From Stock Picking To Systematic Investing Success With Wes Gray (EP.167)

0:28We all need to make smart decisions with our money. One of the sharpest minds in the world of quantitative investing, Wes Gray. Wes is the CEO, Chief Investment Officer, and founder of Alpha Architect, a registered investment advisor that offers ETFs, as well as works with other RIAs to launch ETFs of their own. An accomplished researcher and writer, Wes has authored numerous books on investing and financial topics, including quantitative value and quantitative momentum. Before founding Alpha Architect, Wes worked in academia and consulted for a family office, but his path into finance began at the University of Chicago, where he earned his MBA and PhD studying under Nobel Prize winner Eugene Fama.

1:12Prior to that, Wes served as a captain in the United States Marine Corps. In this episode, we dive into a wide range of topics, including the challenges of active investing, the nuances of factor investing, and why value investing has struggled over the past decade. Wes also shares some candid views on emerging markets and private equity, providing insights that every long-term investor should consider. This episode is packed with actionable advice and thought-provoking perspectives, so let's dive right in. Here is my conversation with Wes Gray.

1:51Welcome to The Long-Term Investor. Thanks for having me, Peter. Appreciate it. Well, you're one of my favorite quants in the business, in part because, I mean, you have the decorated academic background, but what makes you so special to me and your perspective so interesting, I think, to most of our audience is that you started out as an individual stock picker. I wonder if we can start there. Just share a little of what you drew from individual stock picking and why you eventually went to a systematic quantitative approach? Yeah. So my experience was I got forced into it after a lot of bad things happened.

2:29So long story short, I started as a huge, I still am a huge Warren Buffett, Ben Graham fan, which your audience may not know. They're kind of like the pinnacle of stock picking and value investing. And that was my religion. And I believed in every single word and every single thing they said going back to the internet bubble. That's kind of when I started really investing, picking stocks. And I just got lucky in some sense to start around 99. I don't know if you recall, but that was a period when it's kind of like right now where all the tech and all that stuff, they go bonkers and all the value stocks are terrible.

3:07But luckily about a year later, it reversed. And I just happened to get confirmation bias that my stock picking and like undervalued value stocks and Ben Graham stuff just crushed it. And then it continued to crush it for another eight years. So I just got this serendipitous period where I thought stock picking Warren Buffett way was the way to go. And then my timing was perfect. And then the follow on was perfect. We're small cap value stock picking, which is what I did just reinforce how much of a genius I was or thought I was as a stock picker. So that's kind of how I got started. Now, let me tell you the ending part of that.

3:49So basically, eventually, I entered into like the PhD program. And obviously, as your audience probably knows, if they're familiar with Professor Fama, that school, University of Chicago in particular, is the antithesis of stock picking. It's like stock pickers, no, efficient market, yes, factors, quant, yes. And so long story short, one part of my journey from stock picker, old school to quant is part of my dissertation is I actually studied stock pickers. And through that analysis, I literally read like 4 ,000 stock pitches, quantified it. The whole point of this was to show that stock pickers add value, which I think I did.

4:29But another part of that research is I could have just done factor portfolios and got 99 % of what they did, but with way less brain damage, way more efficiency and et cetera, right? So I thought I was a genius, but then as you know, because you're familiar with like factor investing and using computers, the computer is basically as smart as I was, but with way less effort, way less brain damage and presumably less cost. So that was number one reason, but there was number two reason because I just couldn't get enough of a good thing. So I actually ended up launching a hedge fund that was systematic based in September 2008.

5:09If you recall, that was literally the start of the great financial depression or whatever the heck they call it. And in that moment, I was running a long, short, kind of market neutral hedge fund quant strategy, but they wouldn't allow you to short anymore. And I'm not Goldman Sachs. So basically all the brokers are like, you know what, you can't short. I was like, oh, great. So I just launched a hedge fund that's long, short, and they say it's illegal to short or you can't get borrowed. So I was like, crap, what do I do now? And I was like, well, this is the greatest stock picker market in the world.

5:40Cause look at all this like value destruction and chaos. And so literally I convinced the LPs, I'm like, guys and gals, let's switch from this quant strategy and let's do stock picking. Cause I used to do that for a living. And this is the best opportunity. Well, long story short, we switched from quant cause I couldn't do long short anymore, went to stock picking. And then two or three years later, I basically replicated the performance of like the Russell 2000 with three times the volatility. And I said, you know what? Had I just done a quant model, I would have actually done better over that period minus like tons of stress and chaos.

6:17So after that moment, that was probably like 2011, 2012. I literally put a line in the sand for myself and I would never pick a stock ever again unless a computer's involved. And I have literally not looked back since that time period. I am 100 % quant now. That's just because I got scars on my back that suggested that computers, good people, bad. That was my long-winded journey of how I moved from fundamental stock picker who thought I knew everything to just using computers to get it done. Well, I love that. I started out my career as an individual stock analyst as well. And I started in 2007.

6:55So all the way down from peak to trough, when nobody really understood what was on banks or financial companies balance sheets, I tried to avoid those. And I just found dirt cheap stocks, I'd run a screener on my Bloomberg, and it felt like I couldn't lose. I was very fortunate to be a big reader and eventually just kind of came to the realization of, oh, I'm probably just getting lucky. Now you were probably, as you mentioned, honed in on small value, which we'll talk about in a second. But in general, my philosophy, the philosophy we have at PlanCorp is one of rules-based, which simply means we're not making predictions.

7:30That could be index investing. It could be factor investing. I think, though, a rules-based approach really aligns better with, as you mentioned, Professor Eugene Fama's efficient market hypothesis. You studied underneath Gene. How would you explain efficient market hypothesis, just what it is and what it is not? Yeah. So I'll give you like the quasi complex version because it's obviously like a topic that people write thousands of academic papers on. But essentially the efficient market hypothesis, there's kind of three levels of it. It says that prices always equal fundamental value, but there's gradients, right?

8:07The weak form efficient market hypothesis basically says, hey, you can't use just price data to beat the market. I.e. so like something like momentum is not going to work. Then they have another version. It's like, well, as long as you have all fundamental data, like all the balance sheet data, income statement data and price data, it's called semi strong market efficient. As long as you're only using that data, you also can't beat the market. And then they have like the strong form, which says that even if you have all price data and fundamental data and insider trading data, you can't beat the market.

8:43Most people generally agree that if you have inside information, you can obviously beat the market. So the market's not that efficient. But then there's like the arguments on like the weak form version or the semi-strong form version. But in the end, it's basically saying, listen, the market's generally right. Prices generally reflect fundamental value plus noise. But the noise is unpredictable. And trying to be a stock pick or throw darts at the wall is probably not a great idea. Just own the market and do it cheap and minimize taxes and have a plan and be systematic. Basically, what you guys are already doing is generally the recommended advice.

9:21Right. So it's not saying that things don't occasionally get mispriced. It's just very difficult, if not impossible, to identify those mispricings in advance and profit from them and do it consistently. Do it for a career. Do it for an investor's entire time horizon, which is multi-decade. And one of my favorite papers that you have written is called Even God Would Get Fired as an Active Investor. Do you mind talking a little bit about that study and sharing what you found? Yes. So basically what that study does, it was just a thought experiment. What if we had the best quant algorithm of all time?

9:57We can literally predict the five-year highest returning stocks. And what if we were to just build an algorithm that cheats? Obviously, this is not a real algorithm. It's impossible. But after the fact, in the database of stock returns, we can obviously sort securities today on their five-year performance, which we just considered like a rough long-term performance match, right? And so obviously, if you do a strategy that cheats, where you're going to know the winners five years from now, of course, over the long haul, it destroys the market. You're going to be a multi-billionaire without a doubt.

10:34However, what's interesting is not that. That's obvious. Of course, you should outperform if you cheat and pick the stocks that we already knew going to win. What's more interesting is that even the perfect stock picking portfolio has massive drawdowns that are basically equivalent to the market. For example, during the 29 crash, maybe the market's down 85%. Well, we called it the God portfolio, like this perfect portfolio. It's down 80%. The other thing is sometimes that portfolio could sometimes underperform the market itself, like the dumb market that doesn't get a cheat. So the idea is that even stock picking perfection, if one could identify it, which we know is impossible, obviously, the issue is, could you even stick to that portfolio?

11:22Because if someone were to come to you and say, hey, I'm the best stock picker in the world and I can predict the future with 100 % clarity, you'd be like, wow, sign me up. But of course, if in reality, as you're going through the period, this magnificent person underperforms triple Q, which is like the tech stock index for a year or two, you might be like, you know what? That guy's an idiot. I don't care if his name's Warren Buffett. We're going to fire him and go buy this like triple Q strategy. So the reality of investing is you can know everything and be perfect, but you always still got to manage the behavioral aspect and the relative performance aspect and deal with the human elements of investing, which is arguably more important than all the actual investing component in many respects.

12:09Yeah, I agree with you. It's part of why I like this paper so much, because if you really, truly understand and adopt and believe in efficient market hypothesis, even if you don't believe it in perfection, but you believe its existence in some capacity, you're going to probably trend towards a rules based, a systematic, a quantitative approach. but this study you did basically flips efficient market hypothesis on its head says you can predict the future you can have the winners but could you stick with it and investor behavior i agree i mean even when you have the perfect strategy you are going to look different from the benchmark the moment you don't buy the total market index which is a phenomenal portfolio in my opinion if you end up with the total market index portfolio, I'm never going to fight you.

12:57But you and I both agree that portfolio can potentially be improved upon, but not without periods of staying the course. And I think most prevalent and the topic that I think a lot of our profession knows you for is factor investing, something that we've mentioned a few times. We'll start real high level and we'll keep digging deeper. But can you just explain what it means to take a factor investing approach? 100%. But let me add one more point to put a little bow on that last topic we had. Another interesting study Morningstar does is they look at like the 10-year best performing funds and they say, hey, what percentage of the years were you actually like a great fund?

13:39It's typically like two or three of the 10 years you were actually beating the market. Seven of the years you look like an idiot. So it's almost like God portfolio. We're like, we know you're the big winner, but could an investor have sat through seven out of 10 years of looking like an idiot? Probably not. They would have fired you. So it's not like even perfection to your point can achieve it. But anyways, I just want to make it not just the God portfolio, but even Morningstar's data highlights just how challenging it is. Like big winning funds almost on average are big loser funds most of the time, which is an interesting statistic.

14:16So anyways, transition to your question of like, what is factor investing? So this is something obviously you can geek out. The best way I think about it, if people are familiar with like Moneyball, basically what happened in Moneyball in baseball and sports, they said, hey, instead of being like the New York Yankees and paying all these analysts all these money to go do interviews and talk to the players and figure out who's good looking and buff or whatever, pick our baseball team. Let's just go look at the data and let's just identify data that looks at characteristics of baseball players and do those characteristics tend to be related to better performance.

14:54And let's just not spend all the money on like getting all the scouts and doing all this emotional stuff. Let's just look at the data and what do they actually do and how does that translate to performance, right? That's basically what you're doing with factor investing. You're saying, listen, stocks are like my baseball players, right? Some are cheap, some are quality, some have high momentum, some do this, that, and the other thing. But can we form portfolios in a systematic way that just uses the data on our baseball players to build portfolios that shape different return or outcomes that we might prefer?

15:28And that's all factor investing is doing. Look at the characteristics and then buy baseball players or stocks that have the characteristics we like to generate a portfolio outcome that we think is more favorable than just buying the generic market, which to your point is also a fine strategy. But sometimes people want something different than just the broad market. Well, that's what factor investing is going to try to do. Well, and just to expand on your great analogy a little more, and correct me if you feel differently, but generally speaking, I think of this approach is if we're looking at the data we have, it's not necessarily picking and choosing which player or company we like based on the narrative, based on the product, based on where it's from.

16:10It's just buying all of them. Now, all of them could be 50, it could be 1000, it depends on sort of how much variance you as an investor are willing to deal with in terms of differences in return from a common benchmark. But as we go through some of these factors, maybe that will make a little more sense. Why don't we actually start with the value factor defined broadly as cheap stocks, which people can define a lot of different ways. Maybe I should just stop talking, let you define it. Talk to me about value investing. No, no. It's actually very important because coming from a stock picker perspective, value investing means something very different than how systematic quants and academics talk about it, right?

16:50So value investing to a normal person who's a stock picker, you might buy Amazon at 50 times revenue, and that could be a value stock, right? Because if the growth is 100 % a year and they're going to crush the world and have great profit margins, you could say that's a value trade. Likewise, you could say like Joe's Chicken Shack that sells for one times price to earnings, that could be a value stock through the lens of a stock picker. But to be exact, quants and systematic folks, when they say value investing, what they generally mean is we're going to look at a characteristic tied to securities that is going to relate a price to some fundamental.

17:32For example, what is your price relative to your earnings? And so they will never consider, like in my prior example there, Amazon to be a value stock if it sells at 50 times revenue, but they might consider Joe's Chicken Shack, it sells at one time PE to be a value stock. And general quant or systematic value investors, they're just trying to capture the characteristic of cheapness purely. And sometimes they add quality and some other things. But it's just important to differentiate because value investing is a loaded term, depending on your perspective. So Wes, you're talking about the value factor.

18:10And I think there's something like over 300 different factors that have been identified by academia. But generally speaking, a lot of them are just data mining noise. And we're looking for factors that have some economic intuition to them that work in different asset classes, work in different time periods. What is it to you that makes value so robust across these different things you're looking for in an investable factor? Sure. So I'm a big believer that humans will always drive stock market prices because they're the ones that are trading these things with each other, right? And I'm also a big believer in this concept, just to simplify the world, usually assets and markets are driven by fear and greed, which people like to hear.

18:57And I think value as defined by just buying baskets of cheap securities, again, not like stock picking value investing, is the fear trait. Because value stocks are by construction, the cheapest stocks relative to a fundamental in the marketplace. Well, as we discussed, markets are generally efficient. So that means that if you're selling for a low price relative to your fundamental value, people must be worried about something, right? These securities, if you look at them and you go into the weeds and you Google the news on them, almost certainly it's going to be terrible stories about this business sucks, they're losing this, Amazon's crushing them, whatever, right?

19:39That's why they're cheap. So it is the epitome of the fear trait. And that's just something that's innate to the marketplace. Stocks that are not sexy, they're not interesting, or they're having troubles in the short term, say one to three years, they're going to get crushed and they're going to become value stocks, right? So your question was, what is the economic backing essentially behind the value factor? And why would one believe that that might work into the future, right? And as I was kind of talking prior there, I believe the market is going to be driven by humans interacting in the marketplace, whether they've got AI, whether they've got tons of technology, or they're sitting together in a parlor trading pieces of paper.

20:17There's always going to be fear and greed sentiment involved. And the value trade, in my opinion, boils down to the fear component of markets, where you will be systematically buying baskets of securities that sell for the cheapest price on some fundamental metric. Obviously, those securities have problems. If you Google the news on them, it's not going to be pretty. It's going to be ugly because people are afraid of these securities. And so the reason one might expect that you would earn higher returns for securities that have more fear, more problems, more things to deal with, it's almost circular logic.

20:58Well, if less people want to deal with them, the prices will keep going down because you need to get whoever is going to be the person that wants to hold them has to get compensated to hold these things, right? Because everyone else doesn't want to hold them. And the only way to get someone else to hold them is you got to make sure you offer them a little bit higher return. And it's pretty obvious, but not so clear that you're going to earn higher returns in the future by owning the dirty, nasty, ugly stocks and not Amazon that's priced for perfection. Because mechanically, the marketplace will not give you a huge return for securities that are going to have an easy go at it in the future.

21:43They will, on average, give you better returns for handling and dealing with stocks that are subject to more risk and more brain damage to deal with. That's just logical. And then, of course, as we all know, there's huge arguments on, well, is the value, is the premium too big, too small? And we can talk about that. But I think fundamentally, if you just buy a bunch of harder to hold, less favorable securities, by design, they should earn higher returns because that's why you're able to buy them at cheaper prices versus like the stuff that's priced for perfection. It's just logic of a marketplace.

22:20Yeah, I like that last point you make, because when I'm speaking with clients, for example, and I just used hypothetical companies and say, hey, if you're an investor and you have two choices of companies and one is very safe and one is very risky, you would demand different returns from those different securities. So if Amazon seems like a sure thing slam dunk bet, then why would you demand as high of a return from it as something that's beaten down in price? And the hard thing, though, is value investing. It's maybe empirically strong, but financial theory takes some time to play out. And the last 10 years for value have been pretty bad versus growth, not necessarily outside the range of expected outcomes, but bad nonetheless.

23:04And so So I guess if you're willing to spin a narrative for us, Wes, why do you think that value has done so poorly the last decade? And how do you think investors should think about the value factor going forward? Yeah. So I think it goes back to the exact narrative we were just talking about, right? Just going forward, if you're willing to buy securities that generally are subject to more economic risk, not in a favorable position relative to all other securities, you should expect to, on average, earn higher returns. but that's not guarantee high returns. Let's say the next 10 years that on average, you're usually right, but we might have a period like we had over the last 10 years where actually it was the case that big tech, great companies actually outperformed even their expectations.

23:52And a lot of these old school, fuddy-duddy, value-y type stocks did worse than expectations. But that was the risk it took in anticipation of beating the market. And that roll of the dice just over the last 10 years didn't play out that well. Like I've just argued that you took fundamentally more risk betting on companies that weren't as well founded. And it actually came true that they underperformed. So obviously you're going to lose money relative to owning a bunch of like overpriced tech stocks. Right. But that's the bet you take. And we know at a sample going forward. Well, do I want to earn higher returns?

24:31Let's say your answer is yes. And I have horizon. I can deal with the chaos of it all. Well, going forward, it's still probably the right bet. If you want higher returns, you're going to have to own these annoying, troublesome, not as sexy securities because that's why you're going to expect there in higher returns. But the bet doesn't always work. And so you can't expect that value is going to outperform the market every year, every five years, every 10 years, because we already know it has massive cyclicality to it because sometimes it doesn't work. and that's why you get the higher returns.

25:04Yeah, and it's really not a good fit if you're not willing to deal with the underperformance for extended periods of time. And I think people who are performance chasing their way into a factor strategy like this, just like they might chase a well-performing manager are gonna be disappointed if they don't realize that let's say one out of every five, 10 year periods, value's gonna cause a drag on your portfolio. Yes, 100%. And then what's your alternative, right? Well, the alternative is I could go buy a bunch of overpriced gross stocks that sell at 50 times revenue. We know the stats on that.

25:39Maybe one out of 10 times you win there. And yeah, the last 10 years they won, but we always invest on a go-for basis. We don't get to invest backtest. right so if my odd book is hey earn low returns with a high high probability and a lot of volatility or earn higher returns with a more reliable probability but none of these are guarantees like obviously you're going to want to leverage towards the bet that's better odds in your favor right like i don't know if everyone's a poker player but if i get two aces i'll probably bet on that hand if i get a two and a seven and i'm playing texas hold them i could bet on that hand.

26:19But why would you do that? So investing, unfortunately, at some level is nothing's a guarantee. And you just need to play smart bets that on average give you potential to win. But after the fact, that doesn't always work. That's obviously why you diversify and do different bets and what have you. But I'm sure we'll talk about that. Well, that's actually the perfect segue, because I was going to say the best bet you can make in investing is diversification. And we've been honed in on one factor exclusively to this point, which is value, you can diversify across factors. And I think, and correct me if I'm wrong, to me, the research that I've read at least seems to suggest that targeting the momentum factor might be the best diversifying factor versus value.