A first remark: I haven’t read the previous editions and I am a maybe biased active value investor 😉
For many years, O’Shaughnessy’s book “What works on Wall Street” has been the Bible of many quantitative value investors who wanted to avoid analysing single companies and prefer an automated startegy to select stocks.
The book starts with some chapters loosely summarizing current behavioural finance knowledge which implies that human selection is inferior to automated systems.
For the large quatitative part of the book which follows, he seems to have used a new data set on US equities which wasn’t available before which is going back to 1926. He clearly lays out the methodology, with the major features being
– avoiding illiquid small caps
– equal weighting of stocks in the portfolio (we’ll come to that one later !!!)
– reinvesting dividends
– enhanced rebalancing (not only on July 1st per year but the average of 12 annually rebalanced portfolios starting each month of the year)
– no transaction costs assumed
He then uses his data to run many different strategies. Some of the most interesting results for me were:
– small caps outperform large caps and indices pretty consistently by 1-2% p.a.
– low P/E stocks (cheapest decile) outperform by almost 5% p.a., interestingly with a lower beta
– low EV/EBITDA works even better as single factor model (5,5% p.a. out-performance)
– low Price/Cash Flow works, but “only” around 3.5% p.a. out-performance. Price to free cashflow and Price to operating cashflow work slightly better but not as good as EV/EBITDA
– the “old favourite” price to sales does not really work well (only 1.5% p.a.)
– Price to book: DOES NOT WORK for the cheapest decile !!!!
– Dividend yield DOES NOT WORK
– however stock buy back yield works with ~3% p.a. excess return
– Stock buy back yield and dividend yield work better, 3.3% p.a.excess return
– certain accounting ratios work also well, such as low accruals (2.8%), Asset to Equity, asset turnover etc.
– composite accounting ratios (4 factors) work even better, close to 5% p.a.
– composite ratio with only the 25 best stocks scores even better (7% p.a. out performance)
– composite Value factor (P/B, P/E, P/S, EBITDA/EV, P/CF) with 5.8% p.a. out-performance
– Earnings changes, profit margins and ROE DO NOT WORK
– Price momentum (6 and 12 months) works, with 2-3% p.a.
– combining value and price momentum works best, some strategies yielding 10% p.a. excess returns or more
I don’t want to sound arrogant, but from earlier discussions I knew that O’S favoured the P/S ratio in the prior editions. I always thought that this doesn’t make any sense because then you end up with a portfolio of supermarket stocks and wholesale companies.
It is also not surprising that P/B doesn’t work if you don’t adjust for debt. So no wonder, EV/EBITDA does a much better job. But this is something many active value investors know without having to go through 90 years of data.
For any active investor it is also no surprise that it is better to look a various factors as single factors can always be influenced by certain special effects. So welcome to the club, Mr. O’S !!!
Maybe in his 5th edition, O’S then starts to look at the historical developments, who knows ?
For me, the relevance of price momentum is still difficult to really understand but I am willing to learn !!!!
Conceptual issue: Equal weighted performance
I have one big conceptual issue with the whole book: as described in the beginning, O’S just briefly notices that he uses equal weighted portfolios. He doesn’t test if this alone has an impact on the performance of the strategies.
Some recent papers indicate that equal weighted portfolios themselves create significant out-performance vs. market cap weighted indices.
So we do not know for sure, how much of the out-performance of O’S strategies is due to his equal weight assumption as he benchmarks against a market cap index and not against an equal weight index.
O’S book is of course a interesting read. Many of the newer combined strategies make intuitive more sense than some of the older strategies. He also correctly states that strategies work only long term and you have to avoid market timing at all costs !!!
Many investors will underestimate what it means to invest in a mechanical strategy which underperforms for 3 or more consecutive years.
Unfortunately, the conceptual issue with the equal weighted portfolio takes away a lot of my personal “trust” into those mechanical strategies.
For me the key take aways are:
1. Any more or less fully invested value startegy with some basic analysis will perform quite well against the general market
2. Also the most famous mechanical models can become outdated
3. DO NOT TRY TO TIME THE MARKET
4. Price momentum should not be ignored