Active Approaches From “What Works on Wall Street”
In his book “What Works on Wall Street” (2012), James P. O’Shaughnessy examines, singly and in various combinations, those stock characteristics that have seemed to predict exceptional (above-market) returns. The following is a list of those characteristics he has tested in simulations through the years that seem to be the best.
First, note these aspects of O’Shaughnessy’s research that influence his results:
- The research is mostly based on stock prices from January 1, 1964 to December 31, 2009. While the results are still relevant because they include the two major pullbacks since the great depression (1972 and 2008), his book does not include any of the approaches that have appeared in the financial literature over the last four years.
- The cut-off for company size for most of the testing was set at a market capitalization of $200 million. While this is appropriate for O’Shaughnessy’s main audience of institutions, individual investors can easily invest in companies with market caps of $50 million or even less if actively traded. It is worth noting that the limited tests that he carries out on micro-cap (under $200 million) stocks provide the highest returns. The winning approaches that were not tested on micro-caps should do even better with micro-cap stocks.
- Characteristics that resulted in annualized returns of 16% or more are highlighted here partly because actual transaction costs are higher than O’Shaughnessy suggests and partly because if there are multiple ways to get exceptional (over 16%) returns, why bother with lesser returns.
- Not all combinations of individual criteria have been tested. In this and in areas of experimental design, O’Shaughnessy has used his judgment, but his reasoning appears sound. He looks at various size categories of stock. Micro caps are below $200 million in capitalization. His “All Stocks” group includes all other stocks, but is sometimes divided into small stocks and large stocks based on whether they are above or below the average market capitalization. None of the size categories provide 16% returns without other specific characteristics.
Criteria That Can Produce Exceptional Returns When Combined in Various Ways
- Cash flow (CF)
- Enterprise value (EV) = Market value + debt + minority interest + preferred stock at market – cash and equivalents.
- Earnings (E)
- Price (P)
- Sales (S)
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Momentum (MOM) = price change over a given period usually shown as a percentile ranking compared to other stocks
- Buyback yield (BBY) = increase in stock value due to share repurchases
- Shareholder yield (SY) = dividends plus buyback yield
Criteria Used in Various Simulations Individually or in Combination
The following single criteria can lead to significant (above 16%) returns by themselves in certain market-cap groups. Note that if you restrict yourself to only large-cap stocks, there is no factor or combination of factors that will provide exceptional yields.
The specific variations of all the criteria are not listed here. For that, you should read O’Shaughnessy’s book. For example, momentum is included, but there are many ways to use it.
- Momentum (MOM) combined with micro-cap stocks
- Ratio of EBITDA to enterprise value (EV) combined with small stocks or all stocks
- Ratio of cash flow to enterprise value (CF/EV) combined with small stocks
- Price-earnings ratio (P/E) combined with small stocks
- Ratio of sales to enterprise value (S/EV) combined with small stocks
- Ratio of price to cash flow (P/CF) combined with small stocks or all stocks
Special Combinations Suggested by O’Shaughnessy
Value Composite 1 (VC1):
- price-to-book value ratio (P/B)
- price-earnings ratio (P/E)
- price-to-sales ratio (P/S)
- ratio of EBITDA to enterprise value (EV)
- price-to-cash-flow ratio (P/CF)
Value Composite 2 (VC2)
- Value Composite 1 (VC1) + shareholder yield (SY)
Value Composite 3 (VC3)
- Value Composite 1 (VC1) + buyback yield (BBY)
Of the 77 combinations providing returns of 16% or more, almost all (except for the five exceptions above) combine momentum with various combinations of the other characteristics listed above. The range of returns for these simulations runs from 16% to 22%. Many of them involve only slight variations.
Source: “What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time,” James P. O’Shaughnessy, 4th edition (McGraw-Hill, 2012).
