Blending Growth And Value With The O’Shaughnessy Approach

Every other issue of the Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the James O’Shaughnessy-inspired strategy, which has averaged annual returns of 9.8% since its July 2003 inception vs. 6.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the O’Shaughnessy-based investment strategy.

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Hot List: What The Value “Redundancy” Means For Investors

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John looks at new data from renowned researchers Kenneth French and Eugene Fama, and the implications that the data has for value investors.

Excerpted from the May 9, 2014 issue of the Validea Hot List newsletter

Re-evaluating Value

Over the long-term, small-cap value stocks have well outperformed larger growth stocks. For decades, that notion has been a pretty widely known one in the investing world, thanks in large part to the research of highly regarded finance professors Kenneth French and Eugene Fama. Fama and French’s research found, for example, that from 1927-2009, small value stocks beat large growth stocks by an average of more than five percentage points annually. In addition, large value stocks beat large growth stocks and small growth stocks by about two percentage points each annually.

That data would seem to indicate that simply buying stocks with low price/book ratios — the metric Fama and French used to assess value — should be a good investment strategy. And many analysts have supported the idea of such a strategy by contending that the market must reward investors who buy value stocks (which are often in some kind of distress) for taking on additional risk — that, at least, is what efficient market hypothesis supporters usually say.

But new data — from none other than Fama and French themselves — seems to turn that notion on its head. In a working paper that was released last year, Fama and French analyzed historical stock returns again, this time adding in two new factors: profitability and investment intensity (the level of capital investment a company makes). While the paper didn’t get a whole lot of attention, one of its initial findings appears to be quite significant: The profitability and investment factors made redundant the value factor. “In other words, value stocks — defined as those with low price/book — only beat growth stocks because they historically tended to be more profitable and less voracious users of capital,” wrote Morningstar’s Samuel Lee in a recent piece discussing Fama and French’s new paper.

The redundancy of the value factor might seem to be contrary to what many of the value-focused gurus I follow preach. In reality, the takeaways from French and Fama’s new data fit quite well in a several key ways with the gurus’ teachings, and I think they are well worth touching on.

First, it’s important to note that the value gauge French and Fama use is the price/book ratio, which is not one of the more used gauges by the gurus. In fact, in a research report earlier this year, James O’Shaughnessy’s firm wrote that “Despite its popularity, we do not use price-to-book in [the] OSAM Value [composite] because of several problems with the factor.” The price/book ratio “consistently has one of the lowest annualized returns of all value factors,” O’Shaughnessy Asset Management said in the paper. “Also, in half of the time periods shown, price-to-book underperforms the market.” While that particular paper was looking at the Canadian stock market, OSAM said the issue was not isolated to Canada. “In the U.S., price-to-book has been a very inconsistent value ratio with prolonged periods of underperformance,” the group said. “From 1927 to 1963 the cheapest ten percent of stocks by price-to-book underperformed the U.S. market by an annualized 205 bps; and over the next 36 years by more than 200 bps.” O’Shaughnessy, for the record, initially found the price/sales ratio to be the best value factor — that’s what I use in my O’Shaughnessy-based growth model, which has been one of my better performers over the long haul. (Today O’Shaughnessy actually uses a “value composite” that includes several value gauges, similar, in effect, to what the Hot List does.)

What I find interesting about OSAM’s work in relation to Fama and French’s work is that in almost all cases, the gurus upon whom I base my strategies used valuation metrics that focused on earnings, sales, or cash flow — in other words, the concept of profitability was at work within the value metrics. The price/book ratio, in contrast, is based on the value of the company’s assets, not its ability to generate profits — and Wall Street is less concerned with what a company already is than with what it could grow into in the future. It’s also worth noting that of the three guru-inspired models I run that do use the price/book ratio, two of them (the David Dreman and Benjamin Graham approaches) use other value metrics (the price/earnings, price/cash flow and price/dividend ratios for Dreman, and the P/E for Graham) as well. The one strategy that uses price/book (actually its inverse, the book/market ratio) as its sole valuation gauge — the Joseph Piotroski-based approach — includes among its other variables the return on assets rate and gross profit margin, both of which get at a firm’s profitability, as well as cash flow from operations, which is designed to eliminate firms that are burning through cash. Those three variables jive quite well with the profitability and investment factors that French and Fama added to their analysis in their paper.

Then there’s Warren Buffett. Of all of the guru-inspired strategies I use, the Buffett-based approach probably has the least stringent valuation measure — it simply requires that the company’s earnings yield be higher than the yield on long-term treasury bonds. It focuses a great deal on earnings persistence, return on equity, return on retained earnings, and return on capital — profitability. In addition, it looks for companies that have good free cash flows, the idea being that that will weed out firms that require a high amount of capital investment. High profitability, low investment requirements — that’s exactly what French and Fama’s study found made the value factor redundant.

So what does all this mean? Does it mean that value no longer matters? Most definitely not, in my opinion. Price is always important when you are buying anything, stocks included. As O’Shaughnessy’s research has shown, a number of non-price/book ratio valuation metrics have been great ways to identify winning stocks throughout history (metrics like the Price/sales and price/earnings ratios).

Just as importantly, I think French and Fama’s new research highlights the importance of using a well-rounded strategy that looks at a company and its shares from a number of different angles. Profitability, balance sheet, valuation — you should consider all of those factors when analyzing a stock. As Kenneth Fisher, another of the gurus I follow, wrote, “Never assume you have found the one silver bullet.” My Guru Strategies do not look for a silver bullet. Most of the strategies use between seven and 10 different variables; the Motley Fool-based approach uses no fewer than 17. And those are just individual models. With a consensus approach like the Hot List, which gets input from all 12 of my models, you’re talking about putting a stock through dozens and dozens of financial and fundamental tests. Those that make the grade are thus some of the most fundamentally sound stocks in the market, showing strength across a number of different levels. Take Hot List newcomer NetEase, which is being added to the portfolio today. The $9-billion-market-cap tech firm has grown earnings at a 24% pace over the long term, and much more rapidly in the most recent quarter. It has no long-term debt and a 5.4 current ratio, indicating a very strong balance sheet, and it has been extremely profitable, averaging a 10-year return on equity north of 28% and a return on retained earnings over that period of more than 20%. All of that, and it trades for about 12 times earnings and has a free cash flow yield of close to 8%.

Of course that’s no guarantee that the stock will be a huge winner for the portfolio. But over the long term, stocks with those kind of well-rounded fundamentals and financials tend to perform quite well. By investing in baskets of stocks like those, we stack the odds greatly in our favor over the long haul. The proof is in the pudding — the Hot List’s stellar long-term track record is in large part due to its deep, thorough fundamental analysis of companies and their shares. Moving forward, I’m confident that this approach will continue to pay off with returns well ahead of the market average.

O’Shaughnessy on Bond Market Risk, And Stock Strategy

After its huge run-up over the past 5 years, does the stock market still have good times ahead? Quantitative investing guru James O’Shaughnessy thinks so.

In an interview with Canada’s Globe and Mail, O’Shaughnessy says that back in 2009 his firm looked at how the market would have to do in the next decade just to match its worst 20-year return ever. “If memory serves me, it was 6% average annual gain after inflation,” he says.  “If we look back in 2019, I’m not saying that stocks will be giving huge double-digit returns, but I do think they will end up being one of the best-performing asset classes.”

O’Shaughnessy says the big risk investors face right now is “extrapolating the bond market’s fantastic performance since 1981 into the future. We think long-term bonds will be going into a multidecade bear market, and we’re urging investors to invest only in short-term bonds.” He adds, “I’m not saying don’t buy bonds; I’m saying be careful which bonds you buy.”

O’Shaughnessy also talks about what valuation metric he prefers, and offers some general investment advice. “Establish an asset allocation and then rebalance it when it gets 15% out of whack,” he says. “Really, if investors could just do that, they could substantially improve their overall performance.”

Validea’s James O’Shaughnessy-inspired portfolio is up 9.8% annualized since its mid-2003 inception vs. less than 6% for the S&P 500. Check out its holdings here.

Consider Making Staples A Staple Of Your Portfolio

Consumer staples have been struggling recently, but Validea CEO John Reese says that’s no reason for long term investors to avoid them.

“In his most recent edition of What Works on Wall Street, quantitative investing guru James O’Shaughnessy examined decades worth of historical data and found that, over the long term, the best performing sector of the market has been consumer staples,” writes Reese. “From 1968 through 2009, O’Shaughnessy found that staples stocks averaged compound annual returns of 13.6%, beating the next-best sector (financials) by 1.2 percentage points per year. And, staples had the second-lowest standard deviation out of the market’s 10 sectors.”

Reese talks about why staples have such a strong track record, and says his Guru Strategies are finding a number of attractive staples stocks. He examines a handful, including Budweiser parent Anheuser-Busch InBev.

OSAM on the Efficient Market Myth

While many believe that equity markets — particularly large-cap equity markets — are efficient, quantitative investing guru James O’Shaughnessy’s firm says the data shows otherwise.

“Our research shows that, with the right strategy and the right discipline, the U.S. large cap market remains very inefficient and — by selecting stocks using historically proven themes — investors can outperform it by significant margins,” writes Patrick O’Shaughnessy in a new research report from O’Shaughnessy Asset Management. In the report, entitled “The Myth of the Most Efficient Market”, O’Shaughnessy discusses how more and more investors are turning to index funds for the large-cap portion of their portfolios, since the vast majority of large-cap fund managers fail to be the market. But, he says, passive indexing approaches have a key weakness: “The stock selection and weighting criteria for the index are based on one factor: market cap.”

O’Shaughnessy talks about “proven factors” that OSAM has used to beat the market, like value and shareholder yield (dividend yield plus buyback yield). On top of those, OSAM overlays a “quality” test. “To replace market cap in the selection and weighting process, we’ve isolated the stock selection themes that are the most predictive of strong future excess return among U.S.-listed large cap stocks,” O’Shaughnessy writes. “Our research shows that we should favor companies with attractive valuations and strong shareholder yields and avoid companies with highly bloated and unsustainable balance sheets, poor earnings quality, and poor recent earnings growth trends. Each of these five themes can be measured objectively using data from financial statements and applied with the same discipline that characterizes the passive index investment process.”

The results, he says, have been stellar and show that the large cap market is not efficient. A live portfolio built with the above characteristics that was created in late 2001 has outperformed the Russell 1000 Value Index by an average of 5.5 percentage points per year, beating the benchmark in 96% of three-year periods. The same strategy beat the Russell 1000 Value by 5.0 percentage points annually and had a 95% three-year base rate when back tested from 1963 through 2012.

O’Shaughnessy also says that the current environment offers a particularly good opportunity for investors who focus on shareholder yield rather than dividend yield. With interest rates so low, high dividend yield stocks are trading at an 11% premium to the broader market as investors reach for income, he says. But high shareholder yield stocks trade at a 20% discount to the broader market. He also offers some intriguing data showing how high dividend stocks tend to perform in rising interest rate environments compared to high shareholder yield stocks. Bottom line: “We believe investors who index their large cap investments should instead consider an allocation to proven active strategies,” O’Shaughnessy says.

Beating the Market with Growth … and Value

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the James O’Shaughnessy-inspired strategy, which has averaged annual returns of 9.8% since its July 2003 inception vs. 5.3% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the O’Shaughnessy-based investment strategy.

Taken from the September 13, 2013 issue of The Validea Hot List

Guru Spotlight: James O’Shaughnessy

To say that James O’Shaughnessy has written the book on quantitative investing strategies might be an exaggeration — but not much of one. Over the years, O’Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor’s Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.

In addition to finding out how certain strategies had performed in terms of returns over the long term, O’Shaughnessy’s study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns — what he called his “United Cornerstone” strategy.

The United Cornerstone approach, the basis for my O’Shaughnessy-based Guru Strategy, is actually a combination of two separate models that O’Shaughnessy tested, one growth-focused and one value-focused. His growth method — “Cornerstone Growth” — produced better returns than his “Cornerstone Value” approach, and was a little more risky. The Cornerstone Value strategy, meanwhile, produced returns that were a bit lower, but with less volatility. Together, they formed an exceptional one-two punch, averaging a compound return of 17.1 percent from 1954 through 1996, easily beating the S&P 500s 11.5 percent compound return during that time while maintaining relatively low levels of risk.

That 5.6 percent spread is enormous when compounded over 42 years: If you’d invested $10,000 using the United Cornerstone approach on the first day of the period covered by O’Shaughnessy’s study, you’d have had almost $7.6 million by the end of 1996 — more than $6.6 million more than you’d have ended up with if you’d invested $10,000 in the S&P for the same period! That seems powerful evidence that stock prices do not — as efficient market believers suggest — move in a “random walk,” but instead, as O’Shaughnessy writes, with a “purposeful stride.”


O’Shaughnessy has revamped his strategies over the years, most recently in his new, updated version of What Works on Wall Street (which I reviewed in the Nov. 25, 2011 edition of the Hot List). I’ve chosen not to tinker with my O’Shaughnessy-based models, however, given the exceptional performance they’ve had over the long term. The models discussed here are thus based on O’Shaughnessy’s 1996 version of What Works on Wall Street.

So, let’s start with the value stock strategy. O’Shaughnessy’s Cornerstone Value approach targeted “market leaders” — large, well-known firms with sales well above those of the average company — because he found that these firms’ stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch — should hold some value stocks.

To find these firms, O’Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean.

Size and market position weren’t enough to make a value stock attractive for O’Shaughnessy, however. Another key factor that was a great predictor of a stock’s future, he found, was cash flow. My O’Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average.

O’Shaughnessy found that, when it came to market leaders, another criterion was even more important than cash flow: dividend yield. He found that high dividend yields were an excellent predictor of success for large, well-known stocks (though not for smaller stocks); large market-leaders with high dividends tended to outperform during bull markets, and didn’t fall as far as other stocks during bear markets. The Cornerstone Value model takes all of the stocks that pass the four aforementioned criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval.

The Cornerstone Growth approach, meanwhile, isn’t strictly a growth approach. That’s because one of the interesting things O’Shaughnessy found in his back-testing was that all of the successful strategies he studied — even growth approaches — included at least one value-based criterion. The value component of his Cornerstone Growth strategy was the price/sales ratio, a variable that O’Shaughnessy found — much to the surprise of Wall Street — was the single best indication of a stock’s value, and predictor of its future.

The Cornerstone Growth model allows for smaller stocks, using a market cap minimum of $150 million, and requires stocks to have price/sales ratios below 1.5. To avoid outright dogs, the strategy also looks at a company’s last five years of earnings, requiring that its earnings per share have increased each year since the first year of that period.

The final criterion of this approach is relative strength, the measure of how a stock has performed compared to all other stocks over the past year. A key part of why the growth stock model works so well, according to O’Shaughnessy, is the combination of high relative strengths and low P/S ratios. By targeting stocks with high relative strengths, you’re looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio, you’re ensuring that you’re not getting in too late on these popular stocks, after they’ve become too expensive. “This strategy will never buy a Netscape or Genentech or Polaroid at 165 times earnings,” O’Shaughnessy wrote, referring to some of history’s well-known momentum-driven, overpriced stocks. “It forces you to buy stocks just when the market realizes the companies have been overlooked.”

To apply the RS criterion, the Cornerstone Growth model takes all the stocks that pass the three growth criteria I mentioned (market cap, earnings persistence, P/S ratio) and ranks them by RS. The top 50 stocks then get final approval.

The Growth/Value Investor model I base on O’Shaughnessy’s two-pronged approach has been a one of my best performers since its inception back in 2003, with my 10-stock O’Shaughnessy-based portfolio gaining 157.7 % (9.8% annualized) since inception, while the S&P 500 has gained just 68.3% (5.3% annualized; figures through Sept. 10).

The O’Shaughnessy-based portfolio will pick stocks using both the growth and value methods I described above. It picks whatever the best-rated stocks are at the time, regardless of growth/value distinction, meaning the portions of the portfolio made up of growth and value stocks can vary over time. After leaning strongly to the growth side, the portfolio has shifted back toward a more even balance over the past year or so. Currently six of the ten holdings are growth picks. Here’s a look at the portfolio’s holdings:

TEO — Telecom Argentina (Growth)

LEA — Lear Corporation (Growth)

SNP — China Petroleum & Chemical Corp. (Value)

AFSI — Amtrust Financial Services Inc. (Growth)

RDS.A — Royal Dutch Shell (Value)

CVX — Chevron Corp. (Value)

SIG — Signet Jewelers (Growth)

NOC — Northrop Grumman Corporation (Growth)

JPM — JPMorgan Chase & Co. (Value)

RUE — Rue21 Inc. (Growth)


Not Just Numbers

O’Shaughnessy is a pure quant, but you should be aware that some of his most critical lessons are less about specific criteria and numbers than they are about the general mindset an investor must have. Perhaps more than anything else, O’Shaughnessy believes in picking a good strategy and sticking with it — no matter what. In What Works on Wall Street, he writes that in order to beat the market, it is crucial that you stay disciplined: “[C]onsistently, patiently, and slavishly stick with a strategy, even when it’s performing poorly relative to other methods.”

The reason involved human emotions, which cause many investors to bail on a good approach and jump onto hot stocks or strategies that are often overhyped and overpriced. “We are a bundle of inconsistencies,” he writes, “and while that may make us interesting, it plays havoc with our ability to invest our money successfully. Disciplined implementation of active strategies is the key to performance.” Wise words, whether you follow O’Shaughnessy’s approach or another proven method.