Why Quant may work?

In the previous post, we discussed how to construct a quant portfolio. Now let's try to understand why some thinks that it can work (ie it can outperform the market).

Well first, we must get the right factors though. If you screen for something like stocks that has hit 52 weeks high, or stocks with highest volume, or other funny factors, good luck. You have got the GIGO (Garbage in Garbage out) model. The model is only as good as the inputs.

What people usually believes as good inputs are like Low PER, Low PBR, High ROE, High cashflow, High OP margin, High EPS growth etc.

So there are roughly 400 stocks traded in Singapore and you only buy the top 50 with the lowest PER and highest ROE. What this means is that you are buying stocks that are cheap relative to all others and have the highest return potential relative to all others. And you do this every 6 mths, weeding out those that falls off the top 50 and adding new winners in. Theoretically, you SHOULD outperform the market.

But you don't. Murphy Law's works huh.

Well a few reasons. First of all, the data used are either historical or poor estimates. For PER, usually we get the 1-yr forward PER, which is basically the sum of estimates of all the analysts out there. And we know analysts are, well, like private bankers, GFN right? (GFN: Good-for-nothing). As for ROE, usually that's a historical no. so ROE may have changed, or dropped to below those of other stocks.

Second, to beat the market is a zero-sum game. You need to beat most of the other participants in the markets. This means you need to move faster than most other participants. Now when do you think these quant models were first used? Do you think you are one of the early birds using these models? The answer is NO btw. So investors have used this model since the last Ice Age, and here we are re-inventing the wheel and expecting to beat the market. That's not quite possible right?

But there is still hope.

The markets today, as with our world, has gotten very short-sighted. Thanks to MTV and instant noodles. Most people seek instant gratification. They are not interested in growing apple trees and waiting to eat apples years later. They are not interested in stocks that will only payback after 10 yrs.

So as we all know, the markets are unpredictable in the short term but follows earnings growth in the long run. The quant models, if used over long periods of time, should beat the market (esp if the rebalancing period is also stretched, so you don't get killed by transaction costs) bcos most other participants won't wait that long.

Quant Portfolio Construction

One of the more scientific ways to invest is to actually create a quant portfolio and simply rebalance it periodically. Sounds very chim huh? But it's actually quite straightforward. But unfortunately, it is not exactly suitable for retail investors unless

1. You have tons of money
2. You have tons and tons of money

Well, but it's still quite useful to know how quant works, so don't yawn. And don't click the "x" at the top right corner.

Quant is simply the short-form for Quantitative and it is named as such because it uses mathematical models to drive investment decisions. Quant can be very successful because it reduces emotional influences (screw Mr Market man!) and can generate as well if not better an investment performance as fundamental analysis or other types of investment analysis. (Woah that's a statement huh?)

As a very simplistic introduction, we introduce a 2-step quant portfolio construction process here.

1. Use criteria or factors like PER, PBR, ROE, EV/EBITDA to screen out a list of stocks and buy the top 30-50 stocks.

2. Rebalance the portfolio after the pre-determined period like 6 mths or 1 year etc. (ie repeat Step 1 after 6 mths or 1 year.)

Ok, analogy time, say we want to create a 50 stock portfolio and rebalance it every 6mths and we want to use 2 factors, Low PER and High ROE.

For retail, Poems have quite a good screen in its system so can just utilize that. If not, can ask those good-for-nothing Citibank/UOB privilege sweet-young-bankers to generate these screens. Of course, that's like trying to strike Toto, bcos chances are, they ARE good-for-nothing.

Anyways, so you get this list of stocks, and just simply buy the top 30-50 names on it depending on how many stocks you want to hold. But it has to be at least 30 names in order to smooth out the idiosycracies of individual stocks. So now we know why you need lots of money, to buy that 30-50 stocks.

So that's Step 1. And after 6 mths, simply do the screen again, and buy the top 30-50 names. Of course, if the same stock appeared on the first list. You don't sell off what you hold and buy back the same stock lah. Unless you are trying to please your good-for-nothing Citibank/UOB privilege sweet-young-bankers or something.

So simple as that, if you can do this based on some winning factors (that's the catch huh!). Chances are you can make some money. May or may not beat the market average (to do that, the odds are slightly better than finding a good-for-something sweet-young-banker), but you should not have negative return if you invest over the long run (ie 20 yrs or more).

See also Investment Horizon

The Razor-and-Blade Model

In this post, I would like to introduce a familiar business model (for most value investors) that can help most investors in their analysis of companies. It is also a model that entrepreneurs should seriously adopt when they want to start their own businesses. It is a very basic model that can help generate good recurring income and is probably a sign that the company will be in the business for a long, long time and not those fly-by-night bubble tea shops where you see them today but not tomorrow.

This business model is known as the razor-and-blade model. Well for the uninitiated, this is the model where you sell the low profit margin razor at a cheap price and then earn back the money by selling the blades at a high margin.

Though mundane as it may sound, this model has proven itself time and again that it can generate stable cashflow and earn a good margin. Unfortunately, as the guru used to say, it’s hard to teach a new dog old tricks. So a lot of businesses don’t employ this model.

This model plays on the human mindset by enticing people to buy something, usually having the impression that it should be expensive at a low price. Then after “locking-in” the customer, the co. sells him consumable products at a higher margin. However, our ape-evolved minds cannot relate that instantly and we still think we are getting a good deal.

For example, we buy a mobile phone at S$199 thinking that it’s quite value-for-money given a lot of sophisticated stuff goes inside this cool piece of plastic and electronics (So the phone is the razor here). However, we then need to buy the blades (talk-time) that cost us $30-50 a month! And worse still, we are lock-in for 2 years! So is it really value-for-money if you think of the whole package? Hmmm…

Sounds like it’s a bit unscrupulous? Feel like you are being treated unfairly? But hey, that’s life, folks. Become a shareholder of the company then and screw the management during AGM! That’s why I own Singtel! Haha!

Anyways, besides the telcos, today we see various businesses employing this simple model, including our favourite Ipod (selling you the Ipod/razor, then the songs/blades), Canon printers, Playstation and Nintendo games, anti-virus softwares etc. But at the macro level, not a hell lot of businesses are doing this. Well of course, sometimes the nature of the business does not allow the adoption of the model, like the retail business. Which also implies that maybe that’s why retail businesses cannot earn a hell lot of money. Sadly when Singaporeans say they want to be entrepreneurs, most people think of retail businesses like restaurants, bubble tea (*gosh*) and clothings etc. My guess is only 1 in 20 retail shops will actually "succeed" ie earn as much as a full-time job after adjusting for time and effort put in.

The razor-and-blade model also manifests itself in different versions but the crux remains at its ability to generate recurring income stream. This is best exemplify by Dell, which recently announced that it wants to provide IT services to its clients instead of simply selling them the box (ie the PC lah). So in this case, the PC is the razor and the servicing contract is the blade. So Michael Dell really got some Liao one ok? Don’t pray pray!

Maintenance contract is actually a very good razor because it usually last for 2-3 yrs and hence securing the stable cashflow from the client for that time period, like the telcos (btw telcos is short-form for telecommunications companies like Singtel, Starhub hor). And with minimum extra capex or cash outflow, you actually get this money rolling in.

So next time when you see a business with a razor-and-blade model, remember to give it some credit bcos chances are it will still be earning money even when the crunch comes, unlike a lot of other businesses which will probably go into red. Especially those hot sectors nowadays, like RE related construction where majority of co.s involved don’t really have a business moat and are rising simply bcos it’s high tide now.