The Long Short - Deep Fundamental Pair Trading

[Claudius]

So you're effectively chasing black swans.

Inspired by the Michael Berry story in Vanity Fair, I actually looked into testing something very similar to your system last month.
(His early Scion Capital quarterly newsletters are well worth reading).

He appeared to use P/FCF as his main determinant of value.

I ranked stocks using the FINVIZ screener based on a variety of value criteria. I then picked 10 stocks from each end of the ranking to either long or short. I also looked for stocks that already had some momentum. My aim was to review once a week.

I had a few issues with the system:

1. It's very difficult to rank stocks from different industries with different growth prospects, different cash requirements, etc. etc.
Each end of my ranking would be dominated by certain types of industries.

2. Do you set stop losses and then risk shooting an ugly ducking that would have then turned into a beautiful black swan, or no stop loss and risk chasing a loser down into negative return hell?
And is the stop based on relative or absolute returns?

2. Difficult to test the idea. Back testing is almost impossible and even forward testing by paper trading is difficult, because you're always tweaking and changing the rules. It's also psychologically difficult to start using a system that hasn't been tested at all, and maintain interest in a system that doesn't do anything for long periods.

3. Payout distribution and uncertainty. I can handle a bad week. A bad month is stretching it, but I'm not sure I could handle 6 months or a year of going nowhere, with no idea if or when a payoff would arrive. I think it's natural to desire a steady income that can be compounded over time.

4. Poring over company financials is very time consuming, and not particularly interesting. I can think of better ways to spend my life.


Having said all of that, I still think there's a lot of potential in what you're doing, so I'm very interested to see how you go.

Any of the original set stopped out yet?

 

[comfy_slippers]

Quote from Claudius:

So you're effectively chasing black swans.

No, not at all. I would prefer to avoid them.

When they inevitably appear I am doing my best to make them work in my favour.

Inspired by the Michael Berry story in Vanity Fair, I actually looked into testing something very similar to your system last month.
(His early Scion Capital quarterly newsletters are well worth reading).

He appeared to use P/FCF as his main determinant of value.

Yeah great article.

Burry uses FCF...... which for me, makes too many assumptions. Predicting future cashflows is hard at the best of times. Liquidation value is much easier to objectively measure. Remember he primarily long only.... maybe FCF is a better proxy for that type of strategy.

1. It's very difficult to rank stocks from different industries with different growth prospects, different cash requirements, etc. etc.
Each end of my ranking would be dominated by certain types of industries.

Yeah this is cyclical reversion. Industries will always have their moment in the sun. If they are making outsized returns it is just a matter of time before competition pops up, margins decrease, and growth reverts back to the mean. It is often good to short these industries and long the underperformers as over time they will both usually reach some sort of equilibrium.

2. Do you set stop losses and then risk shooting an ugly ducking that would have then turned into a beautiful black swan, or no stop loss and risk chasing a loser down into negative return hell?
And is the stop based on relative or absolute returns?

I am not concerned if a stock does a u-turn after being stopped out.

It has happened to me 100's of times and all part and parcel of trading. It is how you handle these type situations that will determine your success as a trader......

I simply cut and run, move on. No point in cursing the world at your bad luck. If you get frustrated in these situations then you need to question whether trading is really an occupation suited to you.

2. Difficult to test the idea. Back testing is almost impossible and even forward testing by paper trading is difficult, because you're always tweaking and changing the rules. It's also psychologically difficult to start using a system that hasn't been tested at all, and maintain interest in a system that doesn't do anything for long periods.

You need to tweak systems to survive. The market dynamic is always changing and if you don't change with it you die.

Look what happened to Richard Dennis

Using fundamental valuations as a proxy has been mercilessly back/forward tested. You can do a search on google and find any number of studies from reputable investment houses....

3. Payout distribution and uncertainty. I can handle a bad week. A bad month is stretching it, but I'm not sure I could handle 6 months or a year of going nowhere, with no idea if or when a payoff would arrive. I think it's natural to desire a steady income that can be compounded over time..

"A steady income that can be compounded over time.."

If your after a steady income....Maybe try bonds or other income instruments... You even said yourself that traditional pairs trading can have long drawn out periods without any return:

" After four months of pair trading, I have an 80% win rate, 18% small losses and 2% huge losses that blew my slowly accumulated profits out of the water overnight."

I am chasing returns in excess of those afforded by "steady income" type instruments. If I want these returns then I need to accept drawdowns, flat periods etc as part and parcel of the game. It's just nature of the beast

 

[comfy_slippers]

Quote from Claudius:
Difficult to test the idea. Back testing is almost impossible and even forward testing by paper trading is difficult, because you're always tweaking and changing the rules. It's also psychologically difficult to start using a system that hasn't been tested at all, and maintain interest in a system that doesn't do anything for long periods. [/B]

Hi Claudius,

Here's a good read:

http://www.tweedy.com/resources/library_docs/papers/WhatHasWorkedInInvesting.pdf

For those who don't want to sift through, here is an excerpt:

[Please note I don't blindly follow these results and it is only part of my framework. the study is just there to show people have found merit in using fundamental ratios as a screen.]

A second study conducted by Werner F.M. DeBondt and Richard H. Thaler, Finance Professors at University of Wisconsin and Cornell University, respectively, examined stock price in relation to book value in “Further Evidence on Investor Overreaction and Stock Market Seasonality,” The Journal of Finance, July 1987. DeBondt and Thaler ranked all companies listed on the NYSE and AMEX, except companies that were part of the S&P 40 Financial Index, according to stock price in relation to book value and then sorted them into quintiles on December 31 in each of 1969, 1971, 1973, 1975, 1977 and 1979. DeBondt and Thaler then calculated the investment return against the equal weighted NYSE Index over the subsequent four years for all of the stocks in each selection period. The four-year returns against the market index were then averaged.

The stocks in the lowest quintile had an average market price to book value ratio of 0.36 . DeBondt and Thaler found a cumulative average return in excess of the market index over the four years of 40.7%.


Meanwhile, the stocks in the highest quintile, those with an average market price to book value ratio of 3.42 and an average earnings yield of 0.147 (a P/E of 6.8), returned 1.3% less than the market index over the four years after portfolio formation.

Tweedy Browne updated the above studies in 2009. Their own findings confirmined those of the studies described above, and a range of other studies that confirm the findings over different periods of time and in different countries. The findings form a compelling argument for an investment philosophy rooted in deep value and focused on assets.

 

[comfy_slippers]

WEEKLY UPDATE (-1.52%)

Earnings Season: 1
Comfy_Slippers:0

Breezed through last couple of earnings seasons quite well, decided to do the same this week. Fingers caught in the Cookie Jar with OSTK (Short) opening up over 25% post earnings and UWBK (Long) opening down around the same amount.

That being said I am happy with the result. I suffered far worse with no earnings to blame.

For those wondering my stops are 30% above(below) entry, so a couple starting to approach.

Looking forward to next week.

p.s being in Australia I will post weekly updates on Thursday US time..