I am here to talk about

Marriage

Valuations and Momentum.A match made in Heaven

Presented by: Manish Dhawanwww.mysticwealth.in

Disclaimer.

If I have seen further, it is by standing on the shoulders of giants.

Isaac Newton.

Wesley Gray (Alpha Architect) Mebane Faber.

There is a Villian in the STORY.

Efficient Market Hypothesis.

Father of EMH, Mr Eugene F. Fama, 2013 Nobel laureate in economic sciences.

This is What the Villian has to say about our Groom.

You cannot beat the market by stock picking.

Buying something below its intrinsic value and Waiting for market to realize its mistake does not work.

Warren Buffet and alike are just Outliers.

It is like playing chess with someone who thinks using brain Is a waste of time.

We are grateful to them as we owe much of our alpha to academicians who are teaching this to our competetitors.

This is What daddy says....

This is What the Villian has to say about our Bride.

“The premier Anamoly is momentum.”

Eugene Fama

This is What Ed Seykota says....trader takes an Efficient Market Scholar to lunch. On the way the trader sees a 100 dollar bill on the sidewalk and points it out to the Scholar. The Scholar tells the trader he must be mistaken, since if there were one there, someone would have already picked it up.

Random Walk 'Scholars' are still not picking these 100 dollar bills, since it can't be there. And I Am not complaining.

I have one SIMPLE RULE,

Whenever a Person with Proven track record of failure, critizes someone,Take note and remember you might just have spotted an OUTLIER.

Research Study done by Alpha Archetect.

How does the Simulation work?

Step 1. Break Stock down into different valuation deciles from 1963 to 2013 based on EBIT/TEV(avoid weird micro/small cap outlier effects)

For example, if there are 1000 stocks, stocks 1-100 go in the first decile; stocks 101-200 go in the second decile, etc.

Next, do 1000 simulations of random 30 stock portfolios drawn from  the cheap stock decile or the expensive stock decile.

Step 2

So, This is equal to a monkey throwing 30 darts s each month for a 50 year period. And we haveA 30 stock portfolio every month for 50 years. At the end we will have 600 (12months *50 years)Seperate monthly Portfolios. With a total of 18000 (30 *600) stocks.

This represents 01 simulation, a 1000 such simulations were done each for top decileAnd bottom decile

The Best of Costly stock Portfolio could not beat the worst of value stock Portfolio.SO MUCH FOR MOAT INVESTING.

As expected, Volatility on value stocks is considerably lower than costly stock portfolio.

Guess What, DrawDown on value stocks is considerably lower than costly stock portfolio.

Research Study done by Alpha Archetect. 1927 to 1962

How does the Simulation work?

We sort stocks into deciles based on stock performance over the previous 12-month ranking-period returns (months t-12 through t-2, skipping the first month).

Example: If there are 1000 stocks in the universe, stocks 1-100 go in the first decile (High mom/winners), stocks 901-1000 go in the tenth decile (Low mom/losers), and the stocks in between 101 and 900 go in their respective deciles.

Next, each month we draw a random 30 stock portfolio drawn from either the “winners” decile or the “losers” decile.

image we have a monkey throwing 30 darts, every month during the 36 year period, to establish, in each month, a new 30 stock portfolio. Once our monkey has thrown his 30 darts in each month, we will then have 432 separate monthly portfolios (12 months * 36 years) and will have made 12,960 (30 stocks * 432 months) individual stock picks. This represents one simulation.

This represents 01 simulation, a 1000 such simulations were done each for top decileAnd bottom decile

Ride the Winners, Cut the losers.

Strange as it may Sound, High mommentum Stocks are less volatile than low mommentum stocks by a factor of 2. Counter Intuitive!!!

Although, drawdown is a lot lesser than low momentum stock, It still can Churn your Stomach upside down. 70% OUCH.

Momentum investing works and is driven by a Predictable underreaction to positive fundamentals

Value investing works and is driven by predictable overreaction to negative fundamentals

What if I want my cake and Eat it Too.

Result of Marriage

First solution is to have 02 seperate portfolios. One for Value and other for momentum.

Second solution is to BLEND the two.

The Test: Blended Value/Mom vs. Pure Value & Mom

We form the following four portfolios:

1. EBIT VW = Highest decile of firms ranked on Value (EBIT/TEV). Portfolio is value- weighted.

2. MOM VW = Highest decile of firms ranked on Momentum. Portfolio is value-weighted.

3 COMBO VW = Rank firms independently on both Value and Momentum. Add the two rankings together. Select the highest decile of firms ranked on the combined rankings. Portfolio is value-weighted.

4 50% EBIT/ 50% MOM VW = Each month, invest 50% in the EBIT VW portfolio, and 50% in the MOM VW portfolio. Portfolio is value-weighted.

(7/1/1963-12/31/2013):

This is Work in progress.

As per This research, You are better off investing your funds in 02 seperate portfolios.One for VALUE and other for MOMENTUM.

But remember, This study only analyzed simple value and simple momentum strategies. Perhaps there are more sophisticated techniques to make “blended” val/mom better than allocations to pure value and momentum.

I am currently working on similar lines in my own capacity. Trying to figure out and derive ALPHA by combining the 02 outliers named VALUE and MOMENTUM. Like I said

This is Work in progress.

S&p returned 10% cagr during the same period.

Email:info@mysticwealth.in