I recently finished a book entitled “What Works on Wall Street” by James P. O’Shaughnessy. In this book O’Shaughnessy explains the power of passive investing. In fact, O’Shaughnessy goes over several methods of passive investing which lower risk while increasing return, thus highlighting the fact that greater returns don’t always come with higher risk. O’Shaughnessy also shows the reciprocal, that greater risk does not always translate into greater return. In this post I will highlight one of his lower risk methods as well as show you another method which translated into extraordinary gains, albeit with added risk.
The least risky strategy O’Shaughnessy covers is one he dubs “Cornerstone Value.” In this strategy O’Shaughnessy uses Compuset PC Plus, Research Insight, and FactSet Alpha to screen and test stocks. He screens stocks for ones he calls “Market Leaders.” These stocks are non- utility stocks with greater than average market caps, shares outstanding, cashflows, and sales of 50 percent greater than the average stock (this includes ADRs). He then uses $10,000 to buy the top 50 in terms of shareholder yield. He defines shareholder yield as stocks with the highest dividend yield and net buyback activity. O’Shaughnessy would then recycle this strategy every year, buying again the top 50 in terms of shareholder yield.
Over time he found that this strategy would have turned $10,000 into $17,567,144 from Dec. 31 1952 to Dec. 31 2003, versus $2,447,210 for the S&P 500. The amazing part about it was that these results were obtained with less risk using his approach. While the S&P 500 had a Sharpe ratio (reward-to-variability) of 0.42, Cornerstone Value had a Sharpe ratio of 0.65. The minimum and maximum annual return for the S&P 500 was -26.47% and 55.62%, respectively. However, the minimum and maximum for the Cornerstone Value approach was -15.00% and 58.20%. This strategy had 42 positive and 9 negative periods, versus 38 and 13 for the S&P 500. Also, maximum Peak- to-Trough decline was -28.18% for Cornerstone Value versus -44.73% for the S&P 500. Beta was 0.86 for Cornerstone Value and 1.00 for the S&P 500. By now you get a sense of how little risk this strategy carries with it.
Perhaps one of the best strategies O’Shaughnessy shows is one that is extremely simple. Buy 50 stocks with the highest relative strength trading at a price-to- sales ratio less than 1, hold for a year, then recycle. This strategy was able to turn $10,000 into $55,002,724. It had a higher maximum Peak-to-Trough decline of -53.40% versus -50.12% for all stocks during that time period. However, the Sharpe ratio fared better at 0.60 versus 0.46 for all stocks. Beta was 1.08 versus 0.99 for all stocks. In single-year returns it beat all stocks 39/52, rolling five-year compound return 43/48, and rolling 10-year compound return 43/43 times.
Some of you may be wondering at this point why O’Shaughnessy tends to focus on relative strength. What O’Shaughnessy hypothesizes is that by focusing on relative strength investors are getting into a stock as the market is beginning to notice it. By focusing on a value metric like price- to- sales, for instance, investors are making sure they aren’t paying too much for the momentum. However, for some of you interested in the latter method O’Shaughnessy cautions that investors are extremely unlikely to stick to a volatile strategy over the long -haul. The method has a correlation with the S&P 500 of 0.75 and may zig when the market zags. Though, this strategy is more consistent than many of his other strategies and thus the reason I chose it for this writing. But please keep in mind, in order for a strategy to work one must use it through hell and high water, even if he thinks the strategy is failing him. It is this sort of unwavering discipline that separates the successful investor from the unsuccessful.
Additionally, O’Shaughnessy highlights that these strategies can be done holding less than 50 stocks. However, the minimum he recommends is 25. He believes, as mentioned in the above paragraph, that investors are likely to run away from this strategy at the first sign of trouble. The volatility increases tremendously and the correlation with the overall market tends to drop holding less stocks. In his mind investors are much more likely to stick with a strategy that doesn’t deviate from the market too much.
——Written by: The Poor Investor