In my previous article, I briefly introduced two well-respected masters of quantitative investment - Edward Thorpe and Jim Simons (Trades, Portfolio). Again, I recommend Gregory Zuckerman's “The Man Who Solved The Market” (which is about Jim Simons) and Edward Thorpe's “A Man For All Markets.” They are both well worth the read.
Here are the first few lessons that I learned from reading the books. I believe this advice from Thorpe and Simons is highly relevant to value investors.
1. Whatever suits you is the best
There are many investment styles, each has its own beauty and limits. In fact, just like Buffett's "non-transitive dice" or the game of rock-paper-scissors, there’s no best strategy. We can't simply say which style is best or right and other styles are inferior or illegitimate. One style may work better under certain conditions than others. For example, quantitative investment is mostly short-term and high-frequency, while value investment is long-term and low-frequency.
What suits one's own temperament and experiences is the best. Simons’ mathematical talent combined with his high self-confidence (which he attributes to being the only child of a demanding mother) made him particularly suitable for the founding of Renaissance Technology. Likewise, Thorpe’s naturally unique ability to concentrate completely on a task gives him an edge in solving complex problems, particularly those that require a long attention span.
Even within the same style, there are different strategies. For example, some value investors prefer the Graham approach while others may prefer the Buffett approach. Here I am reminded of Guy Spier’s account of his own journey of discovering how to be the best "Guy Spier" rather than trying to emulate someone else.
2. Clear understanding of circle of competence and competitive advantages
The circle of competence is a cornerstone concept of value investment. The best value investing masters have a deep understanding of these concepts. During the after-meeting session of the 2017 Daily Journal shareholder meeting, I had the honor to ask Charlie Munger how he defines the circle of competence. Munger's answer was that it means to know where you have an edge. This answer puzzled me for a long time, but after reading about Simons and Thorpe, I understood. To know where you have an edge means to be aware of both your strengths and your limitations.
In Renaissance Technology’s early days, Simons and his team knew that their strengths were data and algorithms. Renaissance Technology's data set is more complete and accurate than other quantitative funds, and their systems could identify mispricing that competitors' systems could not. Later, Simons recruited Robert Mercer and Peter Brown, two leading figures of the famous IBM speech recognition team, as well as one of their talented coders. They developed a system of half a million lines of codes, which was the most advanced system at that time.
Renaissance follows three steps: 1) Identify anomalous patterns in historic pricing data, 2) make sure the anomalies were statistically significant, consistent over time and nonrandom and 3) see if the identified pricing behavior could be explained in a reasonable way. In practice, the difference between Renaissance and its competitors is that the third step is often ignored at Renaissance because they believe that if an anomaly is statistically significant but unexplainable, it was less likely to be discovered and adopted by rivals.
Similarly, when Thorpe founded PNP, he was very clear that he would not calculate the intrinsic value of a business like Buffett because he would have no competitive advantages compared with Buffett. But he also knows that he can have information and analytical advantages in pricing of complex financial instruments such as convertible bonds, options and warrants. PNP would long the undervalued securities and short the overvalued ones and make profits no matter whether the market went up or down. In the early days of PNP, Thorpe knew his circle of competence and edge was derivatives hedging. Over time, PNP gradually expanded into other securities, but Thorpe always keeps a clear understanding of his circle of competence.
3. Know your limitations
The most famous strategy of quantitative funds is statistical arbitrage. The traditional definition of value investing is also statistical arbitrage, in a sense. The difference is that quantitative funds aim to find the statistical deviation of relative value, while value investors try to discover the statistical deviation of absolute value (aka intrinsic value).
Any strategy has limitations.The increase of scale and competition may lead to declining returns. Both Simons and Thorpe knew that. Therefore, in order to limit its size, the Medallion Fund would distribute its profits to investors on a regular basis and was closed to outside investors. Likewise, Thorpe's fund’s assets under management never exceeded several hundred million dollars. He probably could have managed more money, but he didn’t want to sacrifice his personal life.
A long time ago, the traditional value approach has worked well in the U.S market. Buying a basket of statistically cheap stocks without conducting deep research could outperform the index by 1-2 points per year in Graham's day. This is similar to the strategy of quantitative statistical arbitrage, just with lower frequency.Ă‚ The famous value investors, including Buffett in his early years, were essentially statistical arbitragers. Obviously, size is also a limiting factor, but there might be more limiting factors to the effectiveness of the traditional value approach. This is a question faced by many traditional value investors today.
Read more here:
- What I Learned From Ed Thorpe and Jim Simons - Part 1
- What I Learned From Arnold Van Den Berg - Part 5
- What I Learned From Arnold Van Den Berg - Part 4
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