Musings with Analyst, April 2024

The Benefits of Quantamental Approach

In the ever-evolving landscape of portfolio management, turning towards an innovative approach that blends the best of both fundamental analysis and quantitative techniques can be a game changer. This approach, known as the quantamental framework, harnesses the power of fundamental aspects such as valuations, business overview, and sector dynamics, while integrating quantitative investing strategies such as factor investing. We, at Windmill Capital, are firm believers in this concept and thoroughly apply this framework behind ideating new smallcases and managing existing ones.

Let’s delve deeper into the quantamental framework in order to explore how it offers a comprehensive approach towards managing portfolios and why is it important? 

Quantamental investing : Confluence of Fundamental and Quantitative Factors:

The quantamental framework recognizes that traditional fundamental analysis and quantitative methods each have their strengths and limitations. By combining the two, one can leverage the insights provided by fundamental factors such as business fundamentals, competitive positioning, and industry dynamics, while also harnessing the analytical rigor and efficiency of quantitative screening and modeling techniques.

• Fundamental Analysis:

Fundamental analysis forms the cornerstone of the quantamental approach, focusing on factors such as company valuations, growth prospects, profitability, and industry dynamics. It also involves conducting in-depth research to evaluate the intrinsic value of stocks, assess competitive advantages, and understand the broader economic environment in which companies operate.

• Quantitative Analysis:

Quantitative analysis, at its core, is a process that you run on a broad universe of stocks and with the help of financial ratios, investing factors, or statistical/mathematical models and then finally come down to the final set of stocks that make a portfolio. 

Let’s understand this with the help of an example. Consider the Brand Value smallcase. It’s a thematic smallcase where we look to include companies who have a strong brand in India. Now how do we go about managing it?

First, we define the universe for this smallcase – top 750 stocks in India by market capitalization. Then, we start applying our negative quantitative factors like high promoter pledge, default probability of a company etc. to weed out the poor quality stocks. Post this we try to apply positive quant factors like proprietary quality ratio, growth score etc to concentrate our research on stocks which are doing relatively better among their peers. .  

Now comes the fundamental aspects where we analyze the theme fit, growth, profitability, quality aspects of these remaining companies to arrive at the final set. We have also incorporated proprietary sentiment analysis using LLM in our processes, which help us to scan negative news, sentiment flowing across for a stock, any headwinds a company is facing by scanning concalls etc. This helps us in improving our decision to select or remove a stock by concentrating on aspects which couldn’t be accurately captured by fundamental/technical ratios or factors.

Advantages of quantamental investing :  

• Quick Focussed Portfolio Diversification:

The quantamental approach facilitates improved and quick focussed portfolio diversification by incorporating a broader range of factors and investment opportunities. Diversification across multiple stocks that exhibit attractive fundamental and quantitative characteristics reduces concentration risk and in turn enhances the risk-return profile of the portfolio.

For instance, Affordable Housing smallcase. This is one of the few smallcases that have exposure to many different industries like building products, electrical equipment, household adhesives, cement etc. and many more. We have seen a couple of mutual funds having close to 40 stocks in their portfolio.  By bringing the quantamental framework, one can reduce the number of companies very easily and concentrate on the good ones and go deep in their analysis. This way a good focussed portfolio of 15-20 stocks could be made to get the same thematic exposure with less chance of having poor quality stocks and with quick turnaround time. 

• Dynamic Investment Process:

The quantamental framework offers flexibility and provides a dynamic investment process that adapts to changing market conditions and investment opportunities. By continuously monitoring both fundamental and quantitative factors, managers get to identify emerging trends, adjust investment allocations, and capitalize on evolving market scenarios.

An apt example to this would be the way we came about balance sheet ratios during the 2020 pandemic. 

Since most of the companies had to shut their business operations, it was obvious that they would start facing a severe cash crunch. This could lead to bankruptcy and the traditional ratios were not to be relied on. Hence, to understand the liquidity strength of the non-financial companies, we created proprietary balance sheet ratios. 

Since we were trying to study the current liquidity situation of the company, only specific items from the financial statements were relevant. On the assets side, the company would have access to cash and short-term investments. It might also be able to generate some cash from operating activities. On the liabilities side, the company will be obligated to pay all its current liabilities or at the very least the accrued expenses. It will also have to pay debt and interest that will be due.

• Combating Behavioral Biases:

Another benefit of the quantamental framework is its ability to mitigate behavioral biases that may influence investment decisions. Relying on a systematic and data-driven approach negates emotional biases and subjective judgments that can lead to suboptimal outcomes.

Many times, when one analyst is reading and analyzing a sector for a long time, she might develop an inherent bias towards certain companies. Therefore, with the data driven approach of our quantitative process, these biases get negated as the biased companies might not even qualify for selection based on the quantitative factors that all the companies will go through. 

Conclusion:

The quantamental framework tends to generate performance synergies that exceed the sum of its parts. Fundamental analysis provides qualitative insights into a company’s competitive advantage and growth potential, while quantitative screening adds rigor and efficiency to the investment process, resulting in a more robust portfolio construction.

To sum it up, I found a rather succinct explanation of quantamental investing which goes like – 

When markets fall and the price of a stock falls with it, how does each investment style look at the scenario?:

1. Fundamental investors find cheap valuations and a low P/E ratio. If the reasons for the business to continue to hold, they buy at or below the intrinsic value with a margin of safety.
2. Quants find a sharp divergence between current and historical prices, which is likely to mean-revert since price typically spends very little time at extreme levels. The value factor will make the stock attractive.
3. A Chartist observes a U or a V-shaped bottom formation and a reversal pattern and calls it a buy.
4. Alternate data shows that business is still in full swing because trucks are flowing in and out at the same pace.

Combining the reasons to buy the stock gives the quantamental investor higher confidence to take a position. By simply overlapping multiple analyses the accuracy increases many-fold, giving the investor risk-adjusted returns.

Through our content, we have always communicated about our innovation led mindset. The last year has seen incredible amounts of progress in the fields of Artificial Intelligence and Machine Learning. The innovators have brought about excellent automation in many parts of the work. We have also pushed ourselves and have brought about a bunch of innovative changes to our processes. 

To mention a few specifics, since the last two rebalances, we have been tinkering with our own Chat GPT like version (Windmill Chat App) which helps us with a whole host of things. It helps us summarize long documents (earnings call transcript, sector reports) and ask specific questions which is a huge time saver. We also run sentiment analysis on stocks or sectors to gauge the market narrative and track all the news around them in an organized way. It has led to inordinate amounts of efficiency in our processes and has significantly reduced the turnaround time. 

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_{Windmill Capital TeamWindmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. CIN of the company is U74999KA2020PTC132398. For more information and disclosures, visit our disclosures page here.}