Courtesy of John Nyaradi.
“The Handbook of Equity Market Anomalies” an exclusive interview with Len Zacks
John Nyaradi: Hi everyone. I’m John Nyaradi, publisher of Wall Street Sector Selector, a financial media site specializing in exchange traded funds and global economic analysis. Today, I’m really pleased to welcome our special guest, Mr. Len Zacks. Len, welcome to Wall Street Sector Selector.
Len Zacks: Thank you very much, John. Glad to be here.
John Nyaradi: Len Zacks is a well known giant in the financial industry. He has been the chairman and CEO of Zacks Investment Research since 1978. He holds a Ph.D. from the Massachusetts Institute of Technology. His website, Zacks.com, is a widely known leading financial internet website and he’s also the developer of the Zacks Rank, one of the first ever anomaly-based stock selection tool. Zacks also manages assets for individual and institutional investors. Today, we’re going to talk about Len’s new book, "The Handbook of Equity Market Anomalies: Translating Market Inefficiencies into Effective Investment Strategies (The Zacks Series)." 
Len Zacks: Sure. I think the reason that we started the book was we were inundated and actually overwhelmed by the number of articles that are published in the academic literature related to quantitative equity investment management techniques and anomalies. It seems like just keeping track of the table of contents of the 30 or 40 academic journals was taking up a massive amount of time. We looked for a summary of the research in one form or another and we found that there really wasn’t any. There were a few academic articles that summarized very narrow threads of the research from an academic perspective, but there was nothing that you could look at that if you wanted to trade stocks using say earnings surprises, there was nothing that was a good summary of what the academic research had said about that subject.
So I got involved with a number of professors each in a different specific area and started talking to them about why such summaries did not exist, and they explained to me that, you know, your job is writing academic articles and the academics don’t need a summary because they read the articles, they know what’s been going on. But we found a few that were interested in communicating to individuals the type of research that they have been doing and the findings in their area. It really is a slight deviation from the type of articles that they normally write, but I was lucky enough to find eight or nine people that wanted to do this each in a different area so over a period of about a year worked with them to summarize the articles on anomalies in their specific areas of interest.
John Nyaradi: I do a lot of reading in the industry and I haven’t seen a book like this that really goes into the academic background of some of these things. I mean as a retail investor, we hear all the time the market is efficient and really this book is saying it’s not efficient, is that right?
Len Zacks: Oh, absolutely. I mean that’s the whole thrust of the research since 1980. The last 30 years, the researchers have been analyzing the anomalies trying to understand how they’re related to each other, trying to understand how they’re determined by risk models. And along the way, they’ve developed technique after technique after technique that can be used by individual investors to manage a quantitative portfolio.
John Nyaradi: We’re all told you can’t beat the market but here you’re saying we can beat the market.
Len Zacks: You can — you can beat it if you’re taking a statistical approach I think is the message that comes through from the book. If you create portfolios that might have 50 stocks long and 50 stocks short, you have a very good chance of generating positive returns on a consistent basis.
John Nyaradi: We read a lot about quantitative analysis and quants and I think for the average kind of retail guy, it’s kind of a mystery. Can you kind of talk about what a quant is and how it works?
Len Zacks: Sure. I would separate quants into the professional quants and individual quants and maybe talk about the individual quants. The professional quants generally have a Ph.D. in finance or a statistical area and their full-time job is building and back testing and managing portfolios using quantitative models. The individual quants to whom this book really is dedicated are people that have I would say a familiarity with computers, have knowledge of accounting, and believe in academic research as being a set of information that really has significant value for investors.
So what they do is they’ll use software to screen stocks using criteria, P/E, changes in volume, trading volume, momentum versus the recent highs or lows, whatever techniques they’re combining and they’ll build a screen is the simplest way to think about it. And then they’ll run that screen perhaps monthly, perhaps weekly and they’ll buy maybe the top 30 stocks at the top of the screen. If they’re following the techniques in this book, they’ll be doing the same thing on the short side and shorting 20 to 30 stocks and then they wait. It’s really a very, very disciplined approach to managing a portfolio.
John Nyaradi: In your book you describe nine equity market anomalies. Let’s chat about two, analyst recommendations and earnings forecast anomalies.
Len Zacks: The basic idea is that analysts are the most knowledgeable people about any specific company and therefore the stocks that they recommend you would think would go up. So that anomaly might be that the stocks they recommend do not go up, but the technique is buying stocks that analysts are recommending as buys and selling the stocks that they’re recommending as sells. I think in some years that worked very, very well. In 2009, the analyst buys outperform the sells, but in 2010 it was reversed and in 2008, it was the reverse also whereas in 2007 the buys dramatically outperformed the sells. So using the analyst buy and sell recommendations to create portfolios is kind of one part of this.
The other part is using the changes in the recommendations or the changes in their earnings forecast to select stocks and that’s the initial anomaly that Zacks Rank was created using in 1982. So that really is more of an anomaly because the efficient market theory would say that new information when it exists is immediately compounded in the stock price. And the anomaly is the fact that there’s a delay between when the analysts changed their estimates or changed their recommendations and when the stock prices respond and that you can use that delay to properly create and trade portfolios.
John Nyaradi: What about seasonal anomalies? Everybody has heard of the January effect and sell in May and go away. What does the research say on these techniques?
Len Zacks: This is an interesting idea. The person that wrote this chapter of the book, Bill Ziemba, is probably the world’s foremost seasonal anomaly trader. He’s got a tremendous track record in academia. He was head of the quantitative department at the University of British Columbia and a number of schools over many, many years. So he is probably the one person in the country that knows the most about what is real here.
Because it’s very difficult statistically to separate out the random components from persistent patterns that you can use and trade. And the chapter of the book that talks about a number of different seasonal anomalies that you could look at and that he has looked at. I mean there’s a Ramadan effect that you buy during the Moslem holy month. There’s a Rosh Hashanah effect that you buy or sell between the Jewish holidays of Rosh Hashana and Yom Kippur. There are effects related to what political party is in office, effects related to the day of the week, the seasons. There are just a whole host of these.
John Nyaradi: Let’s talk just for a moment about the Zacks Rank.
Len Zacks: The Zacks Rank is based on two of the anomalies, the estimate revision anomaly and the earnings surprise anomaly. And we constructed the rank in 1982 and we did not change the definition of it over the years so it really has stood the test of time. Essentially, the rank has got four components to it. One is the agreement, which is the extent to which analysts are revising their estimates in the same direction. The magnitude is the percent change in the consensus using this year’s estimate and next year’s estimate. The upside is the statistical measure that we developed of the most accurate, comparing the most accurate estimate to the consensus. As the most accurate estimate is more accurate, the consensus will move in that direction. And then the surprise is based on the pattern of earnings surprises over the last few quarters. So those four components, agreement, magnitude, upside, and surprise are combined together to give a single rank score. And then a universe of about 4000 companies, which are the companies followed by Wall Street analysts in total is ranked weekly using that score and then we publish that score 1 to 5 for each company and that’s the Zacks Rank. And the performance of it has been quite consistent over the last 25 years with, you know, average return of about 30% on the number 1 stocks versus about 1% to 2% on the number 5 stocks.
John Nyaradi: The book comes with a companion website, hema.zacks.com. There’s a link to that here that people can go to. Can you talk a little bit about what’s at the website, what people can expect to find there, and what it might do for them?
Len Zacks: Well, the website contains a page from each of the authors of the book where they interact with the readers. And if you have questions about any of the details of any of the papers that are summarized, you can post a question and then the author of that chapter will respond. It’s like an interactive forum and you can discuss the details of any of the individual papers in the various chapters.
John Nyaradi: Len, I always like to end these conversations with sort of an open-ended question just asking if there’s anything else you’d like to add, the one thing that’s on your mind right now maybe that retail investors like us should watch out for? We’re talking here in December of 2011.
Len Zacks: I think the one thing that came up to me after editing — I didn’t write the book — by editing the book is that it is very, very possible, reasonable, and doable for individual investors to generate returns of 10% to 15% a year and those numbers look very attractive given what’s been going in the market in the last few months. And they can generate these returns by managing their own portfolio using the anomalies and there are a lot of software programs out there now that can be used to do this.
So, I would recommend that anyone actually interested in using the research, implementing the research that’s discussed in the book go to a website we created specifically for that purpose called ZacksRW.com. And there it explains how you can use software, free trials and so forth to test and back test and build your own quantitative investment process with the objective of generating returns of 10% to 15% per year.
John Nyaradi: Well, folks we’ve been talking with Len Zacks, chairman and CEO of Zacks Investment Research since 1978. He holds a Ph.D. from the Massachusetts Institute of Technology and of course we’ve been talking today about his book, "The Handbook of Equity Market Anomalies: Translating Market Inefficiencies into Effective Investment Strategies (The Zacks Series)."
Len Zacks: John, thank you very much, enjoyed talking to you.
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