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+./0 12345647
+1 646 333 8629
Loby[eyquem.neL
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1he Case lor CuanLlLaLlve value lnvesLmenL
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value has conslsLenLly beaLen Lhe markeL
The liteiatuie on value investment, though a ielatively new aiea of stuuy, is
iich anu vast. While ieseaicheis continue to uebate the ieasons why, they almost
univeisally agiee that value stocks outpeifoim the maiket. The chait below
compaies the excess ietuins of poitfolios constiucteu by uiviuing stocks into
quintiles fiom cheapest ("value") to most expensive ("glamoui") accoiuing to
seveial uiffeient piice iatios
1
: piice-to-book value
2
("PB"), piice-to-eainings
S

("PE"), enteipiise value
4
-to-fiee cash flow
S
("EvFCF"), enteipiise value-to-

1
A prlce raLlo" ls a measure of a sLock's cosL relaLlve Lo a fundamenLal," an lLem found Lhrough analysls
of Lhe sLock's flnanclal sLaLemenLs (for example, book value or earnlngs). rlce raLlos make sLocks
comparable on a llke-for-llke basls.
2
8ook value" ls Lhe resldue of asseLs afLer deducLlng llablllLles recorded on Lhe 8alance SheeL.
3
Larnlngs" ls a sLock's proflL afLer Lax recorded on Lhe roflL and Loss SLaLemenL. lL ls Lhe boLLom llne."
4
LnLerprlse value" ls markeL caplLallzaLlon plus preferred sLock plus mlnorlLy lnLeresLs (lf any) plus debL
plus unfunded penslon llablllLles less cash. lL ls Lhe LoLal cosL pald Lo acqulre a company ln lLs enLlreLy.
3
lree cash flow" ls Lhe resldue of cash flows from operaLlons afLer deducLlng caplLal expendlLure
recorded on Lhe SLaLemenL of Cash llows. lL ls Lhe cash flow avallable for dlsLrlbuLlon.

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eainings befoie inteiest, taxes, uepieciation, anu amoitization
6
("EvEBITBA"), anu
enteipiise value-to-gioss piofit
7
("EvuP"). The excess ietuins aie calculateu by
ueuucting fiom each quintile piice iatio's ietuin the equal weighteu peifoimance of
the entiie maiket.
8

79,4.4( >? !"#$% @%"(' A#"0)$1

Source: Cray and Carllsle, CuanLlLaLlve value," uue 2013.

The chait uemonstiates that, whichevei piice iatio we choose to examine,
ovei the 4u-yeai peiiou unuei consiueiation, the quintile containing the cheapest
stocks (the "value" quintile, on the fai iight of the chait) outpeifoimeu the maiket,
geneiating substantial excess ietuins, anu the quintile containing the most
expensive stocks (the "ulamoui" quintile, on the fai left of the chait)
unueipeifoimeu the maiket, geneiating negative excess ietuins. The quintiles also
peifoim in iank oiuei: the value quintile outpeifoims the next cheapest quintile
("Quintile 4"), anu so on until we ieach the ulamoui quintile, which geneiates
negative excess ietuins. The value quintile of EvEBITBA stocks beat the maiket by

6
Larnlngs before lnLeresL, Laxes, depreclaLlon, and amorLlzaLlon" ls calculaLed as lL ls descrlbed. lL ls a
measure of earnlngs LhaL seeks Lo ad[usL for Lhe lmpacL of Lax and dlfferenL mlxes of debL and equlLy ln a
sLock's caplLal sLrucLure.
7
Cross proflL" ls revenue mlnus cosL of goods sold. lL ls an unadulLeraLed measure of a sLock's lncome.
8
noLe LhaL MarkeL lndex" ls Lhe equally welghLed unlverse of sLocks, maklng lL dlrecLly comparable Lo
Lhe qulnLlle porLfollos, whlch are also equally welghLed.

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the biggest maigin, outpeifoiming by 4.62 peicent pei yeai. The value quintile of
PB beat the maiket by the smallest maigin, outpeifoiming by just 1.99 peicent pei
yeai, but, notably, still outpeifoiming.
The extent to which the value quintile outpeifoimeu the ulamoui quintile is
known as the "value piemium," anu, all else being equal, the biggei the value
piemium, the bettei the piice iatio uiffeientiates between value anu glamoui. The
chait in Exhibit 2 makes it cleai that EvEBITBA geneiateu the biggest value
piemium, aveiaging 9.69 peicent pei yeai. The PE anu EvFCF iatios geneiateu
the smallest value piemia at S.S4 peicent pei yeai. Bowevei we uefine it, the
cheapei the aveiage stock's piice-to-a-funuamental (i.e. EBITBA, fiee cash flow,
book, oi eainings), the bettei the stock has peifoimeu. Exhibit 2 shows the value
piemium geneiateu by each piice iatio ovei the peiiou 1971 to 2u1u.
79,4.4( B? 7!C7@D:EF A%/%1"(%' :,% @422%'( !"#$% G1%04$0
Source: Cray and Carllsle, CuanLlLaLlve value," uue 2013.
The peisistence of the value piemium seems to uefy common sense. Why
shoulu a fiee lunch exist. Behavioial finance ieseaicheis }oseph Lakonishok, Anuiei
Shleifei anu Robeit vishny in theii 1994 papei, "Contiaiian Investment,
Extiapolation, anu Risk"
i
aigue that value stocks geneiate bettei ietuins because
they aie contiaiian to the behavioially suboptimal stiategies followeu by "nave"
investois. "Nave" investois foim expectations about the futuie peifoimance of

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stocks without a full appieciation of the phenomenon of mean ieveision. They tenu
to foim these expectations on piospects foi each inuiviuual stock without piopeily
weighting the "base iate," oi histoiical aveiage foi that class of stocks. This
manifests in investois extiapolating past eainings peifoimance too fai into the
futuie; assuming a tienu in stock piices will peisist; simply oveiieacting to goou oi
bau news; oi conflating a well-iun company with a goou investment, iiiespective of
piice. Whatevei the ieason, investois tenu to get oveily exciteu about stocks that
have uone well in the past anu biu them up so that these glamoui stocks become
oveipiiceu. They also oveiieact to stocks that have uone bauly, oveisell them, anu
these out-of-favoi value stocks become unueivalueu. value investois exploit these
behavioial eiiois, investing in unueivalueu stocks on the expectation that they will
ieveit to the mean anu, consequently, beat the maiket.
MosL acLlve managers have falled Lo beaL Lhe markeL
uiven that institutional investois invest piofessionally, we woulu expect that
they aie not nave, but aie awaie of the value piemium, anu invest to captuie it. If
that is in fact the case, it is not ieflecteu in the uata. }ohn C. Bogle, founuei of The
vanguaiu uioup, has long piomoteu passive inuex funus ovei tiauitional, actively
manageu mutual funus foi the ieason that active manageis, on aveiage, fail to
outpeifoim the maiket. Bogle appeaieu befoie the !"#$%" !'()*++,%%"" *#
-,#$#),$. /$#$0"+"#%1 %2" 3'40"%1 $#4 5#%"6#$%,*#$. !")'6,%7 on Novembei S, 2uuS
to uemonstiate that the competitive natuie of the investment management inuustiy
meant that the ietuin of the aveiage mutual funu shoulu equal the ietuin of the
maiket less the fees chaigeu by the mutual funu inuustiy. Bogle testifieu
ii
:
"Buiing the peiiou 1984-2uu2, the 0.S. stock maiket, as measuieu by the S&P
Suu Inuex, pioviueu an annual iate of ietuin of 12.2%. The ietuin on aveiage
mutual funu was 9.S%. The ieason foi that lag is not veiy complicateu: As the
tiaineu, expeiienceu investment piofessionals employeu by the inuustiy's
manageis compete with one anothei to pick the best stocks, theii iesults
aveiage out. Thus, the aveiage mutual funu shoulu eain the maiket's
ietuinbefoie costs. Since all-in funu costs can be estimateu at something
like S% pei yeai, the annual lag of 2.9% in aftei-cost ietuin seems simply to
confiim that eminently ieasonable hypothesis."
While Bogle's thesis is "eminently ieasonable," the inability of most
institutional investois to beat the maiket is still iemaikable. Why. Let's consiuei
what we mean by "the maiket." The S&P Suu is a wiuely followeu inuex of the
laigest Suu stocks listeu on the New Yoik Stock Exchange oi the NASBAQ, anu

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iepiesents appioximately 7u peicent of the value of the 0.S. maiket. The Russell
1uuu is an inuex of the laigest 1uuu stocks, anu iepiesents appioximately 92
peicent of the 0.S. maiket. Both the S&P Suu anu the Russell 1uuu aie maiket
capitalization-weighteu inuices, which means both weight constituent stocks
accoiuing to the stocks' maiket capitalizations. Stocks with laigei maiket
capitalizations have a gieatei influence on the inuices' peifoimance than stocks
with smallei maiket capitalizations.
While the S&P Suu anu the Russell 1uuu inuices uo a fine job of tiacking the
weighteu aveiage peifoimance of the "maiket," we woulu not iegaiu them as
optimal investment stiategies. Behavioial finance theoiy suggests that the S&P Suu
anu Russell 1uuu suffei fiom a systematic flaw. The pioblem is that each incieases
the amount it owns of a paiticulai stock as the piice iises, anu ieuuces the amount it
owns as the piice uiops. This leaus the S&P Suu anu Russell 1uuu inuices to behave
like the nave investoi above, systematically investing too much in stocks that aie
oveipiiceu anu too little in stocks that aie unueivalueu. If that is in fact the case,
then we woulu expect that an equally weighteu veision of the S&PSuu oi the Russell
1uuu woulu ianuomize this eiioi, anu outpeifoim the maiket capitalization-
weighteu S&P Suu anu Russell 1uuu. This is exactly what we finu.
The chait below compaies the peifoimance of the two veisions of the
univeise of stocks examineu in Exhibit 1. "EW Naiket" is the equally weighteu
aveiage annual ietuin of the univeise of stocks that compiise the maiket. "Equal
weighting" means that each stock in the inuex has the same influence on the inuex's
ietuin. Like the S&P Suu anu the Russell 1uuu, "NW Naiket" is the maiket
capitalization-weighteu aveiage annual ietuin of the same univeise. We also incluue
foi compaiison the ietuin to the aveiage laige capitalization mutual funu anu the
aveiage ietuin of the value quintile of piice iatios in Exhibits 1.

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79,4.4( H? 7I$"# J%42,(K L$(8%15)10' M"1+%( N"8KJ%42,( D/64*%'

Source: Cray and Carllsle, CuanLlLaLlve value," uue 2013.
EW Naiket significantly outpeifoims NW Naiket. 0vei the peiiou examineu,
1971 to 2u1u, the equally weighteu maiket inuex, EW Naiket, aveiageu 1S.u4
peicent annually, while the same stocks weighteu accoiuing to maiket
capitalization, NW Naiket, aveiageu 1u.u9 peicent annually. Equal weighting is a
contiaiian stiategy that exploits the nave extiapolation eiiois of othei investois
anu paitially eliminates the systematic eiioi in maiket capitalization-weighteu
inuices.
iii

It is telling that, uespite the systematic flaws in tiauitional maiket-
capitalization weighteu inuices, the S&P Suu anu the Russell 1uuu have been shown
to ielentlessly outpace most active manageis. It is this unueipeifoimance that leu
Bogle to iecommenu maiket capitalization-weighteu inuex funus. As we can see in
Exhibit S, howevei, a maiket capitalization-weighteu inuex suffeis fiom a
systematic flaw that leaus it to unueipeifoim a compaiable equally weighteu inuex.
An equally weighteu inuex funu is logically anu empiiically a bettei bet, but why
stop theie. As we uemonstiateu in Exhibit 1, the aveiage of the value quintile of
stocks has outpeifoimeu the equally weighteu maiket inuex, offeiing the
oppoitunity foi bettei ietuins again. value seems like the best bet, but how can we
be suie oui managei captuies the value piemium.

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value lnvesLors make behavloral errors
Let's focus on the iational investois, those who piofess to be value investois,
anu assume foi the moment that they uo as they say, anu actually buy value stocks.
Bow uo these active value investois peifoim ielative to the peifoimance of a
compaiable passive value benchmaik, foi example, an inuex compiising just value
stocks. In a 2u12 papei, "value Investing: Investing foi uiown 0ps."
iv
Aswath
Bamouaian conuucts a simple test of the ietuins to active value investing by
compaiing the ietuins eaineu by active value investois to a passive value-only
inuex. Bamouaian computes the excess ietuins geneiateu foi all 0S mutual funus,
classifieu into value, blenu, anu giowth (a.k.a "glamoui") categoiies, ielative to
inuex funus foi each categoiy. Thus, the value mutual funus aie compaieu to inuex
funu of just value stocks (low PB anu low PE stocks) anu the giowth mutual funus
to a giowth inuex funu (high PB anu high PE stocks). The iesults aie not goou foi
the active value funus. Exhibit 4 is a chait showing the excess ietuins geneiateu foi
all 0S mutual funus, classifieu into value, blenu anu giowth categoiies, ielative to
inuex funus foi each categoiy.
79,4.4( O? !"#$% M$($"# P$/6' Q/6%18%15)10 !"#$% D/64*%'
Source: uamodaran (2012)

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The value funus unueipeifoim the value inuex in all thiee maiket-
capitalization categoiies, the blenueu funus aie a mixeu bag anu giowth funus tenu
to outpeifoim giowth inuices. Bamouaian makes the following comment:
"The only funus that beat theii inuex counteipaits aie giowth funus, anu
they uo so in all thiee maiket cap classes. Active value investing funus
geneially uo the woist of any gioup of funus anu paiticulaily so with laige
maiket cap companies."
This is not eviuence that value funus peifoim pooily. Fai fiom it. They tenu
to outpeifoim the maiket, but they also tenu to unueipeifoim theii benchmaik, the
passive value stock inuices, which peifoim veiy well. The outpeifoimance of the
giowth investois ovei a passive giowth-stock inuex speaks moie to the pooi
peifoimance of the giowth-stock inuex, iathei than the positive peifoimance of the
giowth investois.
Tim Loughian anu }ay W. Wellman examineu the same pioblem ovei a longei
time peiiou in a 2u1u papei, "New Eviuence on the Relation Between the Enteipiise
Nultiple anu Aveiage Stock Retuins."
v
Loughian anu Wellman ask why, if a value
piemium (measuieu by PB) of 4.8 peicent pei yeai peisisteu ovei the peiiou fiom
1926 to 2uu4, funu manageis coulun't captuie it. They finu as follows:
"Funu manageis peiennially unueipeifoim giowth inuices like the Stanuaiu
anu Pooi's Suu Inuex anu value funu manageis uo not outpeifoim giowth
funu manageis. Eithei the value piemium uoes not actually exist, oi it uoes
not exist in a way that can be exploiteu by funu manageis anu othei
investois."
Bamouaian says that his finuings "|pointj to the neeu foi uiscipline anu
consistency in value investing anu to the veiy ieal fact that beating the maiket is
always uifficult to uo, even foi a goou value investoi."
LxperLs versus slmple sLaLlsLlcal models
What causes value funus to unueipeifoim a compaiable passive value-stock
inuex. In many uisciplines simple statistical mouels outpeifoim the intuition of the
best expeits. The simple statistical mouels continue to outpeifoim the juugments of
the best expeits, "8"# 92"# %2*:" ";<"6%: $6" 0,8"# %2" ("#"=,% *= %2" *'%<'%: =6*+ %2"
:,+<." :%$%,:%,)$. +*4".. }ames Nontiei, an expeit in behavioial investing, uiscusses
this phenomenon in his book 3"2$8,*6$. 5#8":%,#0> ? @6$)%,%,*#"6: A',4" %* ?<<.7,#0
3"2$8,*6$. -,#$#)". The fiist example he cites, which he uesciibes as a classic in the

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fielu, anu which succinctly uemonstiates the two impoitant elements of his thesis, is
the uiagnosis of patients as eithei "neuiotic" oi "psychotic." The uistinction is as
follows: a psychotic patient "has lost touch with the exteinal woilu" while a neuiotic
patient "is in touch with the exteinal woilu but suffeiing fiom inteinal emotional
uistiess, which may be immobilizing." Nontiei says that the stanuaiu test to
uistinguish between neuiosis anu psychosis is the "Ninnesota Nultiphasic
Peisonality Inventoiy" oi "NNPI".
In 1968 Lewis uolubeig, now a piofessoi of psychology at the 0niveisity of
0iegon, analyzeu moie than 1,uuu patients' initial NNPI test iesponses anu then
theii final uiagnoses as "neuiotic" oi "psychotic." Be useu the uata to uevelop a
simple mouel to pieuict the final uiagnosis baseu on the initial NNPI test iesponse.
uolubeig founu that his mouel, applieu out-of-sample, accuiately pieuicteu the final
uiagnosis appioximately 7u peicent of the time. Be then gave NNPI scoies to
expeiienceu anu inexpeiienceu clinical psychologists anu askeu them to uiagnose
the patient. uolubeig founu that his simple mouel outpeifoimeu even the most
expeiienceu psychologists. Be ian the stuuy again, this time pioviuing the clinical
psychologists with the simple mouel's pieuiction. uolubeig was shockeu. Even when
the psychologists weie pioviueu with the iesults of the mouel, they continueu to
unueipeifoim the simple mouel. While the peifoimance of the psychologists
impioveu fiom theii fiist attempt without the benefit of the mouel, they still uiun't
peifoim as well the mouel uiu by itself.
Bow can it be that simple mouels peifoim bettei than expeiienceu clinical
psychologists. Is this iesult a fluke. No. In fact uolubeig's NNPI example is the fiist
of an oveiwhelming numbei of stuuies anu meta-analysesstuuies of stuuiesthat
coiioboiate this phenomenon. In his 2uu7 book !'<"6)6'#)2"6:, Ian Ayies uiscusses
a myiiau of othei fielus in which simple mouels pievail ovei expeits, often in aieas
that woulu not appeai to be fiienuly to a quantitative analysis. Ayies pioviues a
uiveise iange of stuuies compaiing statistical mouels anu expeits, ianging fiom the
uetection of biain uamage, the inteiview piocess to aumit stuuents to univeisity, the
likelihoou of a ciiminal to ie-offenu, the selection of "goou" anu "bau" vintages of
Boiueaux wine, anu the buying uecisions of puichasing manageis. Nontiei makes an
inteiesting obseivation about the stuuies:
"|Asj much as we all like to think we can auu something to the quant mouel
output, the tiuth is that veiy often quant mouels iepiesent a ceiling in
peifoimance (fiom which we uetiact) iathei than a flooi (to which we can
auu)."

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value lnvesLors versus slmple sLaLlsLlcal models
}oel uieenblatt, investoi anu aujunct piofessoi at the Columbia 0niveisity
uiauuate School of Business, has iecently testeu in a ieal-time, value investment
context Nontiei's theoiy that quantitative mouels will act as a peifoimance ceiling,
iathei than a peifoimance flooi. In 2uu6 uieenblatt, publisheu a book calleu "The
Little Book That Beats The Naiket" uesciibing a quantitative veision of Waiien
Buffett's investment stiategy. uieenblatt tianslateu Buffett's uictum, "It's fai bettei
to buy a wonueiful company at a faii piice than a faii company at a wonueiful
piice," into a quantitative stiategy he calls the /$0,) -*6+'.$. In backtest, the Nagic
Foimula uiu as the title piomiseuit beat the maiket. Like the NNPI, the Nagic
Foimula is a simple statistical mouel.
In 2u12 }oel uieenblatt conuucteu a stuuy into the peifoimance of investois
using the Nagic Foimula ovei the peiiou Nay 1, 2uu9 to Apiil Su, 2u11. uieenblatt's
fiim offeis two choices foi investois wishing to use the Nagic Foimula, a "self-
manageu" account, anu a "piofessionally-manageu" account. The self-manageu
account allows clients to choose which stocks to buy anu sell fiom a list of appioveu
Nagic Foimula stocks. Investois aie given guiuelines foi when to tiaue the stocks,
but aie ultimately able to ueciue when oi if to make those tiaues. Investois selecting
the piofessionally manageu accounts hau theii tiaues automateu. The automatic
accounts bought anu solu Nagic Foimula stocks at fixeu, pie-set inteivals. Buiing
the two-yeai peiiou in uieenblatt's stuuy, both types of account weie able to select
only fiom the appioveu list of Nagic Foimula stocks.
What happeneu. Exhibit S has the iesults:

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79,4.4( R? F$()0"(4* L$(8%15)10' S%#5 M"/"2%6 F**)$/('
Source: CreenblaLL (2012)
The self-manageu accounts, wheie clients coulu choose theii own stocks
fiom the pie-appioveu list anu then exeicise uiscietion about the timing of the
tiaues, slightly unueipeifoimeu the maiket. An aggiegation of all self-manageu
accounts foi the two-yeai peiiou showeu a cumulative ietuin of S9.4 peicent aftei
all expenses, against the 62.7 peicent peifoimance of the S&P Suu ovei the same
peiiou. The aggiegateu piofessionally manageu accounts ietuineu 84.1 peicent
aftei all expenses ovei the same two yeais, beating the self-manageu accounts by
almost 2S peicent (anu the S&P Suu by well ovei 2u peicent). Foi a two-yeai peiiou,
that's a huge uiffeience. It's especially so since both the self-manageu accounts anu
the piofessionally manageu accounts chose investments fiom the same list of stocks
anu followeu the same basic guiuelines. People who self-manageu theii accounts
took a winning system anu useu theii juugment to eliminate all the outpeifoimance
anu then some. uieenblatt has seveial obseivations about the causes of the
unueipeifoimance of the self-manageu accounts.
Fiist, self-manageu investois uiun't buy many of the biggest winneis. Insteau,
they exeiciseu theii uiscietion to avoiu them, piobably because they lookeu like
loseis at the time of puichase. This is not a case of ianuomizeu eiiois in the
selection of stocks. The investois ieliably anu systematically avoiueu the best
peifoimeis. uieenblatt says that stocks aie often uepiesseu foi ieasons that aie

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well known. If you watch CNBC, you know why they'ie cheap. Ppait of the ieason
they'ie cheap in the fiist place is that they look like loseis foi one ieason oi anothei.
This is a gieat example of a behavioial eiioi at woik. We know the base case
buying value stocks geneially leaus to outpeifoimancebut we neglect the base
case because we'ie focuseu on the appaient iisk suiiounuing this paiticulai stock.
We can't help it. Stocks only get cheap because they aie out of favoi. We focus on the
haiiy, neai-teim issues anu ignoie the base case. Nany self-manageu investois
eliminateu stocks fiom the pie-appioveu Nagic Foimula list that tuineu out to be
the biggest futuie winneis.
Seconu, the self-manageu investois tenueu to sell aftei peiious of bau
peifoimanceeithei the stiategy unueipeifoimeu foi a peiiou of time, oi the
poitfolio simply ueclineu (iegaiuless of whethei the self-manageu stiategy was
outpeifoiming oi unueipeifoiming the ueclining maiket)anu then tenueu to buy
aftei peiious of goou peifoimance. uieenblatt founu that many self-manageu
investois got uiscouiageu aftei the Nagic Foimula stiategy unueipeifoimeu the
maiket oi the poitfolio ueclineu anu simply solu stocks without ieplacing them,
helu moie cash, oi stoppeu upuating the stiategy on a peiiouic basis. To compounu
the eiioi, they then bought stocks aftei goou peiious of peifoimance. Investois tenu
to sell iight aftei bau peifoimance anu buy iight aftei goou peifoimance, which,
says uieenblatt, is a ieliable way to lowei long-teim investment ietuins.
This is of couise the iesult that we woulu expect. We think we know bettei
than simple mouels, which have a known eiioi iate, but piefei oui own juugment,
which has an unknown eiioi iate. Says Nontiei:
"The most common iesponse to these finuings is to aigue that suiely a funu
managei shoulu be able to use quant as an input, with the flexibility to
oveiiiue the mouel when iequiieu. Bowevei, as mentioneu above, the
eviuence suggests that quant mouels tenu to act as a ceiling iathei than a
flooi foi oui behavioui. Auuitionally theie is plenty of eviuence to suggest
that we tenu to oveiweight oui own opinions anu expeiiences against
statistical eviuence."
We alieauy know that even expeits will unueipeifoim simple mouels. We
also know that we will continue to unueipeifoim when pioviueu with the mouel's
output because we piefei oui own juugmenteven when we'ie wiong. These aie
eiiois not maue out of ignoiance (the mouel piesents us with the coiiect choice),
but iathei out of incompetence (we simply fail to follow the mouel). As Waiien
Buffett says, investing is simple, but it's not easy.

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AnaLomy of a quanLlLaLlve value sLraLegy
While its peisistence seems to uefy common sense, the weight of eviuence
points to value stocks beating the maiket. The pioblem is that value funus uon't
peifoim as well as a passive value benchmaik. The solution is to apply a
quantitative piocess to a stiict value investment philosophy. Such an appioach
enables an investoi to maximise the chances of captuiing the value piemium. value
uoes not guaiantee any level of ietuin, oi even outpeifoimance ovei shoitei
peiious of time. The value piemium winks in-anu-out of existence, anu it's not
always a positive numbei. All we can say is that, ovei the long haul, value has beaten
the maiket. Why is the long iun so impoitant to quantitative value investing.
The "law of laige numbeis" holus that, as we inciease the numbei of
obseivations, the piobability that an event will occui anu the actual occuiiences of
the event conveige. As the numbei of tiials incieases, the piobability of an event
occuiiing will tienu closei to the pieuicteu piobability. In the shoit iun, lucky anu
unlucky events may clump togethei to push the obseiveu occuiiences fiom the
expecteu iate of occuiiences. Pokei playeis call this "vaiiance." vaiiance in pokei
teims is the uiffeience between how much money you expect to win on aveiage
ovei the long iun anu the iesults you obtain in the shoit teim. uoou pokei playeis
know that exploiting theii euge leaus ovei time to a ieliable ietuin, which can be
expiesseu as an houily iate: "big blinus pei houi" (the "big blinu" is the minimum
bet in a hanu of pokei. By calculating theii euge in teims of big blinus, goou pokei
playeis can calculate the likely houily iate available to them in a game by
multiplying theii euge by the minimum bet). Foi pooi pokei playeis, the houily iate
is negative. It is amazing that, in a game wheie luck plays such a huge iole, the
ielative skill of a playei can be quantifieu into an houily iate. uoou pokei playeis
uon't expect to win eveiy hanu, eveiy houi, oi even eveiy time they sit uown to play.
They know that ovei shoit peiious of time luck is moie impoitant that skill. This is
vaiiance.
Chailie Nungei, vice-Chaiiman of Beikshiie Bathaway, Inc., says that playing
pokei in the Aimy anu as a young lawyei maue him a bettei investoi. "What you
have to leain is to folu eaily when the ouus aie against you," says Nungei, "oi if you
have a big euge, back it heavily because you uon't get a big euge often."
vi
As Baviu
Einhoin, founuei of uieenlight Capital, anu outstanuing value investoi says:
"People ask me "Is pokei luck." anu "Is investing luck." The answei is, not at
all. But sample sizes mattei. 0n any given uay a goou investoi oi a goou
pokei playei can lose money. Any stock investment can tuin out to be a losei

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no mattei how laige the euge appeais. Same foi a pokei hanu. 0ne pokei
touinament isn't veiy uiffeient fiom a coin-flipping contest anu neithei is six
months of investment iesults. 0n that basis luck plays a iole. But ovei time
ovei thousanus of hanus against a vaiiety of playeis anu ovei hunuieus of
investments in a vaiiety of maiket enviionmentsskill wins out."
vii

uiven a laige enough sample size, a playei's skill ueteimines the playei's
ietuin. Investing is no uiffeient. Investois who want to outpeifoim the maiket neeu
an euge, anu a value investing philosophy pioviues that euge. The uifficulty foi
many investois will be in exploiting it. Nontiei says that "|ejven once we aie awaie
of oui biases, we must iecognize that knowleuge uoes not equal behavioi. The
solution lies in uesigning anu auopting an investment piocess that is at least
paitially iobust to behavioial uecision-making eiiois."
Nassim Taleb, authoi of -**."4 37 B$#4*+#"::, aigues that we shoulu not
even attempt to coiiect oui behavioial flaws, but shoulu insteau seek to "go aiounu"
oui emotions:
We aie faulty anu theie is no neeu to bothei tiying to coiiect oui flaws. We
aie so uefective anu so mismatcheu to oui enviionment that we can just
woik aiounu these flaws. I am convinceu of that aftei spenuing almost all my
auult anu piofessional yeais in a fieice fight between my biain (not -**."4 (7
B$#4*+#"::) anu my emotions (completely -**."4 (7 B$#4*+#"::) in which
the only success I've hau is in going aiounu my emotions iathei than
iationalizing them. Peihaps iiuuing ouiselves of oui humanity is not in the
woiks; we neeu wily tiicks, not some gianuiose moializing help. As an
empiiicist (actually a skeptical empiiicist) I uespise the moializeis beyonu
anything on this planet: I wonuei why they blinuly believe in ineffectual
methous. Beliveiing auvice assumes that oui cognitive appaiatus iathei than
oui emotional machineiy exeits some meaningful contiol ovei oui actions.
We will see how mouein behavioial science shows this to be completely
untiue.
Reseaich seems to suppoit Taleb's methoutiicking ouiselves into uoing
the iight thingwoiks bettei than simply tiying to uo the iight thing (oi flagellating
ouiselves if we uon't).
viii
The auvantage of the quantitative methou is that it staits
with the iuea that most of us aie tempeiamentally unsuiteu to investment, anu then
seeks to piotect against those potential eiiois. If we acknowleuge this flaw fiom the
outset, we can builu a piocess to minimize behavioial eiiois. In this way, the

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quantitative piocess acts as a shielu, seiving to piotect us fiom oui own behavioial
eiiois. We can also use it as a swoiu to exploit behavioial eiiois maue by otheis.
The quantitative methou outpaces most active value manageis, anu with
moie consistency. It uoes so because oui behavioial eiiois aie most pionounceu
when we ieason intuitively. We can ieuuce oui eiiois by ielying on statistical
eviuence, anu limiting oui uiscietion. This uoes not necessaiily aigue against active
management; it only suggests that active manageis shoulu be measuieu against the
coiiect benchmaik, which, in the case of a value investoi, is a passive inuex of value
stocks. If an active piocess auus value, then it shoulu outpeifoim that passive
benchmaik. If it uoes not, then it's ieasonable to ask whethei the costs of active
management aie woith beaiing. The eviuence seems to suggest that, in the
aggiegate, active value management uoes not beat the passive value benchmaik.
This is the iationale foi a quantitative appioach to value investment.

1oby Carllsle
Managlng Member
)0:;78 <=>76?87=? @2=2A787=? ""1
+1 646 333 8629
Loby[eyquem.neL



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DMGLT:FU: EDSNVFDM7T? The infoimation in this uocument is not intenueu to be an offei to buy oi
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The financial instiument uiscusseu in this iepoit may not be suitable foi all investois anu investois
must make theii own infoimeu uecisions anu seek theii own auvice iegaiuing the appiopiiateness of investing
in financial instiuments oi implementing stiategies uiscusseu in this uocument. The value of secuiities anu
financial instiuments is subject to cuiiency exchange iate fluctuation that may have a positive oi negative effect
on the piice of such secuiities oi financial instiuments, anu investois in secuiities such as ABRs effectively
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necessaiily a guiue to futuie peifoimance. Estimates of futuie peifoimance aie baseu on assumptions that may
not be iealizeu. Investments in geneial, anu ueiivatives in paiticulai, involve numeious iisks, incluuing, among
otheis, maiket, counteipaity uefault anu liquiuity iisk. Tiauing in options involves auuitional iisks anu is not
suitable foi all investois. An option may become woithless by its expiiation uate, as it is a uepieciating asset.
0ption owneiship coulu iesult in significant loss oi gain, especially foi options of unheugeu positions.

l
Lakonlshok, !., A. Shlelfer and 8.W. vlshny, ConLrarlan lnvesLmenLs, exLrapolaLlon, and rlsk," !"#$%&' ")
*+%&%,-, vol. xLlx, no. 3, pp. 1341-1378, 1994.
ll
8ogle, !ohn. C., SLaLemenL of !ohn C. 8ogle Lo Lhe unlLed SLaLes SenaLe CovernmenLal Affalrs
SubcommlLLee," november 3, 2003 (Avallable aL
hLLp://www.vanguard.com/bogle_slLe/sp20031103.hLml)
lll
lyakha, ?ullya, uppal , 8aman and vllkov, Crlgory, Why uoes an Lqual-WelghLed orLfollo CuLperform
value- and rlce-WelghLed orLfollos?" (!anuary 31, 2012). Avallable aL SS8n:
hLLp://ssrn.com/absLracL=1787043 or hLLp://dx.dol.org/10.2139/ssrn.1787043
lv
uamodaran, AswaLh, value lnvesLlng: lnvesLlng for Crown ups?" (Aprll 14, 2012). Avallable aL SS8n:
hLLp://ssrn.com/absLracL=2042637 or hLLp://dx.dol.org/10.2139/ssrn.2042637
v
Loughran, 1lm and Wellman, !ay W., new Lvldence on Lhe 8elaLlon 8eLween Lhe LnLerprlse MulLlple
and Average SLock 8eLurns." (SepLember 3, 2010). Avallable aL SS8n: hLLp://ssrn.com/absLracL=1481279
or hLLp://dx.dol.org/10.2139/ssrn.1481279
vl
Lowe, !aneL. .&/% 0+1234 5-2+%6 32- 7,-%-8 9+32 5-$:82+$- ;&32&9&< 5+''+"%&+$- =2&$'+- >#%1-$, Wlley,
2000.
vll
Llnhorn, uavld. Wlnnlng oker SLraLegles from an lnvesLor, or llnanclal Learnlngs for Make 8eneflL
Clorlous Wlseguys." ?&'#- @%A-83+%1 ="%1$-88, november 10, 2006.
vlll
See, for example, Conslderlng Lhe CpposlLe: A CorrecLlve SLraLegy for Soclal !udgemenL" by Lord,
resLon and Lepper. !ournal of ersonallLy and Soclal sychology (1980) or 8easons for Confldence" by
korlaL, LlchensLeln and llschhoff. !ournal of LxperlmenLal sychology: Puman Learnlng and Memory
(1980).