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What Works On Wall Street : A Guide To The Best-Performing Investment Strategies of All Time
by James P. O'Shaughnessy
What Works On Wall Street is one of my favorite investment books. Previously, I had read Invest Like The Best, also by James P. O'Shaughnessy, and I wasn't overly impressed. Invest Like The Best made it sound as if all you needed was Value Screen, or some other online stock-screening software, and you would easily match and equal the best money managers, regardless of their investment strategy. This could be done because their portfolios always held certain types of stocks, such as high 5-year's earning growth rate stocks.
Now obviously, great investors, like Peter Lynch, have portfolios that consist of different types of stocks, such as growth stocks and some value plays. So, such a strategy seemed at best naive. Worse, O'Shaughnessy made it sound like achieving 20% or great returns was child's play. My only conclusion was that O'Shaughnessy was a child of the great bull market of the later 1980's and 1990's and that he had little real knowledge to offer investors. Invest Like The Best seemed like a book that would mislead the new investor.
So, I wasn't too impressed when I heard O'Shaughnessy had a new investing book out, What Works On Wall Street. I almost didn't read it, but heard good mentions of it from people whose investment experience I respected, so I decided to give the book a look. I'm glad I did!
What Works On Wall Street firmly establishes O'Shaughnessy as a premier researcher in the investment field. Using Standard & Poor's Compustat database, O'Shaughessy put together 50-stock portfolios of certain kinds of stocks (for example, the 50 lowest Price-to-sales ratio stocks, the highest Price-to-sales ratio stocks, etc.). He examined all the measures that most investors rely upon, including PSR's, P/E's, Price-to-cash-flow, Price-to-Book, etc.
The results showed that "value does will out." The strongest and best indicator of solid appreciation stocks were low PSR's (Price-to-Sales Ratios) which were pioneered by Ken Fisher in Super Stocks. Low PSR stocks sell for low multiples of their sales revenue. Next up in usefulness were the more complicated Price-to-cash-flow and price-to-book ratios. Again buying value based upon those criteria proved a winning strategy. Further, buying the high-priced stocks under any of these criteria lead to below average market returns. In other words, don't pay too much for your investments.
The portfolios were rebalanced annually. It was not surprising that overvalued stocks were punished in the long-run, or that stocks bought at value appreciated well, but what was shocking was the extent to which low PSR stocks blew away low P/E stocks. In other words, seeking value based upon low PSR was far more productive.
Exactly why this is still needs to be determined. Low PSR stocks should not only point to unpopular stocks, but also have a bias toward low-profit margin businesses, which is a stunning result. No compensation was made for the difference in average profit margins for different industries. So it is possible that low PSR served as a surrogate for some other factor, maybe turnaround companies, or stocks in trouble.
O'Shaughnessy then goes on to discuss relative strength stocks and growth-momentum measures. He shows how portfolios selected on multiple criteria can outperform portfolios selected on only a single criteria (such as low PSR). Given the annual rebalancing of the test portfolios, maybe having a strong relative strength stock makes sense and it certainly improved the results. But, one question remains: How do individual investors benefit from this knowledge?
One possibility would be to hold 50-stock portfolios and do as O'Shaughnessy recommends. However, many investors will not want to hold 50 stocks, nor rebalance their portfolios annually. For investors who buy-and-hold only a few select stocks, adopting O'Shaughessy's methods would demand a major change in thinking.
What Works On Wall Street also makes clear that criteria have different significance for different market capitalization stocks. In particular, small stocks and big stocks are not the same. Or, as many value investors already know, value is best applied to larger more established companies.
I have only touched upon a few of the findings of What Works On Wall Street.
Overall, however, going from being unimpressed with his first book,
to rethinking my own investment methods, I must say What Works On Wall Street earns my highest recommendation.