New Evidence Shows Graham and Dodd Were Right About Most Quant Investing Strategies

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A recent publication in the Financial Analysts Journal called Facts about Formulaic Value Investing, by U-Wen Kok, Jason Ribando and Richard Sloan demonstrates that most quantitative investing strategies used today are unlikely to generate superior investment performance even with the advent of computers and financial databases.

The research states, “We found little compelling evidence that a strategy of buying US equities that seem underpriced in light of simple fundamental-to-price ratios provides superior investment performance.” Adding, “Over 80 years ago, Graham and Dodd (1934) argued that trading strategies based on simple valuation ratios were unlikely to generate superior investment performance.”

It seems Graham and Dodd have proven to be right.

Here’s an excerpt from the paper:

Value investing is one of the most popular and enduring styles of investing. The idea that investors should buy securities that represent good value has obvious appeal. Yet the term value investing is increasingly being associated with quantitative investment strategies that use ratios of common fundamental metrics (e.g., book value or earnings) to price. Proponents of these strategies claim that they provide a simple and effective way to achieve superior investment performance (e.g., Lakonishok, Shleifer, and Vishny 1994; Chan and Lakonishok 2004).

Such investment strategies sound like easy wins for investors, but our analysis reveals a less favorable assessment. The “value” moniker creates the impression that these strategies identify temporarily underpriced securities. But the strategies do not use a comprehensive approach to identify temporarily underpriced securities and have  systematically failed to do so.

Our findings can be summarized as follows:

1. We found little compelling evidence that a strategy of buying US equities that seem underpriced in light of simple fundamental-to-price ratios provides superior investment performance. The evidence does indicate that small-cap stocks that seem expensive given such ratios have underperformed. Such stocks, however, are relatively capacity constrained, illiquid, and costly to borrow, so the opportunity to exploit these lower returns in practice is unclear.

2. Instead of identifying underpriced securities, simple ratios of accounting fundamentals to price identify securities for which the accounting numbers used in the ratios are temporarily inflated.

a. The book-to-market ratio systematically identifies securities with overstated book values that are subsequently written down.

b. The trailing-earnings-to-price ratio systematically identifies securities with temporarily high earnings that subsequently decline.

c. The forward-earnings-to-price ratio systematically identifies securities for which sell-side analysts offer relatively more optimistic forecasts of future earnings.

We conclude that quantitative investment strategies based on such ratios are not good substitutes for value-investing strategies that use a comprehensive approach in identifying underpriced securities.

Conclusion

Our main contribution in this article is to demonstrate that formulaic value-investing strategies primarily identify stocks with temporarily inflated accounting numbers. These are precisely the accounting distortions that Graham and Dodd (1934, p. 20) deem the function of a capable analyst to detect. Quantitative approaches to detecting these distortions—such as combining formulaic value with momentum, quality, and profitability measures—can help in avoiding these “value traps.” A capable analyst, however, should be able to significantly enhance quantitative approaches with Graham and Dodd–style security analysis.

More generally, our results show that major securities markets are highly competitive. Over 80 years ago, Graham and Dodd (1934) argued that trading strategies based on simple valuation ratios were unlikely to generate superior investment performance. The advent of computers and financial databases has generated new interest in such strategies, thousands of which have been backtested. It is not surprising that some strategies have worked in some markets over some periods. It is also not surprising that some strategies have produced impressive backtest results in illiquid stocks with significant impediments to arbitrage. We caution against using this evidence to conclude that such strategies can deliver healthy out-performance in the future.

You can read the full paper here.

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