On Investment Modeling, Part 3

This is the last piece intended in this series, but I know that I will get a some abuse for it.  One small request to those who agree with me on this issue: if I get flames as a result of this piece, and you disagree with the flames, please comment in my favor.  Thanks.


Warren Buffett once wrote a piece that is in one the editions of Ben Graham’s The Intelligent Investor, called The Superinvestors of Graham-and-Doddsville.  Buffett chooses nine investors that learned from Ben Graham, including himself, and shows how they outperformed the market averages over many years.

Very nice.  Another win for value investing.  I live in Graham-and-Doddsville for the most part, and have admiration for my neighbors.  No envy here.  I do well enough.

But, even though Buffett knew these investors long ago, and they were all students of Ben Graham, what I don’t know is whether Buffett culled only the best of Graham’s students for his essay.  I think the best of Buffett; I generally think he is an honest guy, but I don’t know for sure.  I write this as a convinced value investor.


Far better to try to do a general study.  The trouble is that it is difficult to segment the market into value investors, and everyone else.  The category is squishy.  Even if we could define the category well, we would have a hard time aggregating all of the data from all of the brokerage accounts.


So, what are we left with?  We boil down strategies into their quantitative essences, and measure the performance of the quantitative strategy versus the index.  The result is bloodless, and accurate to the first degree, in analyzing an investment strategy.

This is what the academics do.  Though I disagree with the Carhart factors, because I view them as alphas and not as betas, the basic idea of testing a strategy over the whole of the market is valid, if they take into account a full accounting for transaction costs.

See if the strategy is valid from the first approximation of turning it into a mathematical formula.  For value investing, it has worked.  Value factors have outperformed.  I love being a value investor, and I have been better than most of my competitors.

But that is not enough.  Price momentum factors have also outperformed.  Which brings me to my final point: Michael Covel hand-picked many successful trend followers in the his book, Trend Following.  He had more freedom to pick trend investors than Buffett did to pick value investors.  I give Michael Covel a choice:

  • Are you willing to recognize that value investing works, even as momentum investing works?
  • Or, do you end up a narrow-minded man who only sees one way to make  money in the markets?

Though I am mainly a value investor, I do not abhor momentum investing.  I incorporate it where I can.

But when Michael Covel chose other trend followers to demonstrate the value of his theory, he was less restrictive than Buffett was, and Buffett’s method was less than scientific.

I am not trying to pick a fight with Michael Covel.  On October 1st, we had a “discussion” over Twitter that he started, and I finished, where we discussed this topic.  Anyone who can re-assemble the full details of the topic please e-mail me, and I will post it.

I tried to be a gentleman, but Covel interpreted me as being a wimp.  I hate that.  A gentle answer discourages wrath, and that is what I aimed for, but he did not perceive it.


Much as I am not crazy about academics in finance, the way that they analyze strategies is the only fair way of analysis, because it allows for no discretion.

There are two choices for doing an economic analysis in finance:

  • Segment investors, and analyze their performance
  • Describe the distinct strategies of investors in easy quantitative terms, and show how they perform versus the index.

There are a large number of studies that show that price momentum is a winning strategy.  I agree with those, and let Michael Covel agree with me.  I am not looking for a debate, but an agreement.

With that, I leave it in the hands of my readers.  Why not incorporate both value and momentum into your investing?


Update: here is a transcript of the discussion with @Covel:

Covel: @AlephBlog You get grief because you don’t understand the subject and ignore the performance.

Merkel: @Covel As you wish sir.

Covel: @AlephBlog http://www.michaelcovel.com/2009/04/25/david-merkel-defending-a-wrong-view-to-the-bitter-end/

Merkel: @Covel I don’t bear grudges, do you?

Covel: @AlephBlog Is this seriously how you debate? Everything is an emotional counter?

Merkel: @Covel No, I still stand by what I wrote.  There are five parts, and you would do well to read them carefully.  My opinion is expressed.

Covel: @AlephBlog If you were serious about the subject you would examine the blind spots in your argument. You don’t and wise people see why.

Merkel: @Covel I responded in detail to your statements; you did not. Your use of “ad hominem” argumentation was without basis. Compare me w/Cramer?

Merkel: @Covel Look, I am fair. Please write a piece that shows pt-by-pt where I am wrong, or affirm that your last piece was that. I will +

Merkel: @Covel re-examine my “prejudices” and write a follow-up.  But, are you willing to be as fair? It’s your ball, run with it.

Covel: @AlephBlog If you are truly intellectually curious write a cogent argument for trend following performance. Don’t be lazy like your review.

Merkel: @Covel I have written many times on the value of using price momentum in investing.  I mentioned that in my reviews a number of times.

Merkel: @Covel Try this, then: http://alephblog.com/2009/01/21/a-different-look-at-industry-momentum/

Covel: @AlephBlog No banana. Explain the decades of trend following performance generated by the traders mentioned in my book. Let’s see it.

Merkel: @Covel In any strategy, those who do the best survive and get known. Using hindsight, they get picked to show that the strategy works.

Merkel: @Covel Buffett used the same argument for value investing in his essay The Superinvestors of Graham and Doddsville http://bit.ly/9IKsDf

Merkel: @Covel My answer to you is that cherry-picking is not analysis. Please do a study of all trend followers to prove your argument.

Merkel: @Covel Comprehensive article on the value of momentum and mean-reversion. http://bit.ly/cCzx2p This is what I think is careful research.

Covel: @AlephBlog Who are failures? Name them. Describe why they failed. Let’s see it. Don’t hide behind “Covel it’s only survivors!”

@edwardrooster @alephblog His argument is idiotic. He is trying to say thousands of trades over decades is luck. That is foolish.

Merkel: @Covel Selection of high performing investors does not prove that a method works. I am not saying anyone’s performance is luck. Momo works.

Covel: @AlephBlog I am out. Even if you read my book, there is no comprehension. Typical bias. Wrong, but unable to accept. You must protect self.

Merkel: @Covel Happy trails. Come back when you want to talk reasonably.  If you get to Baltimore, lunch is on me.


  • hippoicthus says:

    As someone who’s used value+momentum for the last 20 years, I endorse David’s suggestion.

    Using both is better than either alone by some 300+ bps per year v. an equal-weighted S&P or Russell benchmark.

  • I don’t do exactly that, but I do something close.

    I’ve posted this before and my investments usually meet these three criteria:
    – Solid fundamentals and attractive valuation (not necessarily a bargain, just not overpriced)
    – Limit opportunity with large macro risks and welcome those with big macro opportunities.
    -Good technical entry and exit points.

    That means once I find a good company in an industry I like, I wait until I have a technical opportunity to dive in. I’m done catching falling knives. No point in trying to time the bottom. If the company is really worth owning, the technical opportunity will present itself and I will be there to buy it. That also means not selling as soon as something is overpriced, but really sticking to your guns and waiting for valuation to overshoot. I am a little trigger happy with the selling, so I’ve taught myself to use collars or vertical spreads once I want to sell but technicals tell me not to. It’s worked great so far.

    the biggest thing, though, is that I don’t buy anything that I don’t believe has a high value-added (regardless of profits made through value extraction). The limit of sustainable returns is the market price given to the value created. Therefore my biggest focus is an attempt to find industries with a high value added that is not being fully appreciated, where a sudden change in the way the value-added is valued monetarily could suddenly generate large gains. You obviously need to have a catalyst, but thats another story. It’s really just about trying to find services and products people take for granted that have a much higher consumer surplus than producer surplus.

  • matt says:

    I’m not sure how you could get flamed for a post like that. It seems innocuous.

    What do you use for a momentum indicator? Relative strength is the only one that I can think of, but the term is nebulous. The original definition that I learned was performance relative to an index. But, which index should be compared and over which time period?

    I have also noticed relative strength metrics that take recent price movement of [security, index, etc.] and compare it to past moves of the same thing. (For example, how does this recent run-up in MCD compare with past run-ups). I don’t understand this measure as well in the context of explaining price momentum.

    I think that adding a momentum indicator to valuation is very important because issues can remain undervalued for longer than your investment time horizon. Finding entry points seems very important.

    • The followers of Covel tend to be fanatical; when I wrote my book review of Trend Following, they were pretty harsh.

      Price momentum — I use relative strength, or depending on the situation, percentage price change over 10 months (momentum)) and 4 years (mean reversion).

  • ljoneill says:


    Good article and series. A few comments and/or questions for you. First, there is no doubt that both value and momentum work. And while I happen to personally be a big believer in (certain) trend-following approaches, the way in which Covel interacts with people is childish at best. There is room for professional discourse and disagreement, but he has little interest in being professional about anything…at least in the blogosphere/twitterverse world. So, keep at it…be a gentleman and let the other chips fall where they may. Now, a few other areas:

    1. First, I’d be interested to have you elaborate a bit further (or point me to a different post) on your views of the Carhart factors. In my mind, there is no doubt that they are betas…but at the same time, there is also no doubt that those betas can and should be used (carefully) as alpha factors as well. Much as my brain has been trained to think about them as simply betas, I’m more than willing to think about them in both ways. They aren’t mutually exclusive, are they?

    2. Second, and importantly, I don’t believe that every investment strategy can be boiled down to a fairly simple mathematical/quantitative approximation. Therefore, not every strategy can be tested in a purely academic sort of fashion. Take Covel’s trend-following, for instance. There are obviously many ways to do trend-following, but few are so simple as to easily do an historical test. It’s NOT simply momentum (as you well know!), and while momentum and trend-following certainly have some correlation, it would be a disservice to the TF crowd to view one as a proxy for the other. The buy and sell rules, timing of entry points, level of stop loss, etc. are hugely crucial to the success of the strategy.

    3. So with #2 as an assumption, the only way to analyze TF is as a group of investors. Is there survivorship bias? Yes, but you have that with value guys, too. Is it enormously dependend on sticking with the system, even when it’s not working? Yes. Is there a good sample of auditable accounts out there? No…not so far as I’m aware. I think the issue that Covel has is that the majority of the best investment returns people have ever put up are from the momentum/TF crowd. However, one should very clearly separate investing from trading. The trading crowd has the ability to put up ginormous returns, but at what cost? Huge volatility, gigantic turnover, etc. that most people are not willing to live with.

    So in the end, as you’ve said before, it comes down to finding a system/approach that has shown the ability to work well for others and sticking with it through the tough times. No approach to investing/trading will be absolutely perfect every month, and most people lack the discipline to actually make it work over time. They switch from system to system, at the most inopportune times.

    Thanks for the good work…keep it up!

  • techperson says:

    David – I wanted to pass on some interesting info. I used to consult for Sid Cottle’s FRS Research. (Sid was the Cottle in Graham, Dodd & Cottle.) Sid told me that he had analyzed Ben Graham’s portfolio for a research project, and except for GEICO, it essentially matched the index. He didn’t mention if the risk measures were lower or not.
    Second, Warren Buffet followed Graham very carefully and never made any money. Buffet himself recently said his 1964 decision to buy Berkshire Hathaway, then a fading Massachusetts textile company, was a $200 billion blunder. It was Charlie Munger who sat him down and told him he needed to stop looking at net asset values and start looking at highly profitable businesses with defensible moats.
    Or to put it another way, what value investing criteria would have led you to buy Coca-Cola, American Express, GEICO or most other Buffet investments? He did go back to Graham to justify the purchase of USAIr, and you know how that turned out.

    • Kyle says:

      @techperson you have to be joking? Never made any money??? Try reading the Buffett Partnership letters. He generated 31% annual returns from 1957-1968 (vs 9% for Dow). He articulates his strategy very clearly and quotes Graham in nearly every letter.

      Seth Klarman is another example. He drinks the Graham and Dodd Kool-Aid too (He recently wrote the Preface to the 6th Ed. of Security Analysis). He’s averaged 20% since 1983.

      Buffett has stated several times that he could generate substantially better returns if he had a smaller capital base. And that he would be investing in smaller/obscure situations (Just like he did in his partnership).

      Hard to find many statistical bargains when your acquisition criteria is in the $5-$20 billion range.

      Buying an exceptional businesses is great but in the end price is all that matters.

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