The Quants Are Here: A Look At Alternative Strategies For 2018

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By SA Marketplace :

2017 has been an exciting year in the markets. All-time highs seem to fall every week, the market has shaken off three Federal Reserve rate hikes as no big deal, and there is so much bitcoin to talk about that it makes a head spin.

It's also been an exciting year on the Seeking Alpha Marketplace. Marketplace is our platform for authors to offer investing services that go beyond what they can do in public articles. In 2017, we went from 75 authors on the platform to 155. Those authors have a wide range of expertise and backgrounds. And while 2017 has felt like a year where everything has gone in one direction - up - we wanted to draw on this diverse array of backgrounds.

So, we're doing a Year End Marketplace Roundtable series. Over the next 2 weeks or so, we will be featuring expert panels giving their outlook on 2018 in corners of the market ranging from Tech to Energy, Dividends to Alternative Strategies, Gold to Value investing. We hope you'll find these discussions useful no matter how you invest.

Today's roundtable features four authors who use an alternative strategy to slice up the market, something beyond a focus on a sector or specific fundamental investing style.

Our panel:

Seeking Alpha: The market is increasingly moving towards either a) indexing or b) quantitative approaches. How does your approach fit into this climate?

JD Henning: My approach relies primarily on several top models in the financial literature that have survived many years of peer-reviewed testing and analysis through different market conditions. I use and enhance these quantitative models to identify value, momentum, and high risk financial forensic characteristics across the market for optimal portfolio selections. I believe that there are always practical methods to be applied that can minimize risk and generate excess returns in any climate. My quantitative approach is delivering sustained double-digit growth across all my different portfolio methodologies for momentum, value, and financial forensic selections.

Andres Cardenal: Investors are moving away from discretionary investing to increasingly focus on data-driven strategies and systems with a proven track-record of performance. The Data Driven investor offers multiple investing system focused on different factors: value, dividends, quality, momentum, etc. Some of these systems have produced annual returns above 20% per year since 1999. Past performance does not guarantee future returns, of course. That said, the systems are based on solid statistical evidence, so chances are that they will continue producing attractive returns in the future.

Fred Piard: I am not in quantitative investing for the fashion, but because it suits my background, mindset and lifestyle. I started investing in my own quant models in 2011. In 2015, I designed a multi-valued systemic risk indicator (MTS10), which is the core of Quantitative Risk & Value.

InsiderInsights: Both trends have been obvious for years, and have absolutely influenced what we do at InsiderInsights. The past 6+ years of my nearly three decades analyzing the insider data filed at the SEC has been focused on "quantifying" this rather old-school (and now very underutilized) investment factor into our InsiderInsights Company Ratings. Our Ratings rank stocks on a straightforward numerical scale from +3 to -3 to indicate Significantly Bullish and Bearish insider sentiment, respectively. Our Ratings have been independently verified as generating alpha, and our methodology has proven time efficient and profitable for integrating the insider factor into a multitude of investment strategies. Our value added insider data and quant-friendly Ratings were accepted onto Bloomberg terminals just this year at {ININ} and {APPS ININ}, and we're further working with an established index firm to construct indexes with our InsiderInsights Ratings to build a family of ETFs.

SA: If your aim is to outperform the market, what strategy do you achieve that given the increased competition from indexing or quant approaches? And if your aim is more focused on portfolio stability or something else, how does that fit into this climate?

JDH: I leverage some of the best models in the financial literature to identify stock selections that can outperform the market. For example, my momentum portfolios leverage the multiple discriminant analysis work of Altman and Taffler to identify strong momentum characteristics. Over the past 37 trading weeks from portfolio formation, this approach is up 48.25%. In the forensic portfolios I leverage the three bankruptcy and earnings manipulation models of Beneish, Altman, and Ohlson to identify the top adverse and positive stocks in the market. My top forensic value portfolio is up 68.11% YTD. Lastly I apply an enhanced value model from Piotroski that is well documented over the past 17 years to outperform all other value selection models in the financial literature. In terms of stability, my top conservative Piotroski value approach is up 10.10% since its September formation. So I use different strategies to outperform the market and each of these quantitative approaches has their own advantage in different market climates.

AC: Quantitative systems are great, and certainly better than a pure discretionary approach to investing. However, I think you can substantially increase the performance of a quantitative system if you add a layer of qualitative analysis to companies in the portfolio.

There are some questions that the numbers just can't answer: How sustainable are the company's competitive strengths? Is management honest and capable? How big is the market opportunity?

In the Data Driven Investor we don't just blindly replicate the quantitative systems, we "handpick" the strongest names in the system based on qualitative and intangible factors.

In the words of Paul Tudor Jones: "No man is better than a machine. And no machine is better than a man with a machine."

FP: First of all, a disclaimer: I am an individual investor and my performance calculations are not audited or verified. Errors are possible. My pure bond ETF model (Bond Rotation) beats bond benchmarks in 2017 YTD and since launch (Jan. 2014). My pure stock models (MN Portfolio, SP500DD, SP500GV) beat [[SPY]] in 2017 YTD and since launch (respectively 2015, 2014, 2013). My personal 25-stock portfolio (MN Portfolio) aims at limiting risks. It beats SPY by only a bit more than 1 percentage point YTD. You know a model is good only when it gets old. My oldest stock model SP500GV (5 large cap positions) beats SPY by about 7 pp YTD and about 95 pp in total return since January 2013. My 2 VIX Trading models are up about 47% and 95% YTD. However, these are high-risk strategies, so I invest a small amount on them. I think the best value I brought to subscribers and to myself in 2017 is through the risk indicator MTS10, which told us to ride the rally with little fear since November 2016 (link: MTS10 Told Us From The Beginning To Set All Sails Out In 2017

II: Reasonable minds will always differ on what strategy is most likely to outperform the market at any given time. Having successfully quantified the unstructured insider data, our clients now profitably use the insider factor in conjunction with their choice of fundamental and price action metrics to screen for individual stocks that tend to outperform the market. Our Ratings also integrate seamlessly into proprietary multi-factor quant models to improve outcomes. We have clients that use our Ratings to help them play penny stocks and microcaps, and others that use our system to identify which stocks' options chains to look deeper into. Fixed income investors also recognize that if those who know a company best think their stock is a value, default on the company's bonds is much less likely.

SA: What was the big story or lesson learned for you in 2017?

JDH: The biggest story for me was the broad adoption of cryptocurrency and the 1,280+% rise of Bitcoin this past year. I suppose the obvious lesson learned was that I should have purchased a lot more Bitcoin in 2015 when I first got my feet wet with cryptocurrency to learn more about this speculative market. I think this currency adoption and market transformation will have an enormous impact on the financial markets and how we do business in the future.

AC: I think the biggest lesson from 2017 is that you need to follow the evidence and leave all opinions and forecasts aside when making investment decisions. The markets were already priced at high levels entering into 2017, and Trump's victory in the presidential election was going to be death sentence for the bull market according to many so called "market gurus".

On the other hand, economic fundamentals and price action data were signaling more upside during the year. Following the data was obviously a much more profitable strategy in 2017 than going to cash because of political noise or similar considerations.

FP: Warren Buffett wrote once, "we will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." That's what I have done for several years and I am especially happy for ignoring the news in 2017.

II: The remarkably dysfunctional political climate in the U.S. notwithstanding as the big "story", 2017 confirmed past investing lessons more than generating new ones. I'm a fundamental analyst at heart and by training, but have found it unprofitable to overthink momentum in individual stocks and the general market. It may feel intellectually satisfying to critique a strong technical uptrend in a stock or the market as merely being a bubble, but it's more profitable to ride the momentum and stay focused on identifying technical exit signs for your individual positions. I stopped spending time formulating hard-and-fast fundamentally based price targets around 15 years ago - and that lesson applied this year as well. I got tired of using my insider data to properly identify an oversold special situation and selling at my fundamentally based price target, only to leave performance on the table as the momentum and growth crowd took over. I've come to think of labels as "value investor", "growth investor" or "momentum investor" as passé. To wring the most performance out of an investment idea, you often have to be all three at various times in your holding period.

SA: What are you preparing for in 2018? Any big themes to watch out for?

JDH: With my quantitative investing models that screen the entire market throughout the day, I basically rely on an inductive investment approach to follow where the strongest momentum, value, and forensic signals lead me. I stay out of a lot of trouble by not pretending to be some brilliant prognosticator of a generally unpredictable world. Historically, the technology and healthcare sectors provide many of the best growth stories and I don't see that changing, especially as the Baby Boomer generation enters retirement. Always keep your eye and a healthy portion of your portfolio on medical and technological companies working on so many amazing new breakthroughs. Many of the best stocks in these sectors appear in each of the different quantitative portfolios I manage.

AC: After several consecutive years of attractive returns in the markets, it's important to avoid complacency into 2018 and keep a close eye on the data. The Data Driven Investor follows different models that protect the portfolio when market fundamentals deteriorate, implementing those protective measures with discipline is remarkably important (A link to this article would be relevant: Getting Ready For The Next Bear Market ).

Looking at the broader picture, key trends such as Artificial Intelligence, Machine Learning, Big Data, Internet of Things, and Virtual Reality are creating amazing opportunities for companies in different sectors. Following these trends could be spectacularly profitable for investors in the years ahead.

FP: In November I started investing in a new 7-position stock model mixing technical trading and value investing. For the rest, I plan to continue executing the same strategies. I don't make predictions, but I think severe sector corrections are more likely than a broad market crash in 2018. I think it is important not to overweight any sector.

II: Our universe of stocks with active InsiderInsights Company Ratings was overweighted in 2017 with biotech & healthcare names, infrastructure-related stocks, and small & medium banks - amongst the usual value plays and special situations. Those bullish themes are continuing into 2018. Notably absent from this universe is an abundance of income-generating names and energy-related stocks - including midstream MLPs. Historically, BDCs and MLPs have been overweighted in our universe, but not at this moment.

SA: What is one of your best ideas for 2018, and what is the story?

JDH: I'm struck by the recent news that both the [[CME]] and [[CBOE]] are set to launch bitcoin futures as early as December 18th. The futures market dwarfs the value of the equity market and this is very likely to add significantly more value to cryptocurrencies in the coming year. On the equity front, Denbury Resources, Inc. ( DNR ) is an independent oil & gas stock with $1.07 billion in sales that I like for the long term. I recently wrote Denbury Resources Beats Q3 Forecasts - How Undervalued Is It? about how well it has performed despite being hard hit by the Gulf Coast's string of hurricanes this season and how its acquisitions and recovery will likely correspond to strong price growth into 2018. Based on my quantitative momentum models, I have a 33% price growth target of $2.50/share from here. DNR is currently up over 42% since Nov. 6 when it was added to my Week 45 momentum breakout portfolio for subscribers.

AC: Apple ( AAPL ) is one of the biggest positions in my personal portfolio, and the stock is also included in several of the quantitative systems in The Data Driven Investor.

Apple is one of the most profitable companies in the world: Operating margin is around 27% of revenue, and return on equity exceeds 36%. Earnings per share increased 24% last quarter, and the company has over $270 billion in cash and marketable securities on its balance sheet. Financial performance is outstanding, yet Apple trades at a conveniently low forward PE ratio of 14.2. As a reference, the average company in the S&P 500 trades at a forward PE around 21.7.

I think the market is pricing Apple like a hardware company, but financial performance shows that Apple is no average hardware company by any means. Apple sells hardware, software, and services in an integrated way. Not only that, Apple has one of the most valuable brands in the world, and this is a key source of competitive strength and profitability for the business. Relevant link: Is It Too Late To Buy Apple Stock?

FP: Most investors understand "idea" as "ticker". The point of quantitative investing is to invest in abstract models, not tickers. I occasionally make a discretionary decision, but it's quite rare. My plan for 2018 is to follow consistently my models week after week with the same discipline. That's my best idea: sticking to a discipline.

II: We have over 30 stocks of various market caps and investment styles on the Recommended List of our InsiderInsights Newsletter, all of which have had full write-ups and garner periodic updates and rationales when we eventually sell. But I've been around the block too many times to fall into the "best idea" trap. Insiders have timely, great ideas no matter what style or risk/reward you are looking for. But I don't know the individual risk tolerance and reward requirements of each reader of this round table, and any one of my stylistic "best ideas" would only apply to a portion of readers anyway. As the owner of an RIA, my regulators would also not appreciate me saying otherwise.

So, my "best idea"? Buy into a strategy, not a tip sheet. Use a system to narrow down and identify numerous investment ideas of various styles, and make the final specific buying decision yourself. You know best what style of investment your portfolio needs. And once you decide on that high-risk/high-reward biotech or low-risk/moderate-return income play - own your decision.

There are no geniuses in this business. But with a process, discipline, hard work, and persistence, you can beat the market. We've designed our InsiderInsights Daily Insider Ratings Reports for the Seeking Alpha Marketplace to fit into every investor's research process.


Thanks to our panel. If you're interested in learning further about their strategies or investment approaches, you should check out the links below:

We are wrapping up our Marketplace Year-End Roundtable series this week with a few last editions. Follow our account to get alerts on those articles, as well as future Marketplace Roundtables and news on what's going on with the SA Marketplace.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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