Insights / June 25, 2024

Minds AND Machines

The Role of Quantitative Analysis in Fundamental Investment Research

EXECUTIVE SUMMARY

  • Wasatch believes that earnings growth drives stock prices over the long term. And we think that the best way to capture earnings growth is through bottom-up, fundamental research of individual companies. Our quantitative analysis complements our fundamental research as we prioritize continual learning, performance optimization and risk management.
  • Our top predictor of future investment performance has been our management ranking system. In this system, we give each of our companies a management ranking, which is subjective (qualitative). However, our analysis of these rankings is objective (quantitative).
  • We want stock picking to be Wasatch’s largest driver of investment performance “alpha.” Our quantitative tools don’t tell us what to buy or sell. Instead, they help us size positions appropriately for performance optimization.
  • Based on four primary inputs, our sizing model generates a suggested weight for each of our holdings. Wasatch portfolio managers are notified if the suggested weight is more than half a percentage point above or below the current weight.
  • For all Wasatch investment strategies, our portfolio managers regularly review risk reports designed to highlight portfolio-level exposures that could prevent stock picking from driving investment performance.
  • Our quantitative work is done at the individual company level and at the portfolio level. For the latter, it’s important that we get a clear picture of the overall characteristics of the portfolio and that we develop a plan to implement any necessary changes.
  • Wasatch portfolio managers sometimes override the flags generated by our quantitative tools. And such overrides are recorded so their level of success can be evaluated in the future. We believe accountability is a necessary part of our commitment to continual learning.


QUANTITATIVE TOOLS TO FLAG POTENTIAL ISSUES

    With continued technological advancements in investing, it’s appropriate that we always think about when to rely on human minds for decision-making—and when to use high-tech “machines” for decision-support. In this regard, consider that the best pilots are firmly in control of their airplanes but nevertheless use sophisticated instruments to plan their routes, stay on course and prevent errors.

    Similarly, at Wasatch Global Investors, our portfolio managers use quantitative tools developed internally to fine-tune our fundamental, bottom-up investment process. Our proprietary tools are constantly operational in the background to flag issues that should be contemplated. This does not mean that the tools make decisions for us. Instead, they simply prompt our portfolio managers to think about the following three questions when a flag is triggered:

    • Is the flag best addressed by automation or by human judgment?
    • If automation is most appropriate, should the automated solution be accepted completely or modified in some way?
    • If human judgment will override the flag, exactly what course of action should be taken based on the portfolio manager’s unique insights?

    MANAGEMENT RANKING SYSTEM

    We’ve found that our top predictor of future investment performance has been our management ranking system. In this system, our research analysts and portfolio managers independently give each of our companies a management ranking, which is subjective (qualitative). However, our analysis of these rankings is objective (quantitative). Put another way, our human minds have been responsible for conceiving and implementing our management ranking system. But our “machines” have been helpful in tracking and archiving the results.

    Over time, the data have shown that the quartile tabulation has been our best predictor of top performance going forward. The first quartile has certainly done better than the other three quartiles and better than the market as a whole. Even more impressively, the first quartile has also done better than the stocks of companies estimated to have the best future sales and earnings growth.


    SIZING MODEL

    Our advanced quantitative work at Wasatch is intended to improve the consistency and efficiency of our decisions. There are two main elements of our work. The first element is our sizing model, which is used in an effort to increase alpha.

    Generally speaking, we consider our sizing model to have been successful if a portfolio has outperformed—on a risk-adjusted (volatility-adjusted) basis—the return of the benchmark and the return that equally weighted holdings would have generated. The sizing model receives four primary inputs:

    • Our management ranking system, which (as described above) groups our companies’ management teams into quartiles based on quality.
    • Our “Olympus” system, which ranks names from 1 (best) to 100 (worst) using about 50 factors that we think are somewhat predictive of the future because they appropriately reflect quality, valuation or momentum. We select the factors based on our decades of experience and back-testing of various Wasatch hypotheses (rather than back-testing of general market indicators).
    • A stock’s absolute volatility, which is reflected in the standard deviation of daily returns. More volatile stocks often have smaller weights, and less volatile stocks often have larger weights. In general, we believe volatility-adjusted portfolios are better-diversified and therefore superior compared to equal-weight portfolios.
    • The relative return correlation, which shows a stock’s fluctuation pattern versus the entire portfolio. Stocks with relatively uncorrelated returns generally deserve larger weights because they’re better diversifiers. And stocks (even strong performers) with highly correlated returns usually receive smaller weights because they’re worse diversified.

    Based on the four primary inputs, our sizing model generates a suggested weight for each of our holdings. The portfolio managers can decide whether or not to act on the suggested weight. Such decisions are then recorded so their effectiveness can be evaluated in the future.


    RISK REPORTING

    The second main element of our quantitative work is risk reporting, which highlights portfolio-level exposures that could prevent stock picking from driving investment performance. Our risk reporting presents three primary types of indicators:

    • Style factors are underlying company characteristics/risks such as quality, growth, value, leverage, procyclicality, market capitalization, and stock-price momentum and volatility.
    • Group exposures are risks we can classify by region, country, sector, industry cluster and industry. Our risk reporting presents group exposures that are adjusted for volatility because unadjusted exposures can be misleading.
    • Risk proxies are themes for which we can measure correlations tied to overall portfolio returns. Risk proxies are too numerous to list completely but include themes such as consumer spending, cyclicals, GLP-1 drugs, inflation, interest rates and work-from-home.

      For all Wasatch investment strategies, our portfolio managers regularly receive risk reports designed to flag higher-level risks being incurred.


      SUMMARIZING THE WASATCH APPROACH TO QUANTITATIVE ANALYSIS

      Our main objectives with quantitative analysis are the following:

      • Have the best investment ideas drive performance
      • Determine how much to scale up or scale back—i.e., own the right names at the right position sizes
      • Keep unintended risks relatively low
      • Limit macro risks so they can supplement—but not overwhelm—our main focus on stock picking
      • Provide a framework for decision-making, which is especially valuable when volatility is extreme

      In conclusion, we return to where we began. Does the age-old struggle of minds VERSUS machines exist in managing investment portfolios? For us, it does not. In fact, our approach is to get the most out of both minds AND machines. Similar to the way we balance the art and the science of investing, we also balance minds and machines as we seek continual improvement in an incredibly challenging profession.

       


      RISKS AND DISCLOSURES

      Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

      Wasatch Advisors LP, trading as Wasatch Global Investors, ARBN 605 031 909 is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.