Is it now smart to be dumb?

Maybe one of the only ways to outsmart a group of really smart people is to hold positions that seem very dumb. The dumbest stocks to hold might be those with the lowest consensus expectations for the future. The best way to find stocks for which the market has very low expectations is to use a variety of valuation ratios, because a low valuation = a low collective expectation for the future.

One way to apply this idea is to use stock selection screens. Screens are simple. Most indexes are simple screens. Index screens select stocks because of criteria X, Y, and/or Z (usually market cap, sometimes something simple like dividend growth or price-to-book). Value screens buy because of low price-to-earnings, low price-to-sales, and so on.

Given that stock screening and backtesting tools are cheaper and more ubiquitous than ever, will investment strategies based off of screens continue to work in the future? This is an important question for prospective and current investors in quantitative strategies.

The hard part is sticking with it. I believe the most pertinent question to ask about any systematic/quantitative strategy is not “how hard would this be to replicate” but rather “how hard would this be to stick with.” I think strategies with the most persistent advantage will fall in the latter category. The best secret sauce, to borrow a funny quote from Wes Gray, is to take as much “career risk” as possible.

You will never feel dumber than when you are looking back at a few years of really bad relative performance, which was earned by blindly buying stocks the market collectively thought were dumb investments, using what will feel in hindsight like an overly simple (and dumb) stock screen.

“Wait, you bought XYZ a year ago? Without investigating the company at all? All you had to do was scratch the surface to see that it was a complete basket case with declining earnings and terrible management—and the market knew it! There was a reason it was priced so cheaply! How can you expect to outperform by buying stocks like that?”

This straw man sounds like he has a point. But the weird thing is that value works because you are willing to continue buying what looks like garbage in the face of bad news and poor prospects–even after living through the above scenario.

We have reams of evidence that the low expectations for cheap stocks are too low, on average.

You’ll have to buy through fear, and hold through shame, but value stocks have consistently rewarded those who are willing to ride out (or for the lucky psychopaths out there, ignore) those emotions. The positions value investors hold may seem laughable, but the returns they deliver have been anything but.

Maybe it is the ability to endure feeling like an idiot for a long time that distinguishes the world’s best investors. Maybe feeling dumb is the smartest thing an investor can do.