Charles Lee on Beating the Crowd at Picking Stocks
Charles Lee's portfolio management style requires accounting for human biases to nudge prices closer to their real value.
by Maria Shao
By now, the fallout from the epic financial crisis is both familiar and tangible: foreclosed mortgages, failed banks, lost jobs, recession. On the less tangible side, the meltdown also shook faith in a widely accepted economic principle: Markets are efficient. Since the mid-1960s, many academics have embraced the theory that prices paid in large public markets, such as those in stocks and bonds, reflect the collective wisdom of investors acting rationally on all available information. Yet there's been growing recognition during the past 15 to 20 years that human psychology — including irrationality — can play havoc with the wisdom of crowds. The historic bursting of the real estate and financial bubbles further undermined the belief that investors and markets behave with machine-like perfection.
The crisis also gave new relevance to the work of Charles M.C. Lee, who joined the Stanford Graduate School of Business as a full-time faculty member in July 2009. The professor of accounting has been at the forefront of the debate about market efficiency for nearly two decades. He was an early believer in the relevance of human behavioral patterns to market dynamics. Lee is among the pioneers in developing computer-based strategies for stock selection that take into account behavioral factors such as the tendency for investors to be overconfident or to ignore statistical likelihoods. The techniques he developed for valuing companies and predicting stock price movements help investors systematically evaluate and trade equities by taking advantage of market mispricings.
"The naïve view that markets are efficient by fiat is silly. You need to look under the hood. You can't just assume the engine works," says the trim and energetic Lee, who is the Joseph McDonald Professor of Accounting at the school.
Born in Taiwan in 1957 and raised in Canada from age 9, Lee was a professor for 14 years at the business schools of the University of Michigan and Cornell University. An innovator in teaching portfolio management, he founded an investment research center at Cornell and oversaw a novel student-run hedge fund. He later worked at Barclays Global Investors, a preeminent money management firm known for quantitative investing. With his return to academia, Lee brings to Stanford a track record in blending theory and practice. His passion for fly fishing has taught him that observation of the environment is as important as casting the line. Professionally, he says, "I have focused on the issue of market efficiency not as a 'yes' or 'no' answer, but a 'how,' 'when,' and 'why' answer."
The financial meltdown of 2007--2009 was a reminder that emotions dominate at the top and bottom of markets -- greed at the top and fear at the bottom. Thus the crisis was "consistent," Lee says, with his view that market efficiency is limited, changes over time, and can be improved upon by active investing.
Classical economists tend to "model human beings like machines," he says. "They assume human beings are totally rational and have infinite processing power." Therefore, market prices reflect intrinsic value. Instead, investors are subject to cognitive biases and constraints such as fear, greed, overconfidence, and overreaction. Lee has studied, for instance, how these imperfections show up in security analyst recommendations and how human biases can result in overvalued or undervalued stocks.
His key intellectual contribution to the debate on efficiency has been developing the concept of "informational arbitrage," in which investors interpreting complex pieces of information actively try to profit from imperfections in market prices. The market's continuous disequilibrium, he argues, creates opportunities for some investors to arbitrage the mispricings, which in turn reduces mispricing. "You can make markets more efficient by trading on the inefficiencies," he says. "We try to make prices better by taking positions different from the benchmark."
At first blush, Lee's belief in active investing seems to stand in stark contrast to the philosophy of GSB professor emeritus and Nobel laureate William Sharpe, among others, who advocates index investing, where investors try to match the performance of market indexes rather than to outdo them. Lee says the two perspectives are not all that different. "I agree that low-cost index investing is the right approach for the majority of individual investors. But professionally managed active investing will always be part of a well-functioning market. Active managers help make prices right.
"As financial economists, we need to start treating active management as a science that involves a technology and a process. Making sausages is a process. There's a way to do it better, and there's a way to mess it up."
In the 1990s, with computing power costs dropping, Lee and others developed ways to use electronic data feeds and mathematical models to run large numbers of stocks through quantitative screens and to structure portfolio trading strategies. [See sidebar for details.] The techniques involve downloading company financial information from databases, slicing and dicing the data to estimate the intrinsic value of companies and identify mispricings. Traditional portfolio managers and research analysts conducted analyses of company financial reports and data, often on paper. A security analyst doing fundamental analysis might actively follow a dozen or so stocks. Greatly automating the process, computer techniques make it possible to analyze and screen tens of thousands of stocks worldwide -- essentially the total investable universe -- in real time.
"It's the idea that we can use technology to harness all the information and systematically use it by applying computers. [Lee] was one of the leading figures in this evolution," says Richard G. Sloan, the L.H. Penney Professor of Accounting at the Haas School of Business at the University of California, Berkeley.
Specifically, Lee developed stock selection techniques that allow investors to value companies and predict stock price movements by using accounting information, analyst data, and various market indicators.
In 1998, with colleague Bhaskaran Swaminathan, he cofounded the Parker Center for Investment Research at Cornell's Johnson School, which features a trading room with data feeds and portfolio management software. Lee taught a course in which students managed the Cayuga MBA Fund with real money from investors. Teams divided by industry sector analyzed stocks, ran them through quantitative screens, and presented investment recommendations voted on by classmates.
Started with $600,000, the student hedge fund now has about $11 million under management. Since 2002, it has recorded positive returns in most years, including 2008, when U.S. equity markets dropped more than 30 percent. Lee's work with the student fund showed that "Charles has a tightly integrated view of research, education, and practice -- for the benefit of all," says L. Joseph Thomas, dean of Cornell's business school. "What he did in the broad area of asset management really added capability to our school."
By 2004, itching to put his ideas to use on a bigger scale, Lee joined Barclays (now part of BlackRock), a pioneer and giant in index investing and quantitative active investing. He moved up over four years from director of accounting research to global head of equity research. Realizing that he missed the "intellectual freedom" of being a professor, Lee joined Stanford as a visiting professor in July 2008 and became a full-time tenured faculty member a year later. At the GSB, he created a course called Alphanomics, an elective on the "science" of active portfolio management. He arranged for software vendors to donate software or services that students can access to try out strategies and techniques.
In a recent class, Lee wove together a dissection of portfolio returns based on factors such as price momentum and trading volume, calculations on the "value" and "glamour" components in stocks, and even an analysis of Krispy Kreme's share price. Whenever he identified patterns or correlations in data and charts projected onto a large screen, he would call out, "This is pretty cool!"
"I really enjoy it," said Alex Liloia, MBA class of '10. "The quantitative style is new to many of us. It's great to have someone who has published and is very well respected and has worked at implementing these strategies."
Lee is involved in designing a 40-seat, high-tech classroom for the Knight Management Center, the school's new facilities now under construction. This "investment lab" will have live data feeds and software tools that enable students to access virtually any information about any company in real time.
He has been weaving together theory and practice since he was young. The son of a civil engineer and a Mandarin teacher, Lee has always had a practical bent. When he was 9, his family moved to Canada, where he grew up in Ottawa and Toronto with a talent for math. After graduating from the University of Waterloo, he became a chartered accountant. "I was a very practical, risk-averse kid," he recalls jokingly. After five years in public accounting, he earned an MBA and doctorate from Cornell.
A "defining experience" for Lee, who did not grow up practicing a religion, was becoming a Christian soon after graduating from college in 1981. He met his wife, Lily, in church and began teaching a life skills and values class to church teens. Lee says, "After that experience, I felt like I really wanted to teach. They were so appreciative. I said, wow, this is very satisfying." He went on to earn a certificate in biblical studies from Ontario Theological Seminary. Like his theological studies, Lee's favorite pastime -- fly fishing -- has taught him to take stock of the big picture. He has been fishing since childhood, and on the wall of his Stanford office is a framed display of 24 colorful feathered fly-fishing lures, each tied and presented by a student portfolio manager at the Cayuga MBA Fund.
For Lee, it's not a stretch to draw lessons about investment management from fly fishing: "When you go to the river, you sit there first and just watch. You see many things you hadn't seen before -- dragonflies are floating or damselflies are flying, the way the wind and sun move. Then you hear sounds you never heard before. Then you notice how the fish are doing. What are they eating? Where are they going? The goal is not to say how many fish you catch. The goal is to know and understand the river. That's the way I look at investing and studying markets. If you understand the river, you will catch a lot of fish."