doesn’t have momentum, it’s got a bad expectation that security has momentum, but it just happens to be also an expensive stock. You have good expectation and that little nuance is all that matters. 

And you hit it right when you said Amazon. Amazon, you know, expectations off the wall, like right now, I don’t even know what the PE is. It’s probably like infinity. But it’s also begin its face ripped. So it doesn’t have as much momentum as it used to have. So that’s becoming less attractive to a momentum investor. 

But go back six, seven months ago. Amazon still has a PE of infinity, but who cares? It has amazing momentum. So it’s that momentum characteristic that drives us. It’s independent of devaluation. It’s a total kind of different way of thinking than value investors typically think.

Preston Pysh  27:34  

That clears it up. it’s crystal clear when you describe it that way. 

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Now I’m just kind of curious on this, Wes, because I know you’re a huge quant guy, you are all about the numbers and going back and back testing and all that kind of stuff. So I’m kind of curious with the average duration that you would if you had a basket of, call it 100 momentum picks over a certain amount of time. How long were you holding on to these picks on average? What would you say that that number is?

Wesley Gray  29:14  

Well, I mean, in order to get it to work, it’s way higher turnover three to four times so value. Here’s some basic empirical facts. You take a value strategy right, let’s just say low P is for for easier. So we’re just going to be Ben Graham, buy cheap stocks low PE. If I go buy the cheapest hundred stocks right now and if I five year rebalance that, I still got some edge. If I one year, rebalance that, I got a lot more edge. If I quarterly rebalance, I got a little more edge. If I monthly rebalance, I got a lot of… You could go crazy on that. 

But value, you could hold that for five years out and you still gonna have an edge. Momentum, it’s like I say you’re driving a fast car. If that fast car has a wreck in front of it, if you don’t change lanes, you’re dead. Right? So momentum, you have to turn that thing over and rebalance that portfolio quarterly, to, frankly, get any of the benefits of it. It’s just the nature of it. If you do it monthly, it’s even better, which means that momentum, while way more compelling, is also way more trading intensive, and arguably has a lot less scalability to it than value because value as I mentioned, you could buy stocks at home for five years and capture some of the edge. In momentum, you have to trade it at least quarterly in your turnover. I’m just gonna throw it out there. But maybe you get 200% a year turnover, we’re maybe a value strategy on how fast you rebalance it, maybe half that or quarter. That is just the nature of the two anomalies. They’re just vastly different.

Preston Pysh  30:54  

So, Wes, a person hearing this like my immediate thought when you hear that the turnover is higher, which is what I totally expected. I think I’m going to be paying taxes through the nose. So how can I invest in an ETF or a fund where somebody is actively managing this, but I buy at once and I, let’s just say that I incorporate this as a 15% position in my portfolio, so that I don’t have to be doing this buying and selling and paying all the taxes that are assessed. 

Wesley Gray  31:23  

So there’s two schools of thought on that. I mean, one, one of the things that’s actually unique about momentum strategy, even if you didn’t have any special tax wrapper on it, is you’re buying winners and basically cut the losers. And so you’re mechanically always booking capital losses, and then a lot of times you’re letting those winners ride. 

So you do have a lot of turnover, but you can have names that end up in 10 exons, and you hold them for five years. So there is some tax efficiency innate to momentum, or at least not as bad as one would think at the outset. But of course, as you mentioned, and it is intuitive because of that trading activity, you are going to generate ton of capital gain liability. So you need to find structures like obviously, we like the ETF structure, because it allows us to internal to that structure, avoid capital gains distributions. So you know a buy and hold investor can basically access that turnover without having an E*inaudible distributions every year, you can also use in qualified accounts. And if you’re, you know, really rich, there’s all kinds of other schemes you can do but hundred percent agree if you’re gonna do momentum, and you’re a taxable person, you need to wrap it in a tax vehicle. And ETF is probably the most accessible one for not billioanire types.

Stig Brodersen  32:39  

So at this point in time, the show we would really like to respond to one of the questions from the audience. And Wes, I know that really putting you on the spot here, but I really hope that you would like to help me out with this question. Does that sound good?

Wesley Gray  32:52  

Yeah, I mean, our mission is in power investors education, so send it on down.

Preston Pysh  32:57  

Alright, so our first question comes from Brian. Kirby.

Brian Kirby  33:01  

Let’s dig in Preston. This is Brian Kirby from New Hampshire. Thanks for all the work you put into the podcast. I’m new to value investing. Over the past year, I’ve been trying to accumulate as much knowledge as I can on value investing, investing in individual companies. Your podcast has been very key in that journey. I’m starting to look at individual companies and their 10Ks. What sections of the 10Ks do you feel are the most important? Thank you. 

Preston Pysh  33:24  

All right, Wes, you take it away.

Wesley Gray  33:27  

If we’re talking about value investing, and we’re talking about 10Ks, there’s a few areas you want to look at. One, you want to first figure out what the heck the price is, which isn’t in the 10K. But after you do that, we’re big fans of operating income oe kind of measures of profitability that are a little bit further up the income statement, not net income because it can be gamed a lot. 

Another thing you want to focus on, there’s actually a really cool paper about this, and I’m a quanr guy  so I’ll give you a perspective. What some researchers did is they actually look at 10Ks, and they machine read them, because for 99% of them are templated. What they did is they said, “Hey, all these lawyers, they make you write this template of language, but what happens when the template language changes? And specifically, are there certain sections of the 10K where when the language changes and it really matters in the future performance?”

And one of those is actually in risk factors. If you just look at the template of the language and risk factor section, and you do it year over year, quarter over quarter, or how you want to do it. Again, I recommend doing a computer but if you don’t have a computer do you can do by hand. Whenever you start seeing additional risk factors listed in there, ie the lawyers are, “Like guys, we need to kind of cover our ass here. And we don’t want to talk about this publicly. But this is our disclosure documents. So we need to legally discuss this here.” But you know, because obviously they’re not going to make this front and center on the conference calls. But I would focus on that risk factors section. And don’t just read it absolutely read it relatively to what they’ve said in the past. If you all sudden see a whole edition of risk factors…

Preston Pysh  35:10  

That’s like a momentum way of seeing the relative *inaudible

Wesley Gray  35:17  

It’s crazy when these guys use a computer to literally like machine read. And they look for these changes. And risk factors is where a lot of these CEOs like bury information that’s super relevant to market expectations, but because obviously they’re CEOs, they don’t want to like talk about these things aor emphasize it. So a lot of times it kind of goes to the wayside, but it’s highly predictive of basically for performance.

Preston Pysh  35:42  

That is so true, you know, that they’d have the lawyers just adding all sorts of that is so smart, and I’ve never heard that before. I really liked that comment. That was amazing.

Wesley Gray  35:53  

I’ll give you one more. That’s also just kind of varsity level fundamental. But there’s another thing you do is like customer supplier relationships. There’s an old trading strategy where, you know, basically in those 10Ks, you got to disclose over 10% revenue partners. And obviously like let’s say Stig, and there’s a classic examples like golf clubs. So Stig is Callaway Golf, and I’m like a head supplier for golf clubs. If all of a sudden you want to follow Callaway Golf, if you come out and Stig says, “Dude, my sales are horrific.” And you’re analyzing me the company that’s making the golf heads because I’m gonna report like a month or so. And I know that Stig is 80% of my revenue. I might want to consider the fact that Stig said his sales are abysmal, because that is gonna affect me a lot. 

What you do is you get these customer supplier price reaction lags where you have information in the marketplace on another company that is economically linked to the company you’re investigating. But you may get blindsided if you’re just looking at the 10K in isolation, but not considering, like the ecosystem. So that’s another trick that a lot of like, kind of varsity fundamental guys like to do. They kind of like to understand the ecosystem of what other guys are releasing.

Stig Brodersen  37:11  

Yeah and just something to add to this because Brian, the real thing, this is a great question. And you’re starting with the 10Ks because most investors like even with years experience never go that far. So that’s really good. One thing to say about this is that reading 10K is really an art. Like, you need to read quite a few really to get a grasp on this. 

I remember one of the first times I was reading this risk section, and I was like, “I need to go through and read all the different types of risk.” And it just seemed so generic. And guess what, like a lot of the risks that you do read about they’re extremely generic. It’s something like, “Oh, if we can keep up with customer preferences, it’s a problem for us.” And I mean, try to see if you can find a business in the world that does need to keep up with customer preferences. 

I mean, a lot of this is completely useless and I think in general, you need to think about that whenever you’re reading, not only the risk section, but basically all the sections in the 10K. The same goes for the management discussion, how sincere is that? Is it completely generic? Did they have someone from the PR department basically write that out? Or are they talking about mistakes they are actually making? Are they talking about the key drivers of the industry or where they are in the cycle? I mean, that’s the things you should be looking for because the requirements for 10k in many ways, they’re really strict because it’s all of this is regulated. But in a way, it’s also very easy to get away with a lot of generic, useless talk. 

So if you can diagnose if it’s sincere. In other words, this is trickle down effect you see thrown the management and the rest of the organization. I know that this is really the art part that I’m talking about, because how do we determine that? But if you get the impression that you’re trying to hide something from you, relating back to what Wes said before, “Hmm, they just suddenly got 50 new risk factors.” Then you probably shoot the run away as fast as you can.

Preston Pysh  39:02  

Well, I’ve got a question for Wes, because he was talking about this a little bit in the beginning of your response, Wes, about the operational income. So are you really big on really kind of going to the cash flow statement and looking at the operational income, and then, you know, subtracting your capex to come up with your free cash flow? Is that what you’re really seeing is the real earnings here?

Wesley Gray  39:21  

Well, in free cash flows a little bit difficult, because capex is all over the place. What I was suggesting is just move up the income statement. So at the top, you got the revenue and then you know, after your cogs, you got like gross profitability, rip off some *inaudible, you’re starting to get like your *REBITA of and then pull off some depreciation, amortization, get the EBIT. Just all those are good. I mean, honestly, if I was just starting off by investing, whether I was professional or not, I mean, because this what we do, we focus on operating income, which is essentially, you know, EBIT and then we look at total enterprise value which essentially like a price, and we just buy the cheapest ones.

Stig Brodersen  40:05  

Preston, I recently did an interview with Bill Miller. He’s basically saying the same thing. He said that EBIT divided by enterprise value, that’s really the indicator that you would go for. But Wes, I’m just gonna throw it over back to you because I see you have another point here.

Wesley Gray  40:21  

What does Warren Buffett do? I think he reads market psychology and whenever he sees a firm, well, we already know he does like presenting those guys wrote a *whole paper ballots called Buffett’s alpha. And we know quantitatively what he does. He buys cheap. He buys quality, and he buys what they call low beta. Let’s just punt that… Systematically, effectively what Buffett does in his computer brain that none of us actually have but he does, he is buying cheap stocks that are high quality.  Key is cheap, and key is quality. And all I think he does he sits back waits. Oh, IBM. Yeah, they’re getting their butt kicked by Google. And yeah, they’re not gonna become like Google. We don’t need to become Google. They’re a great firm. And we just need them to do better than expected that the current price. 

So all the positions he starts taking on, I think he just sits back and waits for the psychology to turn. He’s earning his chops by focusing on market psychology, buying when everyone else thinks it’s a stupid idea, and then just hold it no matter what, even though he may look like an idiot in the short run. 

Preston Pysh  41:31  

Alright, so Brian, thank you so much for submitting your question. We really had fun answering that. For anybody that gets your question played on the show, we’re going to give you a free subscription to our “Intelligent Investor” video course where Stig goes chapter by chapter, step by step teaching all the important lessons inside of “The Intelligent Investor.” So Brian, you get a free subscription to our video course. So thank you so much for submitting that.

Stig Brodersen  41:55  

And Brian, you’re also going to get the TIP Academy course how to invest in ETF, which is a process step by step that we outline for you.

Preston Pysh  42:04  

So if you guys are enjoying our conversation with Wes, make sure you guys tune in next week, because we have the second part of our interview, where we continue this dialogue with Dr. Wesley Gray. And I’m telling you, you’re definitely going to want to tune into that because we really get into some interesting conversations into the second part. 

So Wes, I want to give you a quick opportunity. If people want to learn more about you or see some of your content, give them a hand off to where they can learn more about you.

Wesley Gray  42:32  

Sure, the easiest place to do it is just go to alphaarchitect.com. And I’m sure you guys link to it in the show notes. That’s where we live on the internet. 

Preston Pysh  42:41  

And I also want to highlight your new book, “Quantitative Momentum.” If you’re enjoying this conversation, I know for me, this is challenging a lot of my preconceived notions of investing because I’m a hardcore value guy. But if you want to learn more about this, you’ve got to check out his book. I guarantee it’s going to be the one of the best books you’ve read on momentum because it’s based on data. It’s based on back testing that Wes has done. And that’s something that I don’t necessarily think you’re going to find in a lot of books that are written about growth, which this isn’t growth. I think we’ve kind of dispelled some of that. But more on the momentum side, he backs it up with data and hard facts. So I can’t help promote Wess work highly enough, because it’s something that really help people challenge their way of thinking, especially if you come from a value investing background.

Stig Brodersen  43:30  

That was all that we have for this week’s episode on The Investor’s Podcast. We will see each other again next week.

Outro  43:37  

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of The Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.



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