ETF.com: How do you discern between value opportunities that have moved beyond fundamentals, and value traps?
Gray: There're five steps to that process. First, you have to identify a liquid universe you can actually trade. Then you have to do a lot of forensic accounting analysis. The idea is that when you're value-investing, you don't want to just buy cheap stocks, because cheap stocks can get a lot cheaper. You want to somehow screen-out with some reliability firms that could be permanent loss of capital—i.e., they're going bankrupt, or it's a fraud.
Once we're within cheap stocks, we focus on a whole suite of quality metrics. But in the end, all we're looking for is evidence—at least historically—for economic moat. We’re looking for the ability a firm has to generate returns on capital, and return on assets that are in excess of what we think they're discounted. We’re looking for “fair market rate” of capital return.
As long as you're systematically going after cheap, high-quality firms where we've tried our best to forensically eliminate those that are likely falling knives, we think we can eliminate a lot of the value-trap problems.
ETF.com: So today in QVAL, I think about a third of the portfolio's in consumer discretionary, and then a quarter of it is in energy stocks. Are those the sectors you see the most value opportunity in today?
Gray: Yes, that's where it is. And we don't do any sector neutrality. We just go wherever the cheapest, highest-quality stocks are, period. Right now, that is in consumer discretionary, and oil services and oil companies.
ETF.com: On a more personal note, if I may, I'm curious about your stint in the military. You took a four-year sabbatical to become a Marine and go fight in Iraq. How has that experience impacted how you go about investing today?
Gray: A lot of ways, actually. I would say it was pretty profound for a lot of reasons. Over time, I became a huge fan of psychology, and a huge fan of understanding overconfidence.
I joined the service because I decided it was a good thing to do. I was paying my respects to the Man. But the first thing I learned from being in the military was about being humble.
Even though you may have a lot of skill, and a lot of credentials, being humble at the outset solves a lot of problems in the world. Whether it involves going to war or investing—where you've got to be pretty confident to believe that you can beat the market—you better have a lot of humility about how you go about thinking you're smarter than everyone else.
I also learned about the importance of really thinking hard and strategically before you make decisions. I'm a big fan of systematic decision-making. In the military, you’re often having to make decisions when you're getting shot at. If you haven't trained and you haven't thought through how you're going to react in that situation, in the emotional state of affairs, you're going to do stuff that you're probably not supposed to do.
Sometimes your intuition in a stressful situation is the exact wrong intuition, and you need to have a process to make sure you do the right thing. In investing, when you see oil prices collapse and stocks get super cheap, you are inclined to say sell, sell, sell.
In the military context or in an investing context, where there's a lot of stress and emotions involved, systematic processes eliminate a lot problems.
Finally, I’d say that in the military, you hear a lot of stories. We’ve all seen a lot of movies. But they often don't rely on actual evidence. Over time, you realize they are great stories, but we want to make decisions based on evidence and on what actually works.
That’s very important in a military context, where you could die if you just made decisions based on great stories. I think the equivalent of dying in financial markets is losing money, or paying some idiot to do something that they sold you on because it's a great story, but there's no actual evidence that it works.