Episode #43: Learning to Play Offense and Defense
Guest: Episode 43 is a Mebisode.
Date: 3/14/17 | Run-Time: 24:41
Topics: Episode 43 finds us revisiting the “solo Meb” show. This time, he walks us through his research paper, Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom Up, and the Top Down. If you’re on-the-go, then this episode is perfect for you as it’s a bit shorter.
Sorting stocks based on value and momentum factors historically has led to outperformance over the broad U.S. stock market. However, any long-only strategy is subject to similar volatility and drawdowns as the S&P 500. And as we all know, drawdowns of 50%, 60%, or even 90% make a buy-and-hold stock strategy incredibly challenging. Is there a way not only to add value on your stock selection, but also to reduce volatility and drawdowns of a long only strategy with hedging techniques?
In Episode 43, Meb examines how we might combine aggressive offense and smart defense to target outsized returns with manageable risk and drawdowns.
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Links from the Episode:
Transcript of Episode 43:
Welcome Message: Welcome to the Meb Faber show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing, and uncover and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-Founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s Funds on this podcast. All opinions expressed by podcast participants are solely their own opinions, and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Hello, friends. Today we have a Mebcast, which means it’s just me on the podcast, no guest. I’ve had a lot of great ones lately and some really fun ones coming up in no gif. We thought that the particular market conditions warranted talking a little bit about one of our research papers. So I’m gonna read through this paper that we did. We’ll put it in the show notes, the link. You can download it and read it, or just listen in today. I think it’s particularly suitable for what’s going on in the world, and it’s one that we put out in 2015, and it’s called “Learning to Play Offence and Defense, Combining Value and Momentum from the Bottom Up and the Top Down.”
The quick summary or abstract is, sorting stocks based on value and momentum factors historically has led to outperformance over the broad U.S. stock market. However, any long-only strategy is subject to similar volatility and drawdowns as the S&P 500, drawdowns at 50%, or even 60 to 90%, make implementation of a stock strategy very challenging. Both of those have happened in the past. In the 1920s we had an 80% plus drawdown, whereas many can remember the 250% plus drawdowns of the 2000s. Is there a way to add value on stock selection but also to reduce volatility and drawdowns of a long-only strategy with hedging techniques? So in today’s podcast, we’re gonna examine the possibility of following a strategy that combines aggressive offense and smart defense to target outsized returns with manageable risk in drawdowns. Let’s get started.
I had an old football coach that used to say, “Nobody ever lost a game zero to zero.” He was giving a motivational speech to the defense of the squad, trying to hammer home the idea the defense was just as important to winning as the offense, although offense was a lot more fun, and that’s where all the points that got scored were. The saying has its own complement of course, and when the offense was doing poorly you would also proclaim, “Nobody ever lost a game zero to zero, but nobody ever won one either.”
So many investors struggle with the concepts of offense and defense when applied to investing. Often our emotions work against us here. When we want to play offense is when times are good. Like right now, we think about borrowing to buy more stocks, chasing hot tech names like Snapchat and we chat about how much money we’re making to friends and relatives. On the flip side, when we wanna play defense is often when we start losing money or we have been losing money, so selling stocks after a big decline, and feeling lots of anxiety and fear. Think back to 2008/2009 and how you were feeling, versus how you might be feeling today. Thinking about the concepts of playing strong offense and smart defense together may help investors to find a coherent investment strategy that they can implement and, more importantly, stick with in good times and in bad.
I’d start off talking about offense. So let’s say you take a step back, and set out to design a stock investing strategy. Furthermore, let’s create one that is rules-based, so that anyone can follow it. Likely, the strategy would contain two classic elements that help determine future stock performance: value and momentum. These two factors have been around for better part of a century, ever since Ben Graham and Charles Dow were talking about this in the earliest 20th century, if not longer. At its core, this model should reflect the basic two generalizations: one, invest in cheap stocks, two, invest in stocks that are going up. There are piles of academic papers, stacks of books and real-time fund performance that demonstrate the success of these two factors. They don’t work all the time, and even better they often don’t work the same time, but historically value and momentum have been great ways to select stocks.
The exact specifics of which value factor, so whether it’s price to earnings or price to sales, or which momentum factor, is it 12-month total returns or relative returns or is it 6-month returns? To use doesn’t matter a great deal. Rather what does matter is choosing to use them in the first place, and moving away from market cap-weighted indexes like the S&P 500. Now, there are many, many, many ways to construct such a portfolio and countless others have built simulations before. Think about Joel Greenblatt’s, “The Little Book That Beats the Market,” there’s a famous example of a basic multi-factor stock screen as is “Quantitative Value” by Wes Gray. If you really want to examine various stock factors and how they worked historically, the bible of classic stock screens is “What Works on Wall Street” by our friend Jim O’Shaughnessy. And so we’ll lay out a really basic screen here below, with the help of our good friends, Wes Gray and Jack Vogel, over at Alpha Architects.
So let’s talk about the offensive playbook. In the simulation, we include all historical stocks that trade on the New York Stock Exchange back to 1964, only include large and liquid stocks above the 40th percentile, which is about two billion dollars today, so mid and large cap stocks. Wanna avoid the effects of these tiny small caps and micro caps. The portfolios are formed monthly, with a three-month holding period, similar to some other methods that have been published a long time ago by Jagadish and Tidmen. The two value and momentum variables are as follows. To one invest in cheap stocks, which is value. Let’s rank stocks on PE, which is price to earnings, P to B, price to book, and enterprise value to EBITDA. The average of the three is the value rank. Again it’s not that important the specifics really. We’re just looking for a blended average. Two, invest in what’s going up, or momentum. Here we’re gonna rank stocks on 3-month, 6-month, and 12-month momentum. The average of the three is the momentum rank.
Could we use other variables? Sure, we’re just trying to keep this simple. Each month, we take the top-100 value and the top-100 momentum stocks that are bought and held for three months, equally well outweighed, and we’ll call this combination portfolio, value, and momentum. And again you could do this a million ways, you could do it yearly, you could do it quarterly, you could do it where you take the average rank of value and the average rank of momentum, and take the average of the two. It really doesn’t matter. We’ve seen the research both ways. What really matters, again, is just moving away from the market gap portfolio in general, and looking for these cheap stocks that are going up. So all these returns we’re gonna talk about going forward. Our total returns include the reinvestment of distributions like dividends. No trading or management fees are included. Here are the results going back to 1964: U.S. stocks, S&P 500 did 9.98% per year from 1964 through 2014, pretty awesome.
This value in the momentum strategy, what is called VAMO for short, did over 16% per year. So, again, that is a monster outperformance. Now, the portfolio is more volatile. The S&P was at 14.9% volatility, whereas VAMO was at 18.7%. But that additional return has an effect, even with slightly higher volatility has an effect, of moving the Sharpe Ratio from 0.33 up to 0.62. Interestingly enough, the maximum drawdown, which for the S&P over the period, was 50.95%. So you’ve got cut in half in this bear markets in 2000. The VAMO portfolio was not much worse -56%, but still really hard for a lot of people. So would have outperformed the S&P massively over the time period with over six percentage points over the broad market. Now, of course, we’re benefiting from hindsight, as we now know the value and momentum both worked historically. Every quant around the globe has the same data sets these days, so the historical spread or alpha of these value and momentum of strategies will likely be lower going forward than it has been in the past, as more and more people have implemented such strategies.
We also don’t include transaction costs. It will eat into returns, which should have been more substantial in the 1960s and ’70s. However, we still believe in the benefit of using Value Momentum, and we lump these two concepts into a grouping or strategy that we consider timeless, meaning human nature and the emotional involvement of investors will continue to create stock mispricings in the future. Having an investment approach that focuses on these cheap stocks that are going up seems reasonable, and we believe it is better than market capitalization weighting, and certainly better than buying expensive stocks that are going down. However, the biggest problem is the volatility of the strategy, and more specifically the drawdowns. The buying-whole portfolio would have lost approximately half its assets at one point, and the VAMO portfolio being equal-weighted would have lost slightly more. A 50% drawdown is a very difficult experience for an investor to live through, and most investors simply cannot handle the losses, throw in the towel at the point of maximum pain, often not reinvesting until many gains have been missed. If you’re listening to this podcast, and that seems all too familiar, think about the losses and then if you stuck through it, then also realize, talking to your family and friends, there’s a lot of people that didn’t.
So we all know someone that said, “I couldn’t take it anymore. I got out in 2008 or 2009, never to have been reinvested ever again.” So as evidence of this, we look no further than data published by the research group, DALBAR. Every year they report their findings on investor performance and behavior. Back in 2014 when we wrote this paper, the average 20-year return of the S&P was 9.85, and the average mutual fund investors return over the same period, just 5.19%. DALBAR goes on to attribute a solid half of this underperformance to psychological factors, reporting “behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time.” Top amongst these poor investment decisions is a loss of vision, manifested by panic selling. Quoting DALBAR, “The fear of loss leads to withdrawal of capital at the worst possible time.”
Now while some question the DALBAR methodology specifically, Morningstar’s Ross Kennel examines the impact of poor timing in his classic “Mind the Gap” piece, and they also find one to three percentage points underperformance by investors over the past ten years, versus buy and hold benchmarks. This happens, not just with indexes, but also active managers. People wait for a period of outperformance, chase into that asset class or manager, and then rinse repeat once they’ve done very poorly, sell out again. So now the statistics are not in our favor for involving our emotions. Is there really nothing we can do besides sitting on our hands, while the US stock portfolio declines 50% or even greater than 80%, which has occurred in the past in the US stock market the ’20s. Indeed it is nearly impossible to find an equity market anywhere around the globe that has not declined by at least two-thirds at some point. Almost all equity markets at some point have declined even more. So while most commentators proclaim that it’s impossible to time markets, is there really not any common sense rules that we can apply that may help reduce the draw downs of buy and hold strategy?
So now let’s shift gears from offense, let’s talk about defense. Since we applied both value and momentum rules to the overall stock screening process, what if we applied similar theory to the entire stock market as a whole to determine if we should be in stocks at all, and if so how much? So let’s apply similar broad generalizations to the overall stock market we did to individual stock screening. So rule one, don’t invest in stocks when the broad market is expensive. Sounds simple enough, right? Two, don’t invest in stocks when the broad market is going down. So there are many ways of examining or quantifying these two criteria, and again it doesn’t matter much which specific approach you use as long as it follows these broad themes. In general, when a market is very expensive or also very cheap, almost all the valuation indicators should say the same thing. Likewise when the market is in an uptrend or solid downtrend, most trends signal should be in agreement.
And we’ve published many thousands of words on our hedging strategies and ideas here, and you can find more on the momentum and training component on our paper, “A Quantitative Approach to Tactical Asset Allocation,” just going on 10 years old now, just a little crazy, and more on the value component in our 2014 book, “Global Value.” Following this podcast, we’ll look at two basic methods of value and momentum hedging again, with help from our friends at Alpha Architects, to see if there’s anything we can possibly do to improve our risk-adjusted returns. So let’s talk about the defensive playbook.
When stocks are expensive, let’s hedge half the portfolio by shorting the S&P 500. Likewise, when stocks are going down, in a down trend, we’ll hedge another half the portfolio by shorting the S&P 500. This means a portfolio can be anywhere from 100% long stocks, when the market is cheap and going up, to 50% hedged when the signals are mixed, to completely market neutral, meaning you’re long the portfolio of underlying stocks, the VAMO stocks we’re talking about, but short the S&P 500. And that’s in the case where stocks are expensive and going down.
Now, there’s many ways to implement this. Another way to utilize the timing signals would be to sell the stocks and move to cash. Endure the safety of bonds when the signals say to sell. Both the hedging and the cash choice actually have very similar results. Investors could also use inverse funds, we don’t particularly recommend those, options or many other hedging vehicles that may suit their individual situation for transaction cost, taxes etc. Futures, we are not going to get into that, because there’s a lot of different ways to do it. But let’s talk a little bit more about the playbook. So here we’ll distill the value and momentum theory into the simple rules following. So one, don’t invest in the stock market when it’s expensive. So you can exit or hedge stocks when they are in their top 20% of overvalued territory. Two, don’t invest in stocks when they’re going down. And again by that 20% number, it could be any various number we picked it out of a hat, it could be 30%, it could be 50%, you could scale in and out, but this is meant to be instructive.
So two, don’t invest in stocks when they’re going down. So you exit or hedge your stock portfolio. When U.S. stocks are in a downtrend is defined by being the long-term moving average and the S&P 500. I think we use the 10-month Simple Moving Average here, but something like the 200-Day Moving Average works just the same. And if you want more specifics on the value and momentum signals, we’ll include in the appendix to the paper. No reason to get into it here and cause anyone to get into a car crash or fall asleep at the gym, but if you want more you’ll find it in the paper. So does the hedging help? If you read our prior research, you probably can guess the answer. This following table which is our site shows the VAMO portfolio long-only portfolio with the hedge and the S&P 500. So, as a reminder, and I’m going around here a little bit just to help out, S&P did about 10%, back to 1964. The VAMO portfolio did a little bit more than 16%. The hedged portfolio cuts into returns a little bit, you get closer to 15%. So it’s about a percent lower than the non-hedged version.
However, the volatility, which you remember the VAMO portfolio was a higher volatility than the S&P, the hedged portfolio brings volatility back down to actually slightly less than the S&P. Most importantly, the drawdown comes down. So remember when the S&P lost half, the VAMO portfolio was up around 56%, the VAMO hedged portfolio cuts that drawdown in half, and so you have a much more reasonable drawdown of around 27%. This all has the effect of increasing and boosting the Sharpe Ratio, again from the S&P 500 of 0.33 of the VAMO for 0.62, up to the VAMO hedge for 0.74, which is a pretty nice return.
So the portfolio maintains most of this outperformance of the original stock screen strategy was more reasonable volatility in drawdown numbers, which makes it a lot easier for investors to stick with the strategy. The average returns for the S&P 500 during its worst five years since 1964 was -22.46%. The returns along our VAMO portfolio are similar at -19%, but the hedged portfolio had much more tolerable returns of -2.24%. So for those looking to the market timing Holy Grail, sad to say but we’re sad to disappoint. This podcast, this article isn’t it. Many market timing approaches work, not by massively increasing returns but rather by reducing volatility and drawdowns. This is one reason that many people think that market timing isn’t possible as all they’re doing is focusing on the returns, when basic market timing works potentially by not doing the really dumb things such as buying into bubbles and holding during long bear markets.
And remember, playing defense is just as important to long-term investment survival as offense. Now, some say this reduction in the drawdown from half of 56% to 27 isn’t that big of a deal, and if you can rationally sit through such drawdowns, you may not need a hedging strategy at all. There are some buy and hold investors that realize drawdowns are inevitable, even opportunistic, and have the fortitude to sit through these drawdowns. One of the richest people in the world, Warren Buffett, proclaims, “Unless you can watch your stock holding decline by 50% without becoming panic-stricken you should not be in the stock market.” Likewise his partner, Charlie Munger, chimes in, “This is the third time Warren and I have seen our holdings in Berkshire Hathaway go down top tick to bottom tick by half. I think it’s in the nature of long-term shareholding of the normal vicissitudes of worldly outcomes of markets that the long-term holder has his quoted value of stocks go down by 50%, in fact you can argue that if you’re not willing to react with the equanimity, to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” We largely agree.
However, most individual investors don’t universally share the investing mental toughness of Buffet and Munger, and the comfort of long-term average returns means very little to the investor who’s going through the pain of a 50% drawdown. But remember, 50% isn’t the worst-case scenario, the worst-case scenario is far worse. While the dates of the simulation only go back to the 1960s, market historians will note that one very major mission here, the biggest bear in the U.S. stock market have seen losses over 80%. Could you live through that? Often the bear market occurs simultaneous to significant upsets in the regular economy. So, not only are many people unemployed and investment returns are far from the priority lists, rather simply surviving is. Nearly every global stock market in the world has declined by two-thirds or more in history. Some, like Russia and China, closed altogether. We may think the United States is a special case, but it has happened here, and it is currently happening as we wrote the paper and usually is in various markets around the world. Residents of Russia, Greece, Cyprus and Brazil, currently would probably wish they had a hedging insurance policy in place. Side note: Many of those are now rebounded as we talked about in other valuation concepts. But let’s talk about putting the two together, strong offense, smart defense. So enough doom and gloom for now.
Talking about insurance is never fun when markets are performing well. This has been the case largely in the U.S. since the bottom of 2009. So what’s the system calling for now? As of the day, this podcast which is in March 2017, the outlook for buy and hold is currently very poor with the U.S. stock market being expensive but in an uptrend. An eight-year bull market will often do that equity valuation, stocks were quite cheap by the 10-year valuation metric. We used the Cape Ratio in 2009, but how many investors were buying then rather than selling. For comparison, the Cape Ratio is now up around 30. The historical average is around 17, and it’s hit everything from a low of 5, to a high of 45 in the late ’90s.
So 30 is getting up there. Only a couple times in history when it’s been as high as it is now. So buy an older system, by all means, stick to your system. But for many investors concerned with big drawdowns, or more specifically for investors concerned their ability to hold on to their positions during painful big drawdowns, it may make sense to consider hedging their long U.S. stock holdings. For comparison, foreign, developed and emerging indices, such as MSCI’s EAFE and the emerging markets, are in much more favorable territory being both cheap and also likewise in an uptrend. That’s when you really see the most explosive returns. The best quadrant is “cheap in an uptrend,” second best, remember, is “expensive in an uptrend,” which is where we are in the U.S. The problem comes when that switches from expensive in an uptrend to “expensive in a downtrend.” And that’s when things can get nasty. So as you think about your investment strategy, are you comfortable with only playing one side of the ball?
Are your emotions suited to your system and all the possible outcomes, or would it make sense to play both offense and defense with their equities strategy? There are many ways to improve this of course, or alter these ideas to test your own variants. Find a system that works for your own personal situation. Everyone, thanks for taking the time to listen today. We always welcome feedback and questions through the mailbag at email@example.com. As a reminder, you can always find the show notes and other episodes at mebfaber.com/podcast. You can subscribe the show on iTunes, and please if you’re enjoying the podcast, we would love to see your review. Thanks for listening, friends, and good investing.
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