Different views combine and make the stock market a living organism. It is complex and difficult to predict, but interesting and challenging to attempt it. One thing to keep in mind in the number of different perspectives out there. This could be tied to behavioural biases, a well-documented phenomenon. In our view, this fails to connect with our initial problem statement, which is essential to our construction of the framework in which we operate to solve the quest for alpha.
The investment style varies greatly: from finding a new technology business model or penetrating a new market that will strive in the future, as a growth-oriented investor would do, to finding an undervalued company that has potential to restructure its operations and unlock value, from a value manager perspective.
The industry likes to use those style boxes, where we often see a declination value vs. growth score and small vs. large capitalization. We think of those as biases, anchored in preferences or empirical research that focuses on decades of returns, but lack predictability over shorter time horizons. We are not looking to extend on this debate but introduce how market participants can see the same information and have different interpretations. Growth managers might not look at all at a cheap stock, while the value investors won’t look at a company that burns cash for research & development.
The breath of informative elements about a company is very vast. Ranging from in-person management meeting, analyst ratings, discounted cash flow analysis to reddit forums. Some information is more important to others and vice versa. We can see them as alpha drivers. A few examples are showcased below:
Historical financial ratios ∙ ESG sentiment positioning ∙ Macroeconomics data
Analysts’ expectations ∙ Technical indicators ∙ Correlation with major financial instruments
Qualitative assessment ∙ Management discussion ∙ News sentiments
Market research ∙ Transcript data ∙ …
Having introduced the investment styles and what composes the informative elements, we have sufficient building blocks to start explaining the alpha (or excess return).
The first step, in red in the following equation, is to say that every informative element of a specific company (A) can explain, at the margin, the alpha of this company.
Taking Apple Inc. as an example, we would consider the profitability ratio, the quality of the management, the number of devices sold in the last quarters, the analyst expectations, etc. Adding the marginality of all those informative elements should, in theory, be sufficient to explain the alpha of a company compared to its benchmark.
The second step, in blue, is to say that every investment style will have a view on those informative elements that will average out over many market participants.
Following with the same example, the value manager will emphasize the marginality of the informative elements about the valuation metrics of Apple Inc. and might disregard the high growth numbers in a new market segment like smartphones back in 2007. Conversely, the growth manager will overlook the valuation metrics and focus on this promising new segment and the iPhone’s positioning at that time. Therefore, the effect of the informative elements is average out by the many market participants. Lastly, in green, we have the uncertainty that represents the residual, everything impossible to predict with our current framework. This is needed to formulate an adequate, yet far from perfect, mathematical equation.
Our formulation stands to give us a direction to explore in our quest to predict the alpha. We propose to decompose it using informative elements as it brings an easy framework to consider the many different views of the market participants.
Moreover, since we don’t fit in any of the style boxes by industry standard, we feel the need to clarify where we stand and how different we are from that perspective. This is one of the goals we wish to achieve it by the end of this discovery series.
In summary, the oversimplified hypothesis is that the alpha is a function of the sum of the individual’s marginal alpha created by distinct informative elements and assessed by different investment styles. This results in an average of different views complemented by the uncertainty of the future.
Telling you that we think differently at this point might not be enough. We hope part 3 enlightened you a bit more on how markets movements happen as everyone sees things differently.
Lastly, a final piece is necessary to fully formulate our framework: the lack of knowledge. Simply put, knowing everyone lacks information. This will be the topic of the next part in our discovery series.