My Investment Strategy Statement

Summary

• I have been writing for Seeking Alpha for just over 5 years, making this piece my 50th article.
• For this milestone article, I share my background, my goals, my process and strategies, and encourage other investors to find their own "investing personality”.
• I am exclusively a quantitative investor, developing my own models and strategies, and share some of my favorite factors.
• I also share some key lessons that I’ve learned as an investor.

Dilok Klaisataporn/iStock via Getty Images

Readers of my articles are accustomed to quant research on various investing strategies, but for my milestone 50th Seeking Alpha article I thought I would share with readers my own investing style, personality and goals through this Investment Strategy Statement.

As a brief overview, and as my SA profile reads, I am an individual investor, who is obsessed with finding opportunities for alpha. I am a quantitative based investor, designing models to capture as many edges as possible.

I look almost exclusively at stocks, in both US and Canadian markets, but also globally through ADRs on the US markets. I have a preference for small and microcaps, and I have found these areas to be the most fertile for harvesting alpha.

While I started off as a value investor, I have grown as an investor to be more style agnostic. That said, I use elements of different styles (i.e. value, growth, technical) in all of my models.

Before getting into the details of my thinking and strategies, let me share some of my background.

About Me

I am an engineer by education, and this is the focus of my daytime career at the moment. I am not trained formally in finance, however with my quantitative background I relate well to many elements of finance.

I started off investing very passively, first with my financial planner managing investments through mutual funds, and through my employers' "off the shelf" plans.

Some years later, a close family member passed away, and I received a modest, but not insignificant inheritance. My family worked hard to build their assets, so I felt it my responsibility to better understand my options for best putting these funds to work for myself and in turn, my family. Over time in tandem, I was slowly building up my assets through regular contributions to retirement and savings accounts.

At around this time, I realized that my financial planner's mutual funds and my employers' plans were just not cutting it. I started looking at several other options, from investing on my own in mutual funds, precious metals (physical), becoming a small business owner, and real estate (which I've written about on Seeking Alpha, see here for Part 1 of a multi-part series). I eventually landed on stocks, particularly value investing.

I absorbed everything I could on Buffett at the time, and started investing on my own in his type of high quality, moat bearing, compounding businesses. Using Morningstar stock reports as my source of research, I selected those companies I thought were of the highest quality and the most discounted to fair value.

The investing bug hit me, and it became a mild obsession (and is now maybe more than just a mild obsession).

While I enjoyed this process, in hindsight I was going about it very haphazardly, using discretion to choose companies I felt would be good bets. I was only loosely tracking my performance overall, so I really didn't know if I was making good choices compared to the market or not. That said, over the few years that I was investing this way, from what I could tell I was achieving average returns.

Source

After reading Joel Greenblatt's "The Little Book that Beats the Market", everything changed. As an engineer, using a purely quantitative approach really appealed to me. Greenblatt's "Magic Formula" style of investing became an obsession, and I have written about it extensively (see here and here for starters).

I then went back to one of the first quantitative investors, Benjamin Graham, and read his tome Security Analysis, and then the more accessible Intelligent Investor.

It was shortly thereafter that I stumbled upon Seeking Alpha, and found an article that used quantitative research from an engine called Portfolio123. Here one can devise their own quantitative models and screens for their own investing.

I was immediately hooked, and spent the next 5 years designing my own investing strategies, learning many valuable (maybe "painful and expensive" would be more accurate) lessons along the way. I have not looked back, and am a self-proclaimed "quant".

From my perspective, data provides an edge to differentiate between the narrative and the facts. In finance, there are "narratives" everywhere. Some are backed up by facts and research, others are great stories that "feel right", but with little to back them up. In my background of science and engineering, there are no narratives without a theory based on scientific first principles, or even better, based on tested, empirical evidence. I usually take the latter approach with investing strategies. A strategy or idea can sound really convincing, but unless there is robust, empirical evidence backing up the claim, it is simply just another narrative to me. Perhaps some may find this limiting, but it aligns with my own values and way of thinking.

A reader went so far as to refer to me as an 'intellectual avenging angel'; this may sum up my approach to narratives quite succinctly.

My Investing Approach Today

While I started off as a value investor, many of my strategies today include several different style factors, from value, growth, technical and sentiment.

I started off investing in high quality large caps, and eschewed small and microcaps, following the conventional wisdom that these smaller issues are "illiquid and risky". Over time, my approach nearly inverted 180 degrees, as today the majority of my portfolio is comprised of small and microcaps.

I like small and microcap stocks for several reasons:

• As I use many fundamental factors, I have found that small and microcaps are most sensitive to these factors.
• Microcaps usually have a long runway of growth ahead of them.
• Many small and microcaps are undercovered, so earnings surprises can have a significant upside (which I've written about here)
• If you control for "junk", on balance microcaps have a higher likelihood for higher returns
• A good fit for the "wealth accumulation" phase of investing

My strategies typically consist of a universe of stocks, a ranking system of several factors (in cases 50 or more), and some buy and sell rules. My strategies require re-balancing, some as long as annually, but most are weekly.

As part of this investing strategy statement, I will offer a few key lessons that I have learned over the years, that perhaps can benefit others in their investing journey.

Lesson #1 - "No Free Lunch"

Source

Every investor has a unique journey and personality, but their objective can usually be reduced to either wealth accumulation or wealth preservation. For me personally, I am in the wealth accumulation phase of my investing journey. As I segued above, in my experience microcaps provide an ample opportunity for accumulation. However, it is not a free lunch; even after controlling for "junk", microcaps can be quite volatile. To combat this volatility, I have two defenses:

• Diversification, and
• A strong stomach

I approach diversification a few different ways. First, I have both US and Canadian trading strategies, usually 2 to 4 strategies per market (I currently have 4 US strategies, and 3 Canadian). Second, all of my strategies have a minimum of 20-25 stocks. I employ both "all weather" strategies that are designed to perform in all (or at least most) market environments, and I have others that I cycle between depending on macro factors and broad changes in the market (more on this below).

As for the strong stomach defense, I've learned that the potential for alpha and excess returns from small and microcaps comes at a cost - volatility. If I can hang on, these stocks generally reward me with alpha. I would even go so far as saying that designing a robust strategy is only a fraction of the effort; the ability to trade and take the swings of the market and "stick to the plan" is the real test and path to outperformance. To be fair, I may say that I have a strong stomach, but it is still uncomfortable, at times very uncomfortable. Volatility can really make one question their choices.

Lesson #2 - "Know Thyself"

Source

As one grows older, the simple anecdotes and adages one hears when they are younger become clearer; the wisdom in the meanings (or lessons) is unveiled only through life experience. In an investing context, one of the most critical commandments, in my experience, is to know your investing personality ("know thyself").

For example, do you need certainty? Is it important to follow the crowd, or do you have a drive to go against it and be a "contrarian"? Can you focus on the long-term picture at the cost of short term underperformance, or do you need short-term gains to keep you motivated? How well can you admit that you are wrong, and move on?

These questions need to align with your investing goals as well, i.e. are you accumulating or preserving wealth?

For me, it has taken many mistakes, wrong turns and missteps to "know myself". As I described above, I've gone through many styles of investing before finding my sweet spot of small and microcap quant investing. Even within this arena, I have made mistakes and have had my confidence knocked down a few notches on several occasions. And investing is a journey, where you continue to learn more about yourself; changes in the market have unveiled certain behaviours in me that I did not see just 6 months ago. More on market changes below.

Lesson #3 - Investor or Trader? Does it really matter?

One of the tenets of Buffett style investing is that as equity investors, you are an owner of a business. This is a very compelling idea, and sets one up for very long-term investing.

True, as an investor in the stock, you own a portion of the equity of the company. Truthfully though, unless one is a significant shareholder, most equity investors have little say in the operations of the business, other than some voting rights. These Buffett style companies are typically older and established companies, and move slowly (including their returns).

I am impatient by nature to a degree, so needing to wait for these firms to "do something" is not aligned with my expectations.

As noted above, most of my investing strategies use frequent balancing, as short as weekly. This usually results in an average holding time of anywhere between 2 and 4 months, with some as long as 1 year or more if they continue to rank high in my strategies. Many argue that "investing" is a long-term play (a la Buffett, "Our favourite holding time is forever"), and that holding stocks for an average of 3 months is not investing, but trading.

I'm not sure why, but in my experience many investors look down on traders and do not consider their craft "investing". For the longest time, I had taken this to heart as well. Practically though, the end result of both parties is the same, i.e. accumulate and/or preserve capital. How well you know the companies of your stocks and whether or not you can recite the pets' names of all the board members of your stocks or not, to me, is irrelevant. My priority is accumulating capital through those stocks most likely to appreciate in value. I do not identify myself as a "cigar butt" investor, but my strategies will often find underpriced stocks that deliver a quick return (say within 6-12 months), but are not necessarily a long-term play. Just for the record Mr. Buffett, I am perfectly fine with that.

Lesson #4 - The Market is Always Changing

As a quant, backtesting and research is a major part of my process. The traditional approach of much quant research is to test over very long periods of time. This is informative to identify broad trends in the market, but realistically, the market changes much more frequently, to the point that the average results presented from studies over "long periods of time" can be nothing more than academic. This goes back to one's investing personality. If value investing truly outperforms growth investing, how long (maybe years) can you tolerate underperformance until value overtakes growth?

My most costly investing mistake was to assume that a backtest of a full 20-year period was the most accurate way to assess a strategy. I had developed an investing strategy that showed an impressive backtest, and I levered up. In hindsight, the strategy was over-optimized, had too few data points (using only 5 stocks!), and performance was only measured over the longest period possible. The results were disastrous.

In reality, a strategy can have a very short period of significant outperformance, with the remaining years suffering underperformance, resulting in above average performance "over long periods of time". Market conditions could have been just right for the strategy over the short period, but lacklustre for the remaining years. Looking at an investing strategy only "on average", or any data set for that matter, can lead to some very misleading conclusions.

As a colleague once cynically counselled:

If I put my head in the oven, and my feet in the freezer, then on average my body is at room temperature.

Admittedly this is a simple and exaggerated anecdote, but it does highlight a key lesson on the dangers of taking an overly simplistic approach to data.

My Strategies

As I mentioned above, at any given time I usually implement a combination of "all weather" strategies and strategies for the current market conditions.

I have a preference for small and microcaps for several reasons, one being that they are most sensitive to strong fundamentals and quant strategies. I do much research on a factor, both through existing academic research, and my own. As a pragmatist, if I cannot replicate performance of a given factor in my own tests from those of academia, then it is not included in my strategies. In terms of academic research, SSRN is a fantastic resource.

I usually do not rely on a single factor or style, but rather use several. If current market conditions have historically favoured a particular factor, then I may focus on those factors as well.

Here are some factors I rely on:

Value and valuation

• Traditional value metrics, such as low P/E, low P/B
• Less conventional metrics, gross profit to enterprise value (I wrote about this here), and R&D spend to enterprise value
• For fast growing SaaS companies, I use a relative valuation to growth regression, detailed here

Growth

• High, improving and stable (or sustainable) growth, in terms of sales and EPS
• Both forward (analyst estimates) and trailing growth

Momentum

• Industry momentum - those industries that have performed well recently likely have room to run

Quality

• Both quality of earnings and profitability - low accruals, margin growth, high and stable operating leverage

Technical

• Size! The smaller the better (but still liquid, usually $100K daily volume or greater)
• Insider/founder ownership Sentiment
• Earnings and sales surprises, decreasing short interest, estimate revisions

These factors have varying effectiveness over time and through different industries, and some only work well with other factors; for example, investing based on small size only is generally not advisable, but when combined with growth, quality and other factors returns have been attractive historically.

In terms of seasonal strategies, there are times when Mr. Market favours certain types of stocks or factors. One strategy that I have been using for the last year is based on small cap value. Over "long periods of time", this has not been a very good trade, however when market conditions are right, this group truly shines. I wrote about this "Crisis Investing" extensively here and here, which uses the high yield spread as a signal for entry into the strategy.

The real-time equity curve for this strategy from May of 2020 to today is shown below:

Source: Portfolio123 output, Author Strategy

Where the red curve is the strategy performance (165%), and the blue curve is the benchmark (112%), S&P 600 Small Cap Pure Value index. For reference, the S&P 500 (SPY) returned 55% over the same period.

This strategy did quite well from inception (May 2020) until March 2021, but has since gone sideways and has been range bound; this strategy may have run its course, as the strategy is intended for recovery in the business cycle, which we may have surpassed. Which leads to a relatively new aspect of my investing.

What's next in my investing journey? Macro Factors

One of my favorite investors is Howard Marks; co-founder and co-chairman of Oaktree Capital Management, and of "The Most Important Thing" fame. Not only does he have a fantastic investing record, but as a writer, he has the uncanny ability to clearly and concisely convey complex ideas, not unlike Warren Buffett.

That said, he has been quite vocal about his opinion on macro forecasts. From Marks himself from his most recent memo:

Regular readers of my memos know that Oaktree and I approach macro forecasts with a high degree of skepticism. In fact, one of the six tenets of Oaktree's investment philosophy states flatly that we don't base our investment decisions on macro forecasts. Oaktree doesn't employ any economists, and we rarely invite them to our offices to share their views.

Source

In his memo, Marks continues that the macro environment is important, but it's just extremely difficult to actually know what is going to happen.

I would have to agree with Marks, but I would still like to think that there are some factors out there that can be used to help provide clues on where opportunities lie. The performance of the small cap value strategy above, which was "timed" during the 2020 recovery, gives me some assurance that there may be some ways to practically time the market, or at least understand the business cycle and how it impacts markets and various asset classes.

This is still of burgeoning interest to me, and my research into this is still early, but I do believe that even if one cannot use or forecast macro factors to time the market, at least one should have the background to understand why the market is behaving a certain way due to the prevailing conditions of the day.

I plan to research more into this topic, stay tuned.

Putting it All Together

I've shared some of my investing backstory, my goals and personality, specific investing strategies and tactics, and what I am thinking about next. It is my hope that readers find their own way on their unique investing journey.

I also invite readers to share some of their key lessons over their investing journey.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article is for informational purposes only. I am an individual investor and writer, not an investment advisor or certified analyst. Readers should always engage in his or her own research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or specialized attorney before making any investment, income tax, or estate planning decisions.