In my last post I questioned the long term relevance of some of the fundamental factors outlined in the Navellier's Little Book that makes you rich. However, I also noted that all eight of these factors only add up to a 30% weight in his final analysis. The other 70% is given to what Navellier calls his quantitative stock grade. He describes this as a measure of buying pressure amongst institutional investors.

However, he also tells us exactly what this measure actually is. On page 88 he says "In basic form, we divide a stock's alpha (the return independent of the stock market that typically comes from buying pressure) by its standard deviation. We measure this over a 52-week period".

The 'alpha' Navellier calculates comes from a simple CAPM model. However, as we show in Chapter 35 of Behavioural Investing, the simple CAPM model is deeply flawed. It just doesn't work. In fact in general there seems to be a negative relationship between beta and return, rather than a positive one.

Of course, Fama and French suggested a revised multifactor model of asset pricing - based on size, and price to book as well as the normal market factor. To help reduce the pricing errors in this model a momentum term was introduced by Cahart. A very recent modification has been proposed by Hirshleifer

. This adds a new factor to the equation of repurchases minus issuers (labeled UMO). This again reduces the significance of the alphas calculated from the FF4 model. In general the alphas become statistically insignificant under this five factor model.

So effectively, Navellier is running a semi reduced form model, not specifying which factors matter, but rather taking the alpha as a catch all term (which could be broken down into more understandable elements - such as size, value, issuance and momentum). However, Navellier demonstrates that these alphas have persistence. He estimates them over the past 52 weeks, and then uses them going forward.

To my mind this is consistent with recent work on style momentum. Chen and De Bondt have shown that style categories have a degree of persistence. They show that if you buy styles that have done well in the last year (in terms of size, price to book and dividend yield) they continue to do well over the next 12 months (but not beyond). The return achieved from a long short position based around this style momentum is around 7% p.a. using a 12 month holding period, and style past returns calculated over 12 months. In long only space a style momentum strategy generates a return of around 17% p.a. over the period 63-97. So Navellier's idea of alpha persistence certainly gets some support from this viewpoint.

Some final thoughts

I found much to agree with in Navellier's Little Book such as the over-reliance on stories, and the meeting with company management being a waste of time. His reliance on numbers based analysis echoes very much my own views on evidence based investing. However, ultimately I found the book couldn't stick with its own discipline. For instance, Navellier can't help but eulogize over the wonderful outlook for stocks that deliver out future. Despite his pronouncements that his eight factors and his quantitative grading system are really all you need to invest, he spends a considerable amount of time telling you to read the newspapers, whilst simultaneously ignoring the noise. Such overtly contradictory advice can do little but confuse the reader.

Personally I am not convinced that Navellier puts together a coherent defense of growth investing. But then again that won't surprise those of you who know me!

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## 10 comments:

I love these silly magic formulas that fly in the face of mathematical or investing reality.

For example, you can "merge" two disparate companies by buying a hundred shares of each. If they both have the same starting alpha and standard deviation, the merged company will have the same alpha and... maybe only 4/5 of the standard deviation, due to that mysterious phenomenon, "diversification."

So, how can you take two OK stocks, cause zero interaction between them, and make a better stock? A new form of perpetual motion?

If the answer is that you want a diversified portfolio to invest in, you get an A for creativity but an F for honesty. The scheme was said to be a way to pick stocks, not to diversify a portfolio.

Thanks for the article. By the way, the URL to the Hirshleifer paper is wrong -- it's got an extra "http//" stuck in the middle.

Thanks Rowan. Fixed that now.

I've enjoyed the Little Book series, but there was no way to match the greatness of the first (Greenblatt's).

Anyway, thank you, James, for continuing to publish your thoughts on value-oriented investing, which I have long enjoyed.

Sincerely,

Ian Lucas

Graham Investment Management, Inc.

I'm perplexed by Navellier. I get e-mails from him everyday for his newsletters proclaiming all the great stock-picks his quantitative system yields. IIRC, he often cites how Hulbert has some of his newsletters as top-ranked. Yet, some time ago I remember looking at some of the mutual funds he manages and they were mediocre at best. How could his stock-picks do so well, yet the funds underperform?

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Interesting thoughts... What is interesting is the way emotion drives people's investments...often causing people to invest at the exact wrong times.

Anyway, keep it up.

Cheers.

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