Professional stock researchers can serve as stock pickers for investors who don’t know where to start. Is it better to pick your own stocks or to use a professional stock picker?
Tao Wang, a portfolio manager for Alpha Architect, explains how to begin researching stocks. He outlines the differences between value, growth, and momentum stocks. He also emphasizes the importance of having multiple qualifiers when choosing a stock. If you are lost on how to start to build your portfolio, listen to today’s episode.
The nine steps to build a good money relationship with your spouse
Doug has put together a process called The Secrets of Talking to Your Spouse About Money for couples who need to get on the same page regarding their finances. These steps are down-to-earth suggestions that will make financial discussions a little easier.
Tao Wang can be contacted through Alpha Architect.
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Watch How Stock Pickers Research Stocks on YouTube.Read the Transcript
Interview with Tao Wang
Value investing, growth investing, and momentum investing. These are all terms that are used when it comes to investing in stocks. Tao Wang, a managing member at Alpha Architect, tells us more.
Douglas Goldstein: I am very excited to be talking with Tao Wang, a managing member of Alpha Architect. He works in the trading department, dealing with quantitative research and all sorts of research in choosing stocks.
A lot of times people today say, “Oh, who chooses stocks? You just buy an index bond.” But, you know, the basics of investing is buying stocks; that’s what people start with. Tao, I want to ask you about the very basics. How should someone who wants to invest in the stock market start to find stock to invest in?
Choosing Stock to Invest In
Tao Wang: I would recommend that people start with looking at systems. The way I say that is, you want to start with what kind of preference you want to have toward the investment. Do you want to be a value investor? Do you want to be a growth investor? Or do you want to be a momentum investor?
Then, look at the evidence and see what worked in the past. What does the evidence say about value investment vs. growth investment? Everybody knows that the value beats growth in the long term, so you probably don’t want to get into systematically investing into those growth stocks. Even though some of them might sound really good, you don’t want to systematically do that. That’s what I would say.
The Difference between a Growth Investor and a Value Stock Investor
Douglas Goldstein: I can tell from your sentence that you are a value investor because there are certainly growth investors out there who would disagree with you. But that’s okay because you have Warren Buffett in your corner, so you're allowed to say that.
Let’s first define what this means. My understanding of a value investor is a guy who’s a good shopper. This same guy who would be a value investor would be the type of guy who would go to the store, spot a shirt for $50, and he says, “I know that’s a $90 shirt.” He would buy it because it’s a good deal. Is that the same thing as a value stock investor?
Tao Wang: Yes, pretty much the same. What you want to do is, let’s say you're facing 1,000 stocks; you don’t know which one is value or which one is growth. You basically rank them based on some sort of measure. You can do book-to-market, and from the evidence-based endpoint, EBIT your work may be slightly better than book-to-market. But you're going to be as good as just going with all the traditional value measures.
How Do You Pick a Stock?
Douglas Goldstein: Let’s break that down a little more. When you want to be a value investor, right, you say, “I want to pick a stock that’s really undervalued,” meaning that I could buy it today, but no one else knows except me that this is a $90 stock and I can buy it today for $50. How are you supposed to really identify that, given that there are thousands of stocks out there? Where do you start?
Tao Wang: You're going to basically start by ranking all the stocks based on some sort of measure. You can use book-to-market, you can use EBIT yield. Basically, you can break them down by quintile, quartile, or decile—the cheapest top 10% with the highest EBIT yield or highest book-to-market is your value bucket, and the opposite would be your growth bucket. You want to basically systematically invest in the cheapest of stocks.
Picking any specific one or two from the cheapest bucket, you're going to suffer from idiosyncratic risk, by going with one or two. You want to diversify a little bit, hold like 30 to 40 stocks. Hopefully, you're going to be compensated by taking that risk.
Douglas Goldstein: If you break down the list, you said, for example, you could look at price-to-book. That was one of the numbers that you suggested?
Tao Wang: Yes.
Douglas Goldstein: So what that means is that all companies have what we would refer to as a “book value,” meaning if you liquidate the company, it’s worth $9 a share of stuff, right? That’s what we’re talking about? If the stock is trading at $18 a share, and the book value (meaning just the value of all the coat racks, the desks, the buildings, and the intellectual property) is $9 a share, we would say that this stock is trading at two times its book value.
I guess you might say that that is good. Why is that specifically not growth, because wouldn’t a growth investor consider also the book value of the stock?
Tao Wang: In the academic world, people identify growth stocks by looking at the lowest of book-to-market value. People see value stocks as the highest book-to-market value. For growth inventors, they definitely would look at the book value of the stock, but they tend to put a lot of weight on the price because the market is kind of efficient.
If you think it’s a great stock and growth stock, the price is usually very high. So people are excited about their stock; like, Tesla and Amazon are great examples of growth stocks. I am not saying those are bad companies, bad investments. But systematically investing into growth stocks historically doesn’t work.
Is There Any Difference between Value, Growth, and Momentum Investing?
Douglas Goldstein: Before you started, you differentiated between value, growth, and momentum. Are you differentiating between growth and momentum stocks, or are they in the same bucket?
Tao Wang: Yes, that’s actually a great question and a lot of people are confused. Like, you guys are value investing, and also you guys are backing up this momentum investing philosophy. Aren’t they the opposite? Because value investing is the opposite of growth investing, then people think that growth investing is the same as momentum investing.
They are not the same because what is defined as growth stocks when you look at the book-to-market and some sort of value measure, if it’s high book-to-market, it’s growth stocks. You look at the fundamentals. But momentum is purely price driven; what defines a good momentum stock is they performed super well over the past 12 months, relatively better than their peers.
They’re different, and also we look at the data. Historically, there's only 27th overlap between growth stocks and momentum stocks. So at that point—
Douglas Goldstein: So that could be 27 overlap, or 27...?
Tao Wang: Yes, 27% overlap, so they're definitely not the same thing.
Douglas Goldstein: Got it. So it’s a different way of looking at it. Let’s go back to what I am sensing is your expertise, which is value investing. Let’s say you go through your initial set of screens, and you come up with a list of a few hundred value stocks. What's the next thing to do?
Tao Wang: You want to go to the price first because that’s what the anomaly is, right? The next thing we would look at is quality. With two equivalent, cheap stocks, the next thing you want to look at is quality, so you want to actually hold the high-quality cheap stock relative to the low-quality cheap stock because people kind of hate cheap, crappy stocks. So they tend to overlook the good quality of their cheap stocks.
Douglas Goldstein: When you say quality—maybe I am just missing something—do you mean quality of the product, quality of the management, quality of the industry?
What Is a High-Quality Stock?
Tao Wang: You can look at it from a lot of different angles, but we have like 10, 20 ratios to look at. You can look at return on equity, return on assets, you can look at margin stability, or at margin growth.
We don’t want to specifically look only at one ratio because it’s not fair. We want it to be very comprehensive, so we look at various ratios and combine them. The one that has the highest combined score is what we call the “high-quality stock.”
Douglas Goldstein: Is there any one particular ratio that weighs more, and that you think is more important to determine if a company is particularly high quality?
Tao Wang: What I said, like the margin stability and margin growth, like Procter and Gamble is for sure a good company. But the profit margin of Procter and Gamble is probably 50%. They're not growing anymore because the base is pretty high now.
But you can keep that high margin at a stable level. That means something; it’s definitely a good quality stock. On the other hand, the growth rate of Apple’s margin from 2004 to 2010 is pretty high. They’re growing every year, so that’s certainly a good quality company too. But if you only look at the margin stability or margin growth, you're going to miss each other. Those two companies will be good examples of good quality companies, and we weight them equally, basically.
Douglas Goldstein: Let me give the standard disclaimer, and then we’re going to wrap up. Regardless of the fact that Tao and I are talking about specific stocks, it is certainly in no way a recommendation for anyone. This is just an educational discussion to try to understand investing. Make sure you speak to a qualified financial advisor before you do any investing.
How to Follow Tao Wang
But Tao, I know you guys are out there, and there’s a lot more that you teach and talk about. So in the last few seconds, tell me how can people follow you and follow your work?
Tao Wang: I actually write articles in Chinese because I am a Chinese national. I am not that active in the English world, so Wes and Jack both have a Twitter account. The best place to find us is our website, www.alphaarchitect.com.
We’re constantly posting good ideas and good articles on our blog section. We also have some great guest bloggers that contribute to the content as well. That would be the best place to find us.
Douglas Goldstein: Tao Wang, thanks so much for taking the time.
Tao Wang: Thanks, Doug.