John Reese is founder and CEO of Validea.com and Validea Capital Management LLC. Validea Capital is the investment adviser to an actively managed equity ETF. Reese has been running quantitative models since 2003. He is a graduate of Harvard Business School and MIT, published author and investment columnist. Reese holds two patents in automated stock analysis.
1. How and why did you get started investing? What is your background?
I first became interested in the stock market at the age of 13 when I became curious, then fascinated, by reading each weekly issue of Value Line that my father subscribed to and then trying to figure out which combination of Value Line's ratings and screens would help pick the best stocks. Around that time, I also began playing the 3M bookshelf game "Stocks and Bonds" and became quite good at it, reinforcing my interest in stocks and investing.
When I went to MIT, my main interest was learning everything I could about technology and computers. As part of this interest, I joined the MIT Artificial Intelligence Laboratory, where I learned how to extract wisdom from books and incorporate that knowledge into smart computer programs. With the encouragement of one of my professors, J. Licklider, I began to think about how I might make a smart computer program to pick stocks.
However, that was perhaps one of 10 diverse projects that I was seriously spending time on (the others ranging from nondrug treatment of migraine headaches to the first microprocessor-controlled system for office building HVAC systems to save energy and money to electronic speech recognition to a computer-controlled windrower that could automatically harvest rows of grains without being ridden by a human.) I actually brought several of these projects to fruition, but the program for picking stocks ended up on my incubation list, where it was to lay dormant for many years.
After graduation, I went on to a career in engineering and business, getting my MBA at the Harvard Business School and working in the telecommunications and personal computer industries. I eventually founded a business focused on computer networking. It was the sale of this company many years later that retriggered my interest in the stock market – trying to figure out how to invest the cash that I received from the sale of my company.
2. Describe your investing strategy.
At the core of Validea’s investment philosophy is the belief that the fundamental strategies of some of history's top performing investment managers – Warren Buffett (Trades, Portfolio), Peter Lynch, Ben Graham and a handful of others – offer a foundation for superior stock selection, and implementing these techniques in a disciplined, unemotional and systematic manner can lead to long-term market outperformance.
I consider myself and the investing system I’ve developed as fundamentally based and systematic in nature. The strategies I use to select stocks are based off of the approaches outlined by some of history's best investors. I call them market “gurus.” These individuals have shared their investing methods in books and papers, and I've captured these approaches in the Validea investing system. While each strategy is different, they are all investing approaches that determine whether or not the stock of a company is a good value based on the underlying fundamentals.
3. What drew you to that specific strategy?
I had read many investing books, but it wasn't until I read Peter Lynch's "One Up on Wall Street" in the mid-'90s that I had an "aha!" moment. Here was someone with 1) a proven track record who 2) in his book had publicly disclosed the stock-picking strategy that made him successful and who 3) had a strategy with a substantial, clearly described quantitative portion. I thought that I could extract the wisdom from his book and create a computer program to analyze any stock of my choice and tell me whether Peter Lynch would have a strong interest in it – and why or why not.
This development happened near the beginning of the Internet era, and with my handpicked team I went on to offer access to these models on the Internet at Validea.com.
4. What books or other investors influenced, inspired or mentored you? Which investors do you follow today?
At Validea we run quantitative strategies based on books or academic papers by or about the individuals listed below. In most cases, the gurus have a long-term track record of success, have published a stock selection approach that can be quantified and is clearly defined and carry some amount of name recognition and credibility in the investing world.
- Warren Buffett (Trades, Portfolio) – Patient Investor, Â based on "Buffettology."
- Martin Zweig – Growth Investor, based on "Winning on Wall Street."
- Benjamin Graham – Value Investor, based on "The Intelligent Investor."
- Kenneth Fisher – Price/Sales Investor, based on "Super Stocks."
- Peter Lynch – P/E/Growth Investor, based on "One Up on Wall Street."
- Joel Greenblatt (Trades, Portfolio) – Earnings Yield Investor, based on "The Little Book that Beats the Market."
- David Dreman (Trades, Portfolio) – Contrarian Investor, based on "Contrarian Investment Strategies – The Next Generation."
- Jim O'Shaughnessy – Growth/Value Investor, based on "What Works on Wall Street."
- Motley Fool – Small-Cap Growth Investor, based on "The Motley Fool Investment Guide."
- John Neff – Low PE Investor, based on "John Neff on Investing."
- Joseph Piotroski –Â Book/Market Investor, based on "Value Investing: The Use of Historical Financial Statement Information to Separate Winners From Losers."
5. How has your investing changed over the years?
I have been running fundamentally based models and tracking the performance of these strategies since 2003. I have added new strategies along the way. For instance, I added the Joseph Piotroski long-only book-to-market model to my lineup in 2004 and the Joel Greenblatt (Trades, Portfolio) Magic Formula model in 2005 after his “Little Book that Beats the Market” was published. Since then I have continued to add models behind the scenes, but on Validea’s research site you will find 12 distinct strategies and for now these are the ones I plan to make public.
One of the big lessons I have learned in the 13-plus years of running these models is that none of them work all the time, but most work very well over the long term. However, running relatively focused portfolios that hold the top-rated stocks according to any one of the models can be risky – so risky that the volatility would most likely shake the majority of investors out of the strategy. So what I have tried to do is develop ways that these strategies can be combined together to help limit the overall volatility and smooth returns but still give the portfolio a good chance of outperforming the market.
By blending value approaches with growth and/or momentum models, investors can help limit variability. Limiting the potential of massive underperformance is important because many investors can’t stick with a strategy that has a large deviation from the market. It’s very important for investors to understand that to have the potential to beat the market over time, a strategy needs to look different than the market. This concept is called “active share.”
The higher the degree of active share in a portfolio the more potential it offers for long-term outperformance, but the potential for extended periods of underperformance is also higher. So as someone that runs actual money for clients and through an exchange traded product I have created what I call “consensus” portfolios that look to blend various strategies together. Some of the most volatile strategies out there have great long-term returns, but when you look at the returns investors have achieved, they are far less, and this is because of the volatility. I am trying to control for this in the “consensus” approach.
6. Name some of the things that you do or believe that other investors do not.
Many quantitative investment firms develop and backtest their models. We tend to shy away from this. What we do is build models based on other successful investors, some who have actual track records and some who have backtested their strategies. Once we codify a strategy, we start tracking portfolios that hold the top stocks according to each model and over time we develop a track record for the approaches. I am not testing, tweaking or adding or removing criteria. I want to stay as true to the strategy as I can and then give the strategy time to prove itself in the real world before it becomes a candidate to be a model I release to my web site or that I consider for inclusion in my money management portfolios.
The other thing is that I follow the models on Validea with the utmost discipline and I have the conviction to stay with good, long term strategies even when they are exhibiting periods of poor performance. The vast majority of investors don’t have the ability to stick with strategies for the long run and jump ship at inopportune times.
7. Where do you get your investing ideas?
All of the ideas come from my models, many which I run on my web site Validea.com.
8. Name some of the traits that a company must have for you to invest. What does a high-quality company look like to you?
In general, the companies my models tend to select are profitable, have low levels of debt and have low to reasonable valuations. Because each strategy is different, you can go layers and layers down into the specific investment criteria. In total, the models I utilize take into consideration over 300 distinct fundamental variables.
One of the interesting things I have found is that value models can be very different from each other. The strategy I based on Ben Graham’s "Intelligent Investor" looks for deeply discounted stocks with low multiples while the Warren Buffett (Trades, Portfolio) model, which I based on the book "Buffettology," looks at value different by looking at the earnings and profitability of the firm and then estimates an expected return on the stock into the future.
While most of the models I run on Validea are value oriented, there are some that have a growth or momentum focus. These approaches tend to gravitate to higher growth names, mostly based on earnings growth, and then reward companies with characteristics like stock price momentum via criteria such as relative strength, industry relative strength and other factors.
9. Before making an investment, what kind of research do you do? Do you talk to management?
Our system is 100% quantitative and systematic and because of this we don’t talk to management. We feel that management will almost always paint an excessively positive picture of their business, and it is better to look at the results they have actually produced via published fundamentals.
10. What kind of bargains are you finding in this market? Do you have any favorite sector?
In the U.S. market, small caps looks modestly priced relative to large caps and mega caps. For example, going back to 2005, small caps have only been cheaper relative to large caps 10% of the time and only 16% of the time relative to mega caps based on a TTM P/E (price-earnings). International markets, particularly developed and emerging Europe, are trading at very low multiples. Defensive names, like consumer staples and utilities, look expensive while cyclicals and other economically sensitive groups look more attractive based on valuations.
Value stocks have also been lagging growth stocks over the last few years up until the midpoint of this year and we think that provides a very good long-term opportunity.
So long term patient investors might consider tilting more towards value, smaller/mid caps, economically sensitive and international stocks. These have been the areas of the market that have seen relative underperformance, and yet the long-term data in the market tends to support having exposure to many of these areas as a way to generate strong returns over time.
11. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
The U.S. market looks slightly overvalued, but with that being said there are still plenty of opportunities in individual names. Using my own internal data, when I look at the market’s P/E (based on TTM P/E), the market’s price-to-sales (P/S) and the price-to-book (P/B) ratios for all stocks, the market certainly looks a bit expensive. For instance, in looking at the price-to-book of all stocks, stocks have been cheaper 64% of the time over the last 10 years. If I look at the price-to-sales, all stocks have been cheaper 83% of the time.
Add on top of this that the Shiller or CAPE P/E is high in the U.S., and you have individuals like Jack Bogle and Jeremy Grantham (Trades, Portfolio) estimating lower-than-average long-term returns for U.S. stocks, a result of valuations and the current dividend yield. However, the market is giving the economy and earnings time to catch up so if the change in earnings continues to be positive and we stay at the current levels these valuations will come down, which will be good for returns.
Two of the things I worry about are 1) ultra-low interest rates and company borrowing and fundamentals and 2) pension fund challenges.
The ultra-low interest rates have resulted in many firms being able to borrow. Much of this money has gone into stock buybacks and dividends, and while that might be good for the short term, this can’t last forever. Once rates increase, companies that have become over reliant on cheap money could feel some pain, but my hope is that better growth will offset some of this.
The other thing I see in the public sector is some large pension plans that look to be significantly underfunded. I also worry that some of the return expectations for these plans might be too lofty given where 1) interest rates and 2) stock valuations are.
12. Any advice to a new investor?
“Read 500 pages like this every day. That’s how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.”
The best thing for any new investor is to start reading as much as possible about investing. I think investors should start with the legendary books from Lynch and others. Then move on to Graham’s "Intelligent Investor." After that, get O’Shaughnessy’s and Greenblatt’s books. Read valuable periodicals, like Barron’s, WSJ and subscribe to the AAII Journal, which is a great resource.
There are tons of good blogs and sources out there, Abnormal Returns is another one I like. We even run a blog – Validea Guru Investor blog – focusing on articles and insights we think investors can learn and grow from. You want to read and learn, but you want to avoid being a headline investor at the same time. Don’t let the headlines of the day influence your long-term investment strategy and try to understand that the news of the day often times plays off investors’ fears and emotions, so you don’t want to overweight today’s news.
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