Keying off the Academy Awards last Sunday night, Tom Quinn, CornerCap Co-Founder and CEO, writes about the origins of our proprietary research system 30 years ago, putting it in context of the statistical approach championed by Oakland A’s general manager Billy Beane in 2002.
“To invest successfully over a lifetime does not require a stratospheric iq, unusual business insight or inside information. What’s needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework.”
- Warren Buffet
The Fundametrics® research process is CornerCap’s proprietary research system that guides buying and selling stocks for client portfolios. It is our intellectual framework by which we systematically evaluate stock candidates according to proven fundamental factors, unencumbered by human emotion or bias.
Our founders have operated a version of Fundametrics® since before the inception of CornerCap in 1989. As a result, it is deeply ingrained in the culture and is truly part of the firm’s DNA. We invest considerable time and money into the programming, automation, and ongoing evaluation of this system. After two decades, we believe we have a strong grasp of the characteristics that lead to a stock’s outperformance over a market cycle.
The graphic below highlights the steps involved in our application of Fundametrics®. To summarize, we create our investable universe of stocks (segregated by large stocks and small stocks), rank each one on a scale of 1 to 10 (the first decile being the most attractive), provide a risk overlay derived from fundamental and market characteristics, then seek diversification to help fruther manage risk.
From there, we perform a qualitative review. This is generally an effort to ensure the data is accurate or there are no pending announcements that would change the stock’s ranking.
While Fundametrics® monitors over 120 fundamental factors, we find that a particular grouping of a core 12-14 factors drives the best buy and sell decisions over time. We call this grouping our “Alpha Composite” of fundamental factors, which consists of a broad Universe Ranking and a narrower Sector-Specific Ranking. Valuation characteristics are the most important elements in these rankings, and value and relative value are the largest contributors to excess returns. Also included are elements of GARP, Revisions, Momentum and Growth. Our research has shown that their lower correlation to the Value factors improves overall risk adjusted returns.
Just as we have identified fundamentals that help generate excess return, Fundametrics® contains a large inventory of factors that focuses on company risks. Our Risk Composite, or Financial Warnings Overlay, is comprised of the risk factors that our proprietary research has identified as potentially limiting future performance. This overlay is an important part of our investment process and we believe it allows us to mitigate risk and prevent costly mistakes.
Buy candidates that are highly ranked by the Alpha Composite and pass the Financial Warnings Overlay are then evaluated on how they improve portfolio diversification. The objective with diversification is to approximate the industry group and sub-group weights of the Fundametrics Alpha Composite Buys (deciles 1-3).
A significant amount of an analyst’s job is incorporated into the Fundametrics® process: identification of value, financial statement analysis, risk avoidance, and diversification. CornerCap’s automated Fundametrics® process has allowed us to avoid the flaws of qualitative analysis, i.e. human emotion and bias. As a result, we have attempted to create a nearly flawless analyst for handling these tasks.
The sell discipline is very similar to our buy discipline and is equally important. The higher percentage of stocks we can hold in our best Fundametrics® ideas, the greater probability of long-term success. Stocks are typically sold when they fall below a rank of a 5 or when flagged by our Risk Composite.