This post is also available in: Dansk

Abstract

• The author underscores the importance of having a strategy (e.g. acquiring low /PE, dividend payers or momentum stocks) rather than selective stock picking, since “the human decision making process is systematically defect and unreliable.”
• The best-performing single-factor strategy (selection of stocks based on one screening criteria, e.g. low P/E), is focusing on low P/S stocks. A perfectly executed low P/S strategy would have transformed $10,000 into $22 mio. between 1951-2003.
• The best-performing multi-factor strategy, which would have transformed $10,000 into $60,5 mio. from 1963-2003, consists of the following components: 1) market value between $25-$250 mio., 2) P/S below 1, 3) highest relative strength.
• Beware of spicing of your portfolio with a story stock. James explains it as such: “Value criteria act like a chaperone at a party making sure you don’t fall for some sexy stock with a great story.” He continues by saying that yes, sticking to value picks may keep you from having some short-sighted fun, but sticking to value keeps you out of trouble  by ensuring you don’t overpay for a stock. Finally, he explains that story stocks’ prices are based on hope, greed and fantasies about the future which are rarely realized.

If you have a fetisch for backtesting, numbers, diagrams, graphs, quintile analyses and the like, then What Works on Wall Street can most likely be compared to a Playboy collection in your view. The author, James P. O’Shaugnessy, presents an array of different investment strategies’ results in the period 1951-2003, e.g. acquiring portfolios of high vs. low P/E, P/BV, P/CF and P/D stocks. James’ tests suppose that one acquirers a group of stocks in 1951 based on the given criteria, which are then rebalanced annually to ensure that next year’s portfolio once again consists of the e.g. lowest P/E stocks. That is basically the book’s theme, and what insights it gives!

The importance of a strategy rather than stock-picking
Before I dive into the different investment strategies’ results, it should be highlighted that strategy is key here. In chapter 1, James emphasizes that selection of stocks based on gut feeling, and even analysis, doesn’t work. He proclaims that “the human decision making process is systematically defect and unreliable. This creates opportunities for those who can apply a rational and disciplined method for buying and selling stocks.” (s. 4)

James underscores the importance of sticking to a strategy and consistently executing it, even when – well, especially if – it underperforms the market for a few years. You should in these situations seek comfort in the fact that you have (obviously!) investigated the historical performance of the given strategy, which is why you know it’ll probably outperform the market in the long run.

Single-factor strategies
James ranks all the different strategies alongside what he dubs the ‘All stocks’ universe. This universe covers all stocks in the S&P index with an inflation adjusted market value above $185 mio. Had you invested $10,000 in the ‘All stocks’ universe in 1951 and hold-on till 2003, you would have had $5,743,706. James applies this benchmark to determine which single-factor strategies underperformed the market, and which outperformed, cf. below list:

• $3.063.447: Portfolio of high ROE stocks.
• $3.129.572: Portfolio of high profit margin stocks.
• $3.173.724: Portfolio of large cap stocks.
• $4.814.164: Portfolio of the 50 ‘relatively strongest’ stocks (those which have experienced the highest price gains during the past 12 months).
• $6.752.640: Portfolio of the 50 highest paying dividend (P/D) stocks.
• $8.189.182: Portfolio of the 50 lowest P/E stocks.
• $17.724.382: Portfolio of the 50 lowest P/CF stocks.
• $22.004.691: Portfolio of the 50 lowest P/BV stocks.
• $22.012.919: Portfolio of the 50 lowest P/S stocks.

James calls the low price-to-sales (P/S) “the king of value factors”. Despite of price-to-book’s results matching that of the low P/S strategy, the latter achieves it with far less volatility, or risk as James regards it.

Multi-factor strategies
If transforming $10,000 into $22 mio. can’t make your boat float, you can find salvation by adding more factors to your strategy. If you e.g. combine relative strength with a P/E less than 20, you could triumphantly brag about having brought in 10 times as much as the ‘All stocks’ universe, namely $51,591,744. Not too shabby for rebalancing your portfolio once a year, right? But greed is one of your vices, so you would happily endure higher volatility for a couple of more millions on your savings account. Had you for instance combined relative strength with a P/BV below 1, you would have had $63,253,200 in 2003.

There is thus no doubt that multifactor strategies drastically outcompete single-factor strategies. Generally, the best results are achieved by combining relative strength with any price-to-fundamental, but mixing multiple fundamental factors surely increases your chances of an exceptional return as well.

Know yourself and restrain your greed
In chapter 23, James ranks all strategies based on return. He recommends you do not simply base your strategy on this basis. You need to do some soul searching in order to evaluate whether or not you can endure the volatility that goes hand-in-hand with a given strategy’s return. For instance, if you know that you can’t bear witnessing your portfolio loose 86% of its value, you should not go with a concentrated 10 stock portfolio strategy with these components: 1) 6-months relative strength, 2) small cap ($25-$250 mio.), 3) P/S below 1. Though the strategy experienced a huge pullback, it was the fourth most profitable strategy, bringing in $21.7 mio. between 1963-2003 (note that the timeframe is 12 years shorter than aforementioned period). James’ message is crystal clear: Pick a strategy with a level of a volatility that you can endure.

Another important point James continuously cements: Stick to the strategy! It can be very tempting to spice up your portfolio with a ‘story stock’; a company that the media has praised excessively, which has ignited a buying frenzy that makes P/E ratios and other price-to-fundamental metrics go through the roof. James explains it as such: “Value criteria act like a chaperone at a party making sure you don’t fall for some sexy stock with a great story.” (s. 356) He continues by saying that yes, sticking to value picks may keep you from having some short-sighted fun, but sticking to a value investing mindset keeps you out of trouble by ensuring you don’t overpay for a stock. Finally, he explains that story stocks’ prices are based on hope, greed and fantasies about the future which are rarely realized.

And the winner is..
Which strategy is the absolute high jumper? In the four decades between 1963-2003, you would have cashed in $60,580,240 on a $10,000 investment if you had constructed a 25 stock portfolio with these components: 1) market cap between $25-$250 mio., 2) a P/S below 1, and 3) highest relative strength. The other strategies’ results in terms of return and volatility can be found on p. 338.

I’m not naïve. I’m aware that I can’t just go shopping in a small-cap index by choosing stocks with a P/S below 1 that have had large price increases, and then acquire three miles of shoreline at the Hamptons by the time I retire. These backtests illustrate the investment returns of mechanically, perfectly executed strategies without interference of emotions and the need to change one’s strategy for decades. My primary take-away is rather that one should focus on multi-factor strategies. In addition, I’ve gained an appreciation for relative strength – a component that I haven’t given any credit previously.

The book can at times feel a bit monotonous. It follows the same structure throughout all chapters, and you quickly become lightheaded from all the tabels, numbers and visualizations. But take a deep breath, and have at it; the insights are extremely insightful. There are some tips on how to maintain a rational value investing mindset, too. All in all, a great and enlightening book!

This post is also available in: Dansk