According to IBM, we create 2.5 quintillion bytes of data every day, with 90% of the world’s data having been produced in the last two years alone.1 While individuals may at times suffer from information overload, businesses across the spectrum, from social media and entertainment to banking and investments, have recognised the benefits of harnessing big data.
The use of machine learning to supplement human intelligence demands innovation across industries. A systems view is imperative for leaders who want to lead their respective organisations into the future.
Advances in technology and big data have resulted in data screening tools (quantitative analysis) gaining a strong foothold in the investment management industry. When it comes to finding good companies in which to invest, information and timing are key. This requires the ability to speedily process huge volumes of information from multiple sources.
While quantitative analysis focuses exclusively on the numbers behind data sets, fundamental analysis also incorporates judgement (qualitative analysis) such as company forecasts, industry dynamics and the quality of strategy and management. In this article, we take a closer look at these two approaches and how we combine them in the Investec Equity Fund to optimise idea generation and the risk-return profile of the fund.
Investec Equity: fundamental research is key to what we do
In our search to find good companies in which to invest, our investment team analyses financial statements; the overall health of companies; the management and strategy of the businesses; and industry and economic conditions that impact operations. Fundamental analysis typically entails determining a company’s earnings potential as well as assessing if these fundamentals are reasonably valued. Essentially, fundamental analysts do a ‘deep dive’. Besides critically assessing financial statements, our team visits companies, engages with management, board members, competitors and industry experts, and researches firms’ products and services to identify good investments. A qualitative approach should also include behavioural analysis, which considers investor sentiment to determine share price direction.
As active owners we focus on sustainability of earnings, which includes environmental, social and governance (ESG) principles, which we integrate into our fundamental analysis. Since businesses can circumvent rules, good governance requires strong leadership and sound judgment. Better governance can foster trust in leadership and provide greater confidence in forecasting company earnings. In turn, good corporate governance should lead to better corporate performance and shareholder value over the long term.
Combining fundamental analysis with a quantitative investment approach
A quantitative approach uses mathematical and statistical modelling that collects immense volumes of data at lightning speed to help identify good investment ideas and assess portfolio risks. To put it in perspective, more than 16 million discrete pieces of information feed into constructing a portfolio from a 4000-stock universe. Quant analysts are often described as data analysts working in finance, as they need to be highly skilled in maths, statistics, computer science and finance.
Our Investec Equity quant team’s focus is on mining company-relevant data far and wide, as opposed to considering intangibles such as brand value and intellectual property rights. Such qualitative factors are typically the domain of our fundamental analysts. Quant analysts adopt a disciplined, evidence-based approach to investing and they are not influenced by human emotion or behavioural biases. They rely purely on numbers and data to identify good investment ideas that help to reduce and manage risk.
Figure 1: Harnessing human insight and technology
When it comes to big data and machine learning, public debate tends to pit humans against machines, reinforcing the stereotype of an ‘us versus them’ scenario, rather than entertaining a ‘marriage of two minds’. Even within the asset management industry, it is common to find that active equity managers only employ quantitative analysis as an initial screening tool to identify good investment ideas based on a specific set of criteria. So, quants is often used as a filter to narrow a large investment universe, after which fundamental analysts do a deep dive on these stock ideas.
However, in our view, each approach (quantitative and fundamental analysis) has key strengths and weaknesses. To put it into perspective: quants is ‘a mile wide, but an inch deep’, while fundamental research is a ‘mile deep, but an inch wide’.
Table 1: Both approaches have strengths and weaknesses
Idea generation – finding the right balance
Over the last eight years we have refined our investment process, blending fundamental insight with quantitative analysis to produce more consistent investment returns for our investors. We employ a two-fold process to generate ideas:
- Qualitative: bottom-up fundamental research from our experienced team of analysts, where the best investment ideas are identified based on fundamental company research. For instance, our analysts will examine the market’s earnings forecasts for a company. The aim is to determine whether a company is likely to have higher (or lower) earnings than other market participants expect. When profit forecasts are revised upwards or downwards, we believe it can have a material impact on a company’s share price.
- Quantitative: a stock screen process which identifies the best investment ideas, based on very specific data-driven, fundamental criteria. This screening includes finding companies, based on fundamental investment data, with favourable dynamics (earnings/profit expectations) and reasonable valuations.
Figure 2: Idea generation in the Investec Equity Fund
It is important to note that our quantitative stock screen research and fundamental analysis run parallel to each other, so the one process isn’t relegated to a supporting act: both have a star billing. The investment ideas that are identified by both our quantitative and fundamental analysts typically represent our high conviction stock picks in the Investec Equity Fund. For example, Anglo American and BHP Billiton came up as top picks based on our quantitative and fundamental research. These stocks currently both represent a material holding in the Investec Equity Fund.
A difference of opinion can be healthy
As these two research processes run independently, one may identify a stock as a good or bad investment idea, which might not be supported by the other. For example, Naspers scores poorly on our quant-based metrics (valuation). But a more detailed fundamental analysis reveals that Naspers represents reasonable value, when valuing each business within the internet and media giant separately. Both processes may fuel debate, highlighting the need for further analysis of an investment idea.
This integrated approach reduces the risk of ‘over-confidence’, which can be a pitfall where idea-generation favours only one of these two research processes. Essentially, we capitalise on the best attributes of both. Quantitative screening offers discipline, repeatability, objectivity and efficiency, while bottom-up fundamental research provides depth, human insight and judgement.
Portfolio construction – more than implementing your best investment ideas
Investments may result in financial losses, which is why it’s so important to manage the tension between investment conviction and risk. Portfolio construction and risk management are complex processes for humans. Constructing a simple 30-stock portfolio requires managing hundreds of pieces of expected return, risk and related information, easy for a machine but difficult for a human. Some asset managers will try and manage risk by limiting the weighting of an individual stock or by imposing sector-specific exposures. We believe these measures are a blunt way of managing risk as they constrain potential outperformance and do not consider the multiple correlations between stocks and sectors.2
Having quant expertise within our Investec Equity investment team has enabled us to develop an extensive risk and portfolio management process over years to address these challenges. Proprietary quant tools allow us to combine key risk and return metrics to optimise our portfolio and maximise diversification. Our internally developed system provides crucial information to us on a pre-trade basis. As an example: before we implement a trade to reduce the allocation to one stock in favour of another, the system tells us how it will impact the overall portfolio risk.
While our proprietary models have greatly enhanced the risk management and portfolio construction process, human insight and common sense remain crucial. Fundamental analysts are best placed to interpret breaking company news, market dynamics, regulatory or tax changes, and ESG issues. For instance, fundamental analysis allowed us to assess the risks to Sasol’s earnings when carbon taxes were introduced this year. Given deteriorating fundamentals, we reduced our position in Sasol. When governance issues hit Glencore last year, we took the decision to exit our position.
Figure 3: Investec Equity Fund