What Works on Wall Street? James O'Shaughnessy Tells All!

 History has shown that investors who stick to disciplined, fundamental-focused strategies give themselves a good chance of beating the market over the long haul and one of the investment gurus who has compiled the most data on that topic is James O’Shaughnessy, whose book What Works on Wall Street became something of a bible for investment strategies when it was released 15 years ago. Now, O’Shaughnessy has released an updated version of his book, with a plethora of new data on various investment strategies. Using data that stretches back to before the Great Depression in some cases, O’Shaughnessy back-tests numerous strategies, and comes to some very intriguing conclusions. [Let me share some of them with you.] Words: 1345

So says John Reese (www.validea.com and www.theguruinvestor.com) in edited comments from his original article*.

 Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and www.munKNEE.com (Your Key to Making Money!) has edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) the article below for the sake of clarity and brevity to ensure a fast and easy read. The report’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Reese goes on to say, in part:

Given that his earlier work inspired one of my best-performing “Guru Strategies” on Validea.com (a 10-stock portfolio picked using the strategy has generated compound annualized returns of 9.9% since its July 2003 inception vs. just 2.6% for the S&P 500), I wanted to share some of his new findings with you.

One of O’Shaughnessy’s key points is about broader investment approach. For O’Shaughnessy, one of the biggest problems investors face is the tendency to focus on recent events. In the introduction to his book, he discusses how some began calling the “abysmal” returns of the past decade the “new normal,” even though it wasn’t that long ago that commentators were declaring that the Internet had ushered in a “new era” of perpetually rising stock returns — a declaration that proved to be horribly wrong…While many investors are assuming that the poor performance of stocks during the 2000s is the start of a new era of poor returns, O’Shaughnessy says history shows something entirely different…

Looking at the worst rolling ten-year returns for equities [from] 1900 [through the end of 2010] (and the period ending in February 2009 was the second-worst over that span, with 10 other 10-year spans ending in 2008, 2009, or 2010 cracking the top 50)….[he found] that equity returns following those awful 10-year periods tended to be outstanding;

Since stocks bottomed in early 2009, that pattern has again played out, to an even greater degree:

• the S&P 500 gained 68.57% in the first year after its March 9, 2009 bottom;
• it averaged 39.68% gains in the first two years. (These S&P figures are before inflation is factored in, but the main idea — that bad periods are followed by strong rebounds — holds true.)

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O’Shaughnessy explains that, “historically, we have always seen reversion to the mean. After stocks have had an unusually great 10 or 20 years, they typically turn in subpar results over the next 10 or 20, and after bad 10- to 20-year stretches, the next 10 to 20 tend to be above average.” Why is that? O’Shaughnessy astutely notes that it’s largely about valuation — stocks get overvalued after good decades, and undervalued after bad decades – and disciplined investors who are willing to invest in stocks following bad decades, like the one we’ve recently had, can take advantage of that.

Using Raw Return Measurements to Analyze Stock Performance

In O’Shaughnessy’s updated version of What Works on Wall Street, he looked at how stocks that were in the top decile based on a number of valuation metrics fared from 1964 through 2009 and found that, when it comes to valuation, the price/sales ratio (PSR) was nolonger the best predictor of future performance as was the case in his original edition. Here are the average annual compound [raw, i.e. excluding the risk factor expanded upon below] returns for some of the more popular measures for the top decile based on:

(Enterprise value is equal to common equity at market value, plus debt, minority interest, and preferred equity at market value, and minus associate company at market value and all cash and cash equivalents. EBITDA is earnings before interest, taxes, depreciation, and amortization. Buyback yield is the change, percentage-wise, between the amount of shares outstanding now and a year ago. Shareholder yield is buyback yield plus dividend yield.)

Using the Sortino Ratio Measurements to Analyze Stock Performance

Of course, raw returns aren’t everything; risk is also a big factor to consider, so O’Shaughnessy looked at factors like standard deviation of returns, biggest annual declines, percentage of years in which returns were positive, and consistency of returns. One measure that takes into account both risk and return is the Sortino ratio. Here’s a look at how the various valuation metrics [for the top decile] stacked up…[based on the Sortino ratio]:

• Enterprise Value/EBITDA –0.50
• Shareholder Yield –0.47
• Price/earnings –0.46
• Price/operating cash flow –0.45
• Buyback Yield –0.44
• Dividend Yield –0.31
• Price/book value –0.30
• PSR –0.29

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Combination of Raw Return/Sortino Ratio Measurement is Best Way

So, which valuation does O’Shaughnessy recommend? None, in a manner of speaking. As the data above shows, the higher-returning strategies aren’t always the best when you factor in risk. On top of that, different approaches fare better in different environments. [the aforementioned being the case,] O’Shaughnessy… [analyzed] how stocks that had the best composite valuation fared based on a number of metrics [and] found that combining value metrics could produce even better results. [He found that] an approach that incorporated the:

• price/book,
• price/earnings,
• price/sales,
• EBITDA/EV, and
• price/cash flow ratios as well as
• buyback yield

was a top performer… To do this, he ranked all stocks by percentile in each of those categories, with those with the worst of a particular ratio (say, the PSR) getting 1, and those with the best getting 100. Then he simply added up the six scores, and split the results into deciles. He found that stocks in the top decile based on those six factors historically averaged a compound annual return of 17.30%, with a Sortino ratio of 57 — much better than any of the individual metrics.

Key Tenets

Finally, O’Shaughnessy also lays out some of his broader investing advice in the updated version of his book. Here are some of his keys to success:

1. Always Use Strategies: “You’ll get nowhere buying stocks just because they have a great story,” O’Shaughnessy writes. These stocks usually come with huge price tags, and usually go down in flames. “You must avoid them,” he says. “Always think in terms of overall strategies and not individual stocks.”
2. Ignore the Short Term: “When you look only at how your investment portfolio has performed for the last quarter, year, and three- and five-year period, you are looking at a tiny snapshot of time,” he writes, saying that that snapshot can be very misleading. He recommends focusing on rolling returns vs. a benchmark over time.
3. Use Only Strategies Proven Over The Long Term: O’Shaughnessy says to make sure you use an approach that has proven its worth over several different market environments. Short-term performance, or even the fact that a strategy might make intuitive sense, are no match for a long-term track record. “Stocks change. Industries change,” he says. “But the underlying reasons certain stocks are good investments remain the same. Only the fullness of time reveals which are the most sound.”
4. Invest Consistently: “If you use even a mediocre strategy consistently, you’ll beat almost all investors who jump in and out of the market, change tactics in midstream, and forever second-guess their decisions,” O’Shaughnessy writes.
5. Always Bet With The Base Rate: “Base rates are essentially the odds of beating the market over the time period you plan to invest,” O’Shaughnessy says. “If you pay attention to the odds, you can put them on your side.”
6. Never Use The Riskiest Strategies: O’Shaughnessy says to always focus on strategies with the highest risk-adjusted returns.
7. Always Use More Than One Strategy: O’Shaughnessy says that combining strategies that focus on different types of stocks (i.e., growth, value, large-cap, small-cap, geographic regions) can allow you to do much better than the broader market while not taking on more risk.
8. Use Multifactor Models: “You should always make a stock pass several hurdles before investing in it,” O’Shaughnessy says.

*http://theguruinvestor.com/2011/11/25/new-data-on-what-works-on-wall-street/

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