HCP Quant !

A Non-UCITS fund investing in global small- and mid-cap stocks

Pasi Havia!

27.1.2014

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What has worked in equity investing? Successful investment strategies

What causes undervaluation?!Influencing factors

How to improve investment returns?Utilization of quantitative methods

”It’s a bumpy road ahead”!Nothing is perfect

• Small companies have returned across the world better than the market

Small-cap stocks

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Country Time Period Excess return (p.a.) Research

Australia 1985-1996 5.9 % Liew & Vassalou (2000)

Austria 1978-1995 5.8 % Heston et al. (1999)

Belgium 1978-1995 -1.2 % Heston et al. (1999)

Canada 1960-2001 5.0 % L’Her et al. (2003)

Denmark 1978-1995 3.5 % Heston et al. (1999)

France 1978-1995 3.1 % Heston et al. (1999)

Germany 1978-1995 1.3 % Heston et al. (1999)

Greece 1982-1997 0.5 % Rouwenhorst (1999)

Ireland 1977-1986 5.6 % Coghlan (1988)

Source: ”International Evidence on the Size Effect” (Savina Rizova, 2006)

Small-cap stocksCountry Time Period Excess Return (p.a.) Research

Italy 1978-1995 -0.2 % Heston et al. (1999)

Japan 1975-1994 4.2 % Hawanini & Keim (2000)

The Netherlands 1978-1995 3.5 % Heston et al. (1999)

New-Zealand 1977-1984 6.1 % Gillan (1990)

Norway 1978-1995 5.6 % Heston et al. (1999)

Portugal 1989-1997 -8.9 % Rouwenhorst (1999)

Singapore 1975-1985 4.9 % Wong et al. (1990)

Spain 1978-1995 9.0 % Heston et al. (1999)

Sweden 1978-1995 4.1 % Heston et al. (1999)

Switzerland 1978-1995 1.7 % Heston et al. (1999)

UK 1955-2001 1.8 % Dimson et al. (2003)�4

Source: ”International Evidence on the Size Effect” (Savina Rizova, 2006)

Small-cap stocks

Country Time Period Excess Return (p.a.) Research

Argentina 1982-1997 46.1 % Rouwenhorst (1999)

Brazil 1982-1997 15.8 % Rouwenhorst (1999)

Chile 1982-1997 3.7 % Rouwenhorst (1999)

China 1994-2001 11.1 % Drew et al. (2003)

Korea 1982-1997 3.8 % Rouwenhorst (1999)

Mexico 1982-1997 28.7 % Rouwenhorst (1999)

Taiwan 1986-1997 8.2 % Rouwenhorst (1999)

India 1982-1997 -4.2 % Rouwenhorst (1999)

Turkey 1989-1997 8.6 % Rouwenhorst (1999)

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Source: ”International Evidence on the Size Effect” (Savina Rizova, 2006)

Small-cap stocks

• Focusing on small-cap stocks has worked well in both the developed and emerging markets

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Market Time Period Excess return (p.a) Research

Europe 1978-1995 3.5 % Heston et al. (1999)

USA 1962-1989 ~8 % Fama et al. (1992)

Developed markets 1986-1996 11.2 % Bauman et al. (1998)

Emerging markets 1982-1997 8.2 % Rouwenhorst (1999)

Sources: ”International Evidence on the Size Effect” (Savina Rizova, 2006), ”Is Size Dead? A review of the Size Effect in Equity Returns” (Mathijs A. Van Dijk, 2011)

Value investing

• Value investing has outperformed the market in the long-run • Several of the world’s most successful investors are value investors:

Warren Buffett, Joel Greenblatt, Mohnish Pabrai, Guy Spier etc. • Value investing refers to investing in undervalued companies • Value investor values companies using different ratios, for example:

– P/E (Price to Earnings,– market price per share divided by earnings per share)

– P/B (Price to Book value, market price divided by book value of equity) – P/S (Price to Sales, market price divided by sales) – Dividend yield (dividends divided by market price) – FCF (Free Cash Flow)

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Value investing

• Value stocks outperformed growth stocks in Europe by 10 % p.a. between years 1985-2007

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

Value investing

• In the developed markets, value stocks have returned 12 % p.a. better than growth stocks between 1985 and 2007*

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

* In the sample, stocks have been arranged in an order based on their multiples: P/E, P/B, P/CF, P/S ja EBIT/EV. A stock’s ranking in each multiple is added together and stocks are put in order based on the total sums. Value stocks are the cheapest 20 % of the stocks based on their summation value and growth stocks are the expensive 20 %. The minimum market capitalization in the sample is 250 million dollars. Returns are calculated in U.S. Dollars.

Value investing

• In the emerging markets, value stocks have returned over 18 % p.a. more than growth stocks and 11 % p.a. more than the market between 1985 and 2007

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

* In the sample, stocks have been arranged in an order based on their multiples: P/E, P/B, P/CF, P/S ja EBIT/EV. A stock’s ranking in each multiple is added together and stocks are put in order based on the total sums. Value stocks are the cheapest 20 % of the stocks based on their summation value and growth stocks are the expensive 20 %. The minimum market capitalization in the sample is 250 million dollars. Returns are calculated in U.S. Dollars.

Value investing

• A portfolio consisting of stocks from the cheapest fifth in developed and emerging markets returned on average 18 % p.a.*

• Growth stocks returned less than 3 % p.a.* • The excess return of value stocks over growth stocks globally was 15 %

p.a.*

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

* In the sample, stocks have been arranged in an order based on their multiples: P/E, P/B, P/CF, P/S ja EBIT/EV. A stock’s ranking in each multiple is added together and stocks are put in order based on the total sums. Value stocks are the cheapest 20 % of the stocks based on their summation value and growth stocks are the expensive 20 %. The minimum market capitalization in the sample is 250 million dollars. Returns are calculated in U.S. Dollars.

Value investing

• The fall of the Japanese stock market has been record long • Between 1990 and 2011 the Japanese stock market dropped -62.21 % • Value investing generated excellent returns even in this difficult market

environment • Low P/E ratio stocks returned 16.9 % p.a. between 1990 and 2011 • Low P/B ratio stocks on the other hand returned 10.6 % p.a. • Between 1975 and 2011 low P/E ratio stocks returned 23.6 % p.a. and

low P/B ratio stocks 19.3 % p.a.

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Source: ”Performance of Value Investing Strategies in Japan’s Stock Market” (Hong Kong University of Science and Technology Value Partners Center for Investing, 2013)

Value investing

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Source: ”Performance of Value Investing Strategies in Japan’s Stock Market” (Hong Kong University of Science and Technology Value Partners Center for Investing, 2013)

Value investing

• Regardless of good returns, risk in value investing has been lower

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

Value investing

• During market distress, value stocks have lost less of their value than the market or growth stocks

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

Value investing

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!• Between 1975 and 2007, value stocks in the U.S. returned 13 % p.a.

during a recession and 22 % p.a. during a expansion • Growth stocks returned 5 % p.a. during a recession and 17 % p.a.

during a expansion • Value stocks overperformed growth stocks in both recession and

expansion

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

Small-cap value investing

• Small-cap and value investing have performed well in the past • How would value investing in small-cap stocks have worked in the

past? • In the U.S. small-cap value stocks returned 5.28 – 8.40 % p.a. more

than growth stocks between 1979 and 1997

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Source: ”The Value Premium for Small-Capitalization Stocks” (Manjeet S. Dhatt, Yong H. Kim & Sandip Mukherji, 1999)

Small-cap value investing

• The risk (volatility) of small-cap value stocks was lower than the risk of growth stocks

• The amount of excess returns generated varied depending on the ratio used (e.g. P/E or P/S)

• Using different ratios simultaneously improved the risk-adjusted returns related to individual ratios

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Small-cap value investing

• Between 1926-2004 small-cap value stocks in the U.S. returned 15.9 % p.a. while large-cap growth stocks returned 9.26 % p.a.*

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Source: ”The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks” (Ian Wyatt, 2009)

* The New York Times used as the source of the graph Eugene S. Fama ja Kenneth R. French’s research and allocation of stocks.

Small-cap value investing

• Small-cap value stocks have returned better than large bluechip stocks up to today

• Russell 2000 Value ETF, which began trading in 2000 invests in small-cap value stocks in the U.S.

�20RUJ (blue) = Russell 2000 Value, SPY (red) = S&P 500. Source: Google Finance

Small-cap value investing

• In the developed countries, one of the most recent study is the research done by Nobel Prize Laureate Eugene Fama and Kenneth French ”Size, Value, and Momentum in International Stock Returns”, which was released in 2012

• Fama and French state the following: ”Our new evidence centers on how international value and momentum returns vary with firm size. Except for Japan, value premiums are larger for small stocks.”

• According to the studies, investing in small-cap value stocks has worked globally

• Using several different ratios simultaneously has improved the chances to generate even higher returns when investing in small-cap value stocks

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Small-cap value investing

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Source: ”What Works on Wall Street” (James P. O’Shaughnessy, 2005)

Small-cap value investing

• Similar results can be found in Europe. For example, below is a table of returns between 1991 and 2011, where P/B ratio was used as a primary factor among other ratios

• STOXX Europe 600 returns in the same period were 0.91 % p.a.

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Source: ”Quantitative Value Investing In Europe: What Works for Achieving Alpha” (Philip Vanstraceele & Tim du Toit, 2012)

Focused portfolio

• Diversification lowers portfolio’s total risk • In an equity portfolio, diversifying to approximately 30 stocks gives

already a close to maximum benefit from diversification

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

Focused portfolio

• Warren Buffett: ”Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

• Worldwide, the cheapest fifth of stocks returned 18 % p.a. between 1985 and 2007*

• That group includes 1800 stocks • That kind of diversification is too broad when considering the benefits

received from diversification • How would a portfolio invested in the 30 cheapest stocks in the world

have performed?

�25* In the sample, stocks have been arranged in an order based on their multiples: P/E, P/B, P/CF, P/S ja EBIT/EV. A stock’s ranking in each multiple is added together and stocks are put in order based on the total sums. Value stocks are the cheapest 20 % of the stocks based on their summation value and growth stocks are the expensive 20 %. The minimum market capitalization in the sample is 250 million dollars. Returns are calculated in U.S. Dollars.

Focused portfolio

• The cheapest 30 stocks worldwide returned 25 % p.a.

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

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What has worked in equity investing? Successful investment strategies

What causes undervaluation?!Influencing factors

How to improve investment returns? Utilizing quantitative methods

”It’s a bumpy road ahead”!Nothing is perfect

Majority of companies are small-cap companies

• There are a lot more small-cap stocks than large-cap stocks

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Sources: Montanaro, FactSet. As of 3.1.2012.

Majority of companies are small-cap companies

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Source: ”Analyzing the Analysts: A Survey of the State of Wall Street Equity Research 10 Years after the Global Settlement” (Timothy J. Keating, 2013)

Companies in the U.S. stock market divided into groups based on market capitalization. Apple’s market cap is more than 2.6 times the combined value of all 2021 micro-cap

stocks

Minimal coverage

• Even though there are a lot more small-cap stocks, fewer analysts cover them

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Source: ”The herd vs the reward, or in praise of contratian investing” (Stacy-Marie Ishmael, Financial Times, 4.11.2009)

Minimal coverage

• The U.S. Stock market is considered to be the world’s most efficient • Still, at the end of 2012 almost 29 % of listed companies didn’t have an

analyst covering them or the coverage was inadequate*

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Source: ”Analyzing the Analysts: A Survey of the State of Wall Street Equity Research 10 Years after the Global Settlement” (Timothy J. Keating, 2013)

* The tables last column represents how big percentage of the companies doesn’t have analyst coverage at all. For example, 30 % of 74-248 million dollar market cap companies weren’t covered by an analyst.

Minimal coverage

• The analyst coverage of small companies is minimal, which makes it possible for small-cap stocks to be trading at a different level than the companies’ true values

• This makes it easier for investors to find more undervalued stocks among small-cap value stocks

• Analyzing small companies would require more resources • Analyzing them isn’t profitable for analysts, because small-cap stocks

cannot be offered to as many investors as large-cap stocks • Therefore small-cap stocks will remain less covered in the future • This also leads to undervalued small-cap stocks returning more than the

market in the future

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What color are A and B squares?

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The copyright holder of this work allows anyone to use it for any purpose including unrestricted redistribution, commercial use, and modification.

Answer: They are both grey

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The copyright holder of this work allows anyone to use it for any purpose including unrestricted redistribution, commercial use, and modification.

Human decision-making process is flawed

• In the previous example, our brain tells us that square B is white => the information is incorrect, even though our brain is telling us the opposite

• A computer would have answered the question correctly => the RGB values of both of the squares are the same

• The human ability to process information is limited and decision-making process is imperfect

• In traditional economics people are assumed the act rationally • In reality, people often behave irrationally

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Human decision-making process is flawed

• An example of a coin flipping game: – Heads: you win 10 euros – Tails: you lose 10 euros

• Would you play the game? • Let’s assume that you have just won 100 euros. Would you now play

the game? • What if you had just lost. Would that change the game’s attractiveness? • Majority of people are ready to alter their behaviour based on previous

results • This is despite the fact that each round’s expected value is the same • Completely rational person would act the same way every time

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Human decision-making process is flawed

• In the past few years behavioral finance has gained popularity • Behavioral finance studies unsystematic behavior in investing • Research findings explain why investors don’t act optimally

– A loss hurts twice as much as an equal size gain – The holding period of a profitable investment is shorter than the holding

period of an unprofitable – Anchoring to a paid price of a stock – Investors are active in a bull market (high risk) and paralyzed in a bear

market (low risk) – Etc.

• Knowing investment psychology is a step forward, but alone it is not enough to change investor behaviour => causes of behaviour are rooted deeper

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Human decision-making process is flawed

• The same reasons explain why it is difficult for investors to take advantage of profitable investment practices

• The most profitable investments are often ”ugly” and ”doomed” companies

• It is easier to invest in a company with a good ”story” behind it as other investors are excited about the company as well

• Due to herd behaviour, it is difficult to act against the general view => it is easier to be wrong in a group rather than alone

• Statistics show that the bright futures of many growth companies are shattered => investors overpay for future expectations

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Human decision-making process is flawed

• On the other hand, the distressed times of ”ugly” companies don’t last as long as investors expect => future expectations are overly pessimistic and therefore stock prices are too low

• The idea of utilizing quantitative investment methods is to eliminate the human error from the investment process preventing good returns

• Analyzing tens of thousands of small-cap companies is also impossible by using a traditional way of analyzing each company separately

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What has worked in equity investing? Successful investment strategies

What causes undervaluation?!Influencing factors

How to improve investment returns?!Utilizing quantitative methods

”It’s a bumpy road ahead”!Nothing is perfect

Quantitative methods

• An investor is his own worst enemy => people are prisoners of their feelings

• In several situations a simple computer model works more reliably and more accurately than a person with a subjective view

• As an example; there is a standardized test called MMPI-test (Minnesota Multiphasic Personality Inventory) to identify neuroticism and psychoticism

• Identifying them is important because they are treated differently • In 1968 Lewis Goldberg went through 1,000 patients’ MMPI test results

and formed a model based on the data, which gave a correct diagnosis 70 % of the time

• Goldberg then asked psychologists to diagnose the same patients

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Quantitative methods

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!• The model was clearly more accurate than even the best psychologist • Next, Goldberg gave the model to the psychologists who could use the

model to help their own diagnoses

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Source: ”Painting by numbers: an ode to quant” (James Montier, 2006)

Quantitative methods

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• By using the model, the accuracy of diagnosis increased significantly • Still, the accuracy of the diagnoses done by people was worse than the

model’s • There are similar results for identifying brain injuries and probability of

repeating probation violations etc.

Source: ”Painting by numbers: an ode to quant” (James Montier, 2006)

Quantitative methods

• Grove et al. went through 136 different studies, which dealt with decision-making ranging from heart attack diagnosis to evaluating job compatibility

• Only in eight of the studies the quantitative method lost to people • The simililarity in all eight of these studies was that the quantitative

methods didn’t have access to the same information as people did • In every study where the quantitative method had access to the same

information as people, quantitative method was better

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Sources: ”Clinical versus mechanical prediction: a meta-analysis (Grove, Zald, Lebow, Snitz & Nelson, 2000)” ja ”Painting by numbers: an ode to quant” (James Montier, 2006)

Quantitative methods

• Quantitative models are useful and widely used: – Airplane pilots’ check list before take off – Weather forecasts – Car insurance – Etc.

• Simply put, a quantitative method means using a computer to analyze a large amounts of data => peoples’ ability to process large amounts of data is weak

• It is possible to screen the most potential stocks out of tens of thousands of stocks using quantitative methods => it is impossible for a person to go through the same number of stocks one by one when every quarter there’s new information coming out

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Quantitative value investing strategy

• Quantitative methods work the best when used to analyze small and medium size companies, because of lack of analyst coverage

• So many professionals analyze large companies that quantitative methods don’t give a competitive advantage when analyzing them

• Quantitative value investing strategy combines value investing and efficient use of numerical information

• Companies’ annual and quarterly reports are numerical information • Traditional ratios used by value investors are well suited for automated

data processing (P/E, P/B, dividend yield, etc.) • Quantitative methods enable the combining of different value investing

strategies

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Quantitative value investing strategy

• Research shows that the multi-factor models produce better risk-adjusted returns than when only one factor is used

• Using quantitative methods can protect against fraudulent accounting methods:

– Dechow F-score – Altman Z-score – Beneish M-score

• For example Beneish M-score measures a company’s revenue growth, gross profit, accounts receivables and debt level

• 76 % of companies with an M-score below -2.22 used fraudulent accounting methods

• Only 17.5 % of companies with fraudulent accounting received an M-score above -2.22

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Source: ”The Detection of Earnings Manipulation” (Messod D. Beneish, 1999)

Quantitative value investing strategy

• Quantitative methods can be used to efficiently utilize different value investing strategies based on fundamental information: – F-score (Piotroski) – Magic Formula (Greenblatt) – ERP5 (Vanstraceele & Allaeys) – Net Current Asset Value (Benjamin Graham) – Tiny Titans (O’Shaughnessy) – Value Composite One (O’Shaughnessy)

• For example, Piotroski F-score measures a company’s profitability, leverage and operation efficiency by utilizing nine different factors (e.g. ROA, OCF, profit margin, long-term debt development)

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What has worked in equity investing? Successful investment strategies

What causes undervaluation!Influencing factors

How to improve investment returns?!Utilizing quantitative methods

”It’s a bumpy road ahead”!Nothing is perfect

Nothing works all the time

• One must keep in mind that even though a good investment strategy works most of the time, it doesn’t mean it will work all the time

• Even the best investment methods encounter periods of lower returns, sometimes continuing for years

• The fact that an investment strategy doesn’t always work makes it possible that it will work in the future – All investors would use the same strategy if one strategy would always

work without a risk – During periods of poor returns, some investors abandon the strategy

• Often this occurs right before the strategy starts producing excess returns again

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Nothing works all the time

• 70 % of portfolio managers who have generated excess returns of over 3 % p.a. have underperformed the markets for three years or longer

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

* Figure 14.6 uses a constructed universe where all the fund managers have 3 % alpha and 6 % tracking error. I then let the make-believe managers run money for 50 years. The chart illustrates the frequency of years of back-to-back underperformance. Around 70 % of the make-believe fund managers displayed 3 or more years of underperformance! –James Montier

Nothing works all the time

• Goyal and Wahal studied in 2005 the hiring and firing of four thousand portfolio managers managing funds for pension funds in the U.S. between 1993 and 2003*

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Source: ”Value Investing: Tools and Techniques for Intelligent Investment” (James Montier, 2009)

* More accurate information can be found in ”The Selection and Termination of Investment Management Firms by Plan Sponsors” (Amit Goyal & Sunil Waha, 2005)

Nothing works all the time

• A pension fund traditionally hired a portfolio manager with 14 % excess returns in the last three years

• Portfolio managers who got fired due to poor performance generated 5 % excess returns in three years after being fired

• This indicates well how painful periods of underperformance are • A period of underperformance has historically always been followed by

outperformance, which compensates for the previous poorer returns • Even HCP Quant fund can be expected to have periods of

underperformance, which have historically been two to three years at their worst

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Nothing works all the time

• The best performing fund of the decade in the U.S. at the end of 2009 was CGM Focus Fund

• The fund returned on average 18.2 % p.a. over the decade • A typical fund investor lost -11 % p.a. • This is because investors invested in the fund after a good period and

took their money out during a poor period • Timing is extremely difficult, if not impossible • According to different studies, investors who try to time the markets

perform worse than others • Even the best fund doesn’t help the investor, if the investor cannot

tolerate price fluctuations

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Source: ”Best Stock Fund of the Decade: CGM Focus” (Eleanor Laise, The Wall Street Journal, 31.12.2009)

Individual investor’s tax shield

• HCP Quant fund’s investment strategy’s stock turnover ratio is high • A typical stock is held in the portfolio from six months to a year • An individual investor paying taxes in Finland has a capital gains tax of

30/32 % • The funds returns are tax-free • In a fund-based investment strategy compounding effect is emphasized

because the investor pays taxes only when withdrawing money • The same investment strategy is more profitable for a long term

individual investor as a fund than if invested individually

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Portfolio Manager

• Portfolio manager is Pasi Havia • Portfolio manager has cross-sectional education; have studied

Information Processing Science and Finance at the University of Oulu • Portfolio manager has invested his personal funds in the HCP Quant

fund • Portfolio manager has personally used the strategy since 4.10.2010 • Realized returns net of transaction fees is +134 % (as of 24.1.2014)

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Portfolio manager’s realized returns

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Blue = HCP Quant strategy’s realized returns!Red = S&P 500 Total Return index in euros!Purple = MSCI ACWI SMID Value Total Return index in euros (global small- and mid-cap value stock index, HCP Quant fund’s benchmark index)!Green = S&P 350 Europe Total Return index in euros

Summary of HCP Quant

• A non-UCITS fund investing in small- and mid-cap stocks • Invests in global developed and emerging market stocks (Europe, USA,

Asia, Australia) • Utilizes quantitative investment methods in investing, with a goal to

avoid human limitations • Focuses investments in a few dozen stocks analyzed to be the best of

class • Doesn’t use the typical market weighted portfolio weighting • Is built on a strong scientific research; uses proven successful

investment strategies, which can be assumed to perform well in the long run

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Helsinki Capital Partners!

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