There is no shortage of investment advice to “keep it simple, stupid.” Peter Lynch, Warren Buffett, and Joel Greenblatt have all been said to have dispensed this wisdom.
I don’t like it.
I recently met an investor who was planning to use a very simple value-based investment model that he’d created. He backtested it and got decent excess returns. But the very first company his system picked was one whose insiders were selling like there was no tomorrow. I looked at this company and saw that it was indeed a great value by most of the conventional measures. But its growth was poor and its earnings quality was awful.
“My advice,” I told him, “is to build not a simple model, but a complex one. You want to take into account not just value, but quality, growth, sentiment, and size. The more things you take into account, the better off your investments will perform in real time.”
This investor, however, doesn’t like complicated models, feeling that they’re the result of curve-fitting. And he has a point. There is something quite attractive about simplicity.
Look at Joel Greenblatt’s system, as explained in The Little Book that Beats the Market: he considered only two factors, return on capital and earnings yield. And he certainly beat the market.
And look at Jeff Miller, one of the most trusted advisors on Seeking Alpha. He recently wrote, “Simplicity. The temptation for the untrained modeler is to introduce as many variables as possible, hoping to find correlations that others have missed. What they find is misleading. Computers are powerful enough to discover apparent links between variables when there is actually no relationship. A great model uses as few variables as possible. The backtest may not seem as good, but the real-time trading will be much better.”
I hate to contradict investors like Greenblatt and Miller, who have so many more years of experience than I do. My experience is regrettably brief. I implemented my multi-factor ranking strategy only eighteen months ago. But in those months, I’ve made over 75% on my investments.
Is this going to last? It should. It works because I’ve minimized my risk by evaluating my investments from more than thirty different angles. It’s impossible to insulate oneself against stocks that will lose value, but the best insurance is to evaluate every pick as carefully as possible. That’s what most of the great investors have done. If a few simple rules worked, they would render all stock market speculation obsolete overnight.
The more complex and well-thought-out your system is, the more likely you are to beat the market. Most investors don’t implement a few rules and sit back and think, ah, yes, I’m done now. They constantly tinker, trying to anticipate what the market is going to throw them next. Also, it’s more fun that way.
Keep-it-simple investors have a different approach. As the investor I met pointed out, in investing, you’re aiming at a moving target. Technology, interest rates, core beliefs: everything’s changing. The more rules you have, the more likely you are to put your foot on shifting ground. The safe approach is to have just a few, effective rules. And then there’s the danger of curve-fitting, that bugbear of people who backtest their investment strategies.
But curve-fitting and complexity are totally different things. Here’s a very simple two-rule system. Pick the stocks from the S&P 500 with a projected PE for the current fiscal year between 10.5 and 12 and with the number of institutional shareholders between 450 and 470. Then hold for five years. Sounds crazy, right? But if you did this five years ago, your four stocks would be DXC Technology (DXC), Huntington Bancshares (HBAN), Newfield Exploration (NFX), and Constellation Brands (STZ), and your total return would be 378%. Now that’s curve-fitting in action. And the number of rules is irrelevant.
What matters is whether your rules make financial sense. When you buy stock in a company, you want to know how likely that company is to beat expectations. How are you going to find that out if all you’re focusing on is two or three things about it? Looking at companies from a lot of different angles isn’t curve-fitting, it’s common sense. But those “angles” can’t be arbitrary ones. They have to be well-researched and deeply thought through.
I’m going to perform an experiment now. I’m going to design a very simple ranking system on Portfolio123 and test its performance. Then I’m going to make it complicated and test its performance again. I swear to you that I did not “curve-fit” this example—I designed it completely, from beginning to end, before I tested it even once.
There are five main things I look at when I invest in a company: growth, value, quality, investor sentiment, and size (smaller is better). So let’s choose one factor for each. GAAP EPS growth, latest quarter compared to the same quarter last year; forward earnings yield, measured by the ratio of the current year’s estimated EPS to the current price; return on equity; short interest (shares short divided by shares outstanding, the lower, the better); and market cap (lower better too). We’ll design a basic ranking system consisting of those five factors, equally weighted.
In order to test our system, we need to create a universe for testing. It will consist only of stocks sold on the three main exchanges with a minimum average daily dollar volume of $100,000 and a minimum price of $3.00. For simplicity’s sake, we’ll exclude stocks from three sectors: financials, utilities, and real estate.
The following chart shows the results of our ranking system by decile if we bought all the stocks in each decile with monthly rebalancing since the beginning of 1999 (with no transaction costs).
Now we’re going to complicate the system. Let’s start with growth. Instead of just looking at EPS growth, let’s also look at sales growth and income (EBIT) growth, still compared to the same quarter last year, and add, for good measure, next quarter’s EPS estimate compared to the analysts’ actual EPS for the same quarter last year.
Now let’s complicate our value measurement. Let’s add price-to-sales ratio, price-to-book ratio, and EBITDA to EV.
Now we’ll complicate quality. Let’s look not just at return but also three other things: debt, free cash flow, and accruals. We’ll add the debt-to-EBITDA ratio (I reverse this and divide EBITDA by the maximum of total debt and, say, $100,000, so that I can rank companies with negative income and/or no debt), free cash flow margin (free cash flow divided by sales), and an accruals ratio (net income minus operating cash flow divided by total assets, with lower numbers better).
Now we’ll complicate investor sentiment and size. We want not only small companies with low short interest, but companies that are in general flying under the radar of most investors. So we’ll add low dollar volume (three-month average) and low share turnover (volume divided by float).
Now we’ll weight all our sixteen factors equally just to avoid accusations of curve-fitting. Here are the results.
Quite an improvement, right? Our top decile went from a 21% annual return to a 27% annual return, and our bottom decile went from 2% to –3%. If we had invested in the top decile of each system over eighteen years, we would have made 2.4 times the profit with our complicated system than we did with our simple system.
And if we complicated things further, we could get even better results. Since early 2016 I’ve been investing with thirty-to-forty-factor ranking systems (somewhat different from the one I’ve illustrated here), and I’m on track to double my money by August. The top decile of the one I’m using now would have gotten 38% annually since 1999 with the same universe (this doesn’t include transaction costs).
I’ve always been aesthetically inclined to complexity. I have a taste for the baroque. I’d rather visit a building by Borromini than one by Mies; I’d rather listen to Prokofiev than Philip Glass, Amon Tobin than Kraftwerk; I’d rather have Jalqa textiles than Dansaekhwa paintings on my walls. In my book, simple = boring. So it’s only natural that I’d be drawn to complicated, multi-factor investing systems.
But investing well isn’t a matter of taste. It’s a matter of wisdom. Don’t pay attention to people who tell you to keep it simple. Keep it complicated.
My ten largest holdings right now: INTT, NBN, BASI, CNTY, MEIP, ULBI, TGD, RCKY, ARCI, ASRV.
CAGR since 1/1/16: 54%.
