The Advantages of Quantitative Approaches to Stock Selection
by Charles Rotblut, Sudhir Nanda
Charles Rotblut will speak at the 2019 AAII Investor Conference in Orlando this fall. Go to https://www.aaii.com/conference for more details.
Sudhir Nanda is the head of T. Rowe Price’s Quantitative Equity Group as well as a portfolio manager for the company’s QM U.S. Small-Cap Growth Equity (PRDSX) and QM Global Equity Fund (TQGEX) mutual funds. We spoke about his approach and what investor investors can learn from it.
—Charles Rotblut, CFA
—Charles Rotblut, CFA
Charles Rotblut (CR): Could you explain what a quantitative approach to investing is?
Sudhir Nanda (SN): There are a number of different approaches included in the common usage of “quantitative.” At one extreme is anybody who is doing high-frequency trading. These investors call themselves “quants.” The general public may also call them “quants.” That’s because they’re using automated processes and automated tools rather than having human beings analyze each stock or do portfolio construction.
At the other extreme, there are people like me who I would call “fundamental quants.” I use the same sort of metrics that a fundamental analyst might use to evaluate a company, but I use them in a very systematic process for ranking stocks.
For example, a fundamental analyst will look at the price-earnings (P/E) ratio to value a company. They will talk to the management, look at management’s capital allocation, and look at other forward-looking metrics about the economy.
As a quant, I use valuation metrics like price-earnings (P/E) and free cash flow yield (free cash flow per share divided by the stock’s price). I use metrics that capture management’s capital allocation, like return on equity (ROE). I consider whether the firm is paying dividends, increasing dividends or buying back stock. What are they doing with their capital expenditures? Is it increasing, decreasing? Then I’ll look at metrics like earnings quality, earnings estimate revisions and price momentum.
If I compare what a fundamental analyst does to what a quant does, they both look at similar metrics in many cases and come up with a way to figure out which stock is good. A fundamental analyst might cover 20 stocks or 30 stocks and buy one or two. A quant ranks every stock in his or her universe. If I’m looking at, say, the small-cap universe, I’m ranking 2,000 stocks. A fundamental analyst will not be able to cover 2,000 stocks. You need 40 or 50 analysts to cover 2,000 stocks. So to that extent, a quant process is very efficient because it can rank every stock globally. One thing a quant does not do that fundamental analysts do is talk to the management of companies considered for investment.
Most quants will use three or four types of metrics to rank stocks. The first is valuation. That’s typically in every quant model, though how valuation is defined could differ. You could use the same valuation metric across your whole universe or you could use different metrics for different industries in your universe. For example, you may use a different metric in health care and a different metric in technology stocks.
The second set of measures captures profitability and capital allocation. We look at metrics like return on equity and stock buyback and dividend policies. These capture what a company’s management is doing with its profits.
The third type of metric that a typical quant model will always have is price momentum and earnings estimate revisions, and maybe even an earnings quality element. Those are the elements we use here at T. Rowe Price in our quant models.
CR: What about due diligence to see if there is something that models are missing—skeletons in the closet that the screens aren’t picking up?
SN: Even within the quant universe space, there are two different approaches. Some people are using very automated black-box processes. They get all their data, they rank stocks on different metrics and combine the metrics to come up with one composite rank for a stock. Then they have an optimizer determine the portfolio construction and do the trade. That’s what the majority of quants might do.
The problem with this is that you are not capturing individual events. What are individual events? There might be a legal issue for this firm, such as an asbestos liability, the CFO may have resigned yesterday, the firm may have made a significant announcement about its future, the company may be going to split into three firms, etc. Those are things you can check for.
At T. Rowe Price, our quant process uses a model that ranks stocks. Instead of having a black-box process, once we have a ranking, we have a human being or a portfolio manager constructing the portfolio and deciding which trades to do. That’s a less-automated approach than the fully automated process that many quants use. You’ll find that at different quant firms, managers may do anything from fully automated to what I am describing we do at T. Rowe Price.
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