Man Plus Machine
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Man Plus Machine

The Industrial Life Cycle (ILC) team has developed an innovative investment process that combines a structured approach to data analysis and human expertise for fundamental stock selection. This successful approach has resulted in the ILC strategies outperforming volatile equity markets to deliver consistent and stable returns for their investors. 

Have you ever thought the world of chess could provide the investment world with valuable lessons on effective investing? Michael Mauboussin and Dan Callahan of Credit Suisse, Global Financial Strategies, have published the paper "Lessons from Freestyle Chess: Merging Fundamental and Quantitative Analysis." The paper explores "the applicability of freestyle chess to the world of investing, where fundamental analysts are 'man' and quantitative analysts are 'machine.'" The lessons are simple:

  • In chess, the best computer programs can beat the best humans. This was proven in 1997, when the world champion of 20 years, Garry Kasparov, lost to an IBM computer called Deep Blue. 
  • Yet, man plus machine is better than either man or machine. In 2005, freestyle chess was proven to be superior to the best computer programs, whereby freestyle chess involves humans using inputs from chess programs to assist in their moves. 
  • This proved that taking the best of humans and machines allows for better results than a man or machine alone.

Placing these findings in the context of investing poses the question, "Can the combination of fundamental and quantitative investing add overall value to an investment process?" As Michael asks, "Can we combine the best of what humans and computers offer and avoid the worst of each?" Computers provide ongoing, data-driven insights across a large universe that can overcome some common mistakes that fund managers make, including: biases, emotionally-led decisions and trade-fueled fears. By contrast, fundamental analysts are better placed to recognize shifts in regime changes whilst providing more granular insights that a rules-based computer cannot see.

The Cycle of Life

In an industry where fundamental and quantitative approaches are largely kept separate, the Industrial Life Cycle investment team has developed a process that successfully combines a structured approach to data analysis and human expertise for fundamental stock selection.
ILC leverages an innovative and proprietary method of stock picking that applies a life cycle approach to investing. ILC recognizes that all companies go through different stages of corporate maturity and that there are different drivers of performance based on which life cycle stage a company is in. ILC uniquely classifies the equity universe into five stages: Startup, Growth, Cash Cow, Fading Winner and Restructuring.
The approach then identifies the primary drivers of future share price performance within each life cycle stage, determining attractiveness based upon measures including Valuation, Quality (Cash Flow Return on Investment or CFROI), Earnings Momentum and Price Momentum.

ILC Stages and Alpha Generation Matrix

ILC Stages and Alpha Generation Matrix

Source: Credit Suisse

To demonstrate the ILC approach, the table above shows that, for example, applying a valuation discipline to a Growth stage company yields low explanatory power with regard to prospective relative returns, while, by contrast, focusing on factors such as quality and momentum trends is quite productive. As corporations mature into the Cash Cow stage, a focus on valuation coupled with strong earnings trends offers the greatest potential. Valuation and capital discipline become the pre-eminent factors in selection for the later stages of Fading Winner and Restructuring.

So in total, the powerful combination of fundamental and quantitative has proven consistent in generating stable excess returns across the ILC equity platform since its inception. Furthermore, given the structured and repeatable nature of the ILC philosophy and process, it has allowed ILC to leverage this process across other equity strategies.

Structured Process, Human Expertise

The ILC structured process analyzes 10,000 companies in the HOLT database, classifying each into one of the five life cycle stages. Companies are then systematically ranked according to the primary drivers of excess returns within each life cycle stage to provide an ILC score from 1 to 100.

The advantage of the ILC idea generation engine is the ability to apply the process to a large and diverse investment universe whilst ensuring that the classification and ranking process removes the emotional element of investing.

The other key component of the ILC investment process is the due diligence that is performed on each top scoring name that comes out of the idea generation engine. The purpose of the qualitative input performed by the investment team is to validate the attractiveness of the company and the ILC score to eliminate any "false positives". False positives can occur for various reasons, including data integrity, corporate actions, limited HOLT coverage, local government intervention, corporate governance, etc. This depth of view provided by the qualitative overlay results in 25 to 35 percent of the investment ideas that come out of the ILC idea generation process being rejected. In these cases, the team will move to the next most attractive idea in the life cycle stage.

By designing a qualitative process that validates and eliminates any false positives, the often subjective nature of such an overlay is removed. This ensures an investment process that is objective and unemotional. Most importantly, machine and man work together rather than against one another, which can often be the case with asset managers who employ a combination of qualitative and quantitative approaches.

The Best of Both Worlds

The ILC investment process embodies the philosophy that "man and machine are better than man or machine" by effectively combining a systematic process of data analysis and human expertise for fundamental stock selection. This combination is designed to appeal to the strength of man and machine and avoid the worst of each.
The result for clients is an investment solution which has the ability to source highly unique companies in a repeatable manner, providing the opportunity to consistently deliver excess returns.