Security Valuation and Quantitative Analysis
For many years, security valuation was viewed as an esoteric theory, mainly left to academicians. Investors did not clearly understand, nor have the computing power, to carry out the developing theory. Today, however, times have changed. MBA’s, who have had a steady diet of quantitative investment analysis, have stormed Wall Street. Sophisticated personal computers are now not only commonplace, but also essential to compete in a challenging world. The effect has been to elevate security valuation methods to an important new level in the day to day decision making process of both professional and individual investors.
Quantitative investment analysis has as its foundation the work of Harry Markowitz (1952). Before Markowitz, investors had widely focused on classical forms of security analysis that generally ignored important risk components. Practitioners intuitively knew investors were risk adverse, but had not been able to link risk with return. Thanks to the early work of Markowitz, the academic community set out to quantify the relationships between risk and return, and hence, Modern Portfolio Theory (MPT) was formed.
During the sixties and seventies, more academics became involved in refining the methodologies of valuation analysis. As the theory expanded, rigorous tests were initiated. Universities provided the ideal atmosphere to evaluate these theories, in that they had both the required computing power and access to the historical financial data. The results clearly indicated that a quantitative approach could improve the investment process. However, these conclusions did not overcome the reluctance of practitioners to implement this new investment theory. After all, these mathematical investment models were mysterious “black boxes” that required a great deal of labor and number crunching.
By the late seventies, however, the personal computer had arrived on the scene. These powerful mainframe descendants could easily handle complex mathematical equations, eliminating the problem of how to implement quantitative techniques. Meanwhile, the concerns about the realistic value of security valuation models were dispelled by the large supply of MBA’s who were thoroughly familiar with the discipline.
Today, quantitative analysis is a widely accepted discipline for many reasons. The advantages of this approach include the recognition that risk should be commensurate with return, that investment models help identify potential risks and returns, and that an objective process for making investment decisions is very useful. Further, by examining elements of risk and focusing on relevant security information, investors are able to use valuation models to help select securities and organize portfolios.
The importance of adding discipline to the investment process is essential to the quantitative method. Established goals, supported by consistent rules, form the basis for investors to use the prevailing theories. Once the discipline is recognized, the investment model focuses on maximizing returns for a given level of risk. From there, quantitative techniques are able to create more efficient investment portfolios, provide better and faster investment decisions, and theoretically identify under/overvalued securities.
As you might expect, quantitative analysis has its critics. One common complaint focuses on the use of financial projections, where it is argued that this data is imperfect. While this is often true, practitioners now rely on projections based on consensus opinions. By using consensus opinions, the probability of using projections far off the mark is reduced greatly. Further, these projections are adjusted regularly by analysts due to the ongoing trend of corporations to provide the financial community with better information. The result is more reliable and more accurate projections. Another complaint regarding the quantitative approach is that it overlooks important elements of companies which are generally not quantifiable. Good examples of these include exceptional managements, technological breakthroughs, stock price momentum, and dressed up balance sheets. The quantitative response to this is straight forward: valuation models should be viewed as tools for decision making and not as the decision maker. The proper approach is to use investment models with other knowledge – and common sense – to make better decisions.
In summary, both professional and individual investors have come to realize the tremendous advantages of security valuation analysis. Quantitative research, once disregarded by Wall Street, is now widely accepted. Although the results of models – be they scientific or financial – are meant to be theoretical estimates and not exact, professionals and individuals have come to realize the importance and validity these techniques bring to the decision process. Simply stated, quantitative analysis is here to stay. If you have any questions, feel free to post your inquiries on our Facebook page.