For the longest time, fundamental analysts and fund managers such as myself have sat on our high horses claiming that investing/investment is purely an art; one bets on people which cannot be accurately modeled. While there is some truth to these statements, it is important not to disregard the importance of quantitative tools in both research and portfolio management.
In research, quantitative tools can help speed up research as well as help scour the breath of the market far more effectively. After having gone through the cases of corporate misallocation and misappropriation uncovered in the past decade, we compiled a list of markers in companies’ financials that were consistent across all the fraud cases.
With these further codifications, it becomes effortless for us to utilize our comprehensive in-house accounting check to identify any potential warning signs when evaluating company names. This allows us to not get carried away by stories and provide a very real health check of the companies.
The greater use case of such tools is however in helping us overcome our biases. In our desire to scour the entire breadth of the market for businesses that fit well with our investment philosophy, we wrote down our entire framework in code and converted it into a scoring mechanism. We then applied it across the entire gamut of listed companies in India. This tool helped us to achieve prowess in companies as compared to previously as we outline to prevail biases.
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For example in December 2019, steel companies saw a significant score improvement and conversely the biggest consumer of steel in India, the automobile industry saw the biggest deterioration in the score. The flavor in the investment world however at the time was investing in perceived “quality” businesses, one with moats and brand power. Metals and commodities were completely ignored by most active investors including us. Using the quantitative model, however, opened our eyes much before active investors accepted this to be a valid trend (post the first wave of covid).
In today’s day and age, it is naive for investors to believe that they can garner an information edge over others. The information is all out there, available for consumption. Developing tools to digest it effectively can help one work far more productively and overcome biases in evaluating ideas and constructing one’s portfolio.
More importantly, though, quantitative tools can be a blessing for all fundamental managers in portfolio management. The act of selecting what to buy or stock picking has consistently received excessive attention and been overemphasized in our profession. However, the true differentiating factor often lies in the decision of when to sell. Investors who rely on analyzing company fundamentals typically dedicate a substantial period, around 1-2 months, to evaluate a new investment idea for their portfolio. Once an investment is included in the portfolio, they allocate even more significant amounts of time to it.
Hence, they are emotional about their positions no matter how rational they may be. By utilizing a quantitative model aligned with their investment philosophy, investors can maintain a higher level of objectivity when evaluating the businesses they own. Numbers have a way of compelling us to acknowledge reality more promptly. During a specific instance when we owned a branded business, we found ourselves skeptical of its fundamentals, yet we witnessed a decline in the brand’s strength as indicated by the prolonged elongation of working capital over time. Restoring a damaged brand image can be a lengthy process, testing the patience of even the most skilled investors. However, our adherence to a cash flow-focused scoring system, in line with our investment philosophy, allowed us to overcome our biases and save a substantial amount of time and money. It took the business five years to recover and return to its previous levels of utilization and functionality. By effectively managing this time correction, we were able to free up mental resources to explore other investment opportunities.
It is a fallacy to believe that quantitative indicators are solely technical. You can choose your quantitative tools so that your investment philosophy and time horizon are best served. We are not advocating taking the ‘art’ out of investing, simply making a case to augment it by using science too.
(By Harini Dedhia, Portfolio Manager and Head of Research, Tamohara. Views are personal)