The following is an excerpt from the recently published book on applying quantitative strategies to value investing: Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors* by two veteran investment bloggers Wesley Gray (Turnkey Analyst) and Tobias Carlisle (Greenbackd). I think this early passage focusing on two very different legendary investors Ed Thorp and Warren Buffett provides a non-technical look at the underpinnings of their process. Tomorrow I will post a Q&A I had with one of the book’s authors.
Excerpted with permission of the publisher John Wiley & Sons, Inc. (www.wiley.com) from Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminated Behavioral Errors by Wesley R. Gray and Tobias E. Carlisle. Copyright (c) 2013 by Wesley R. Gray and Tobias E. Carlisle.
As Buffett and Thorp sat down for the 1968 game of bridge, it appeared that a deep philosophical chasm existed between each man’s investment strategies. Buffett, the value investor, used fundamental analysis on individual securities to carefully calculate their “intrinsic value,” and find those trading at a market price well below that intrinsic value. Thorp, the quantitative investor, valued securities on a probabilistic basis and relied on the statistical phenomenon known as “the law of large numbers”—the law states that more observations we make, the closer our sample will be to the population, and hence greater the certainty of our prediction—to construct portfolios of securities that would, in aggregate, outperform the market. There were other apparently irreconcilable differences. In his 1992 Berkshire Hathaway, Inc. Chairman’s Letter, Buffett said of value investing:
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase—irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.
Thorp had a different view of value investing, spelled out in Beat the Market:
My attraction to fundamental analysis weakened further as practical difficulties appeared. It is almost impossible to estimate earnings for more than a year or two in the future. And this was not the least difficulty. After purchasing an undervalued stock it is essential that others make similar calculations so that they will either purchase or wish to purchase it, driving its price higher. Many “undervalued” stocks remain bargains for years, frustrating an owner who may have made a correct and ingenious calculation of the future prospects.
Buffett spoke in his 1987 Chairman’s Letter about the use of computer programs in the investment process:
In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.
Thorp countered in the introduction to Beat the Market:
We have used mathematics, economics, and electronic computers to prove and perfect our theory. After reading dozens of books, investigating advisory services and mutual funds, and trying and rejecting scores of systems, we believe that ours is the first scientifically proven method for consistent stock market profits.
While the philosophical differences between Thorp and Buffett were vast, over a game of bridge they were able to find common ground chatting about their shared interests in statistics and finance. For his part, Thorp was thoroughly charmed by Buffett, writing later that Buffett was a “high speed talker with a Nebraska twang and a steady flow of jokes, anecdotes and clever sayings.”[i] He also observed that Buffett had a “remarkable facility for remembering and using numerical information, plus an adeptness in mental calculation.” At the end of the evening Thorp told his wife that he thought Buffett would one day be the richest man in America. Buffett’s subsequent trajectory through life is well chronicled, and Thorp’s prediction has been true, or within spitting distance, since the 1990s. Buffett’s opinion on Thorp is unfortunately lost in the sands of time. We can, however, guess that it was favorable.
At first blush each man’s strategy seems diametrically opposed to the other, and irretrievably so. They agreed, however, on one very important point: both believed it was possible to outperform the stock market, a belief that flew in the face of the efficient market hypothesis. While it is true that Thorp’s strategy was grounded in the random walk, a key component of the efficient market hypothesis, he disagreed with the efficient market believers that it necessarily implied that markets were efficient. Indeed, Thorp went so as far as to call his book Beat the Market. Buffett also thought the efficient market hypothesis was nonsense, writing in his 1988 Chairman’s Letter:
This doctrine [the efficient market hypothesis] became highly fashionable – indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but also by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.
On this most important point, Buffett and Thorp agreed: The market was beatable, if you held an edge.
*I provided a blurb for the book and received a complimentary copy from the publisher.