When I began the research for what would eventually become the first edition of “What Works on Wall Street” in 1995, I sought to identify which individual factors delivered the best alpha (risk-adjusted performance) over time and did so with the greatest consistency (base rates).
What I have found is that there is no “best” factor, per se; rather, the strongest individual factors come in and out of favor. The price-to-sales ratio and EBITDA-to-enterprise-value ratio vie for top billing, but it depends on the time period under review. (EBITDA is earnings before interest, taxes, depreciation and amortization. Enterprise value is a combination of a company’s market capitalization, debt, minority interest and preferred stock at market value, less any investments in associated companies at market value and all cash and cash equivalents.)
Figure 1 illustrates the changing nature of individual factors over rolling 10-year periods. Look at how the free-cash-flow-to-enterprise-value ratio briefly added 4% more value than the value composite, but then took a nose dive.
This new research led to what can be considered the key new findings in the fourth edition of “What Works on Wall Street” (McGraw Hill, 2012): You get much better and more consistent results by using several factors together in a composite than you get using a single factor alone. Here I discuss our value composite first, then move on to others that look for financial strength and earnings quality. What’s more, by combining these three factors you greatly improve your chances of finding high quality, financially strong companies that offer excellent value. Let’s start with a look at O’Shaughnessy Asset Management’s (OSAM) value composite.
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