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.

OSAM: How To Win In Emerging Markets

Emerging markets can make for enticing investments, and new research from James O’Shaughnessy’s firm shows how fundamental-focused investors can really take advantage of EM opportunities.

“U.S. investors, and other investors around the world, tend to overweight their home country in their equity portfolio,” write O’Shaughnessy Asset Management’s Patrick O’Shaughnessy and Ashvin Viswanathan in a report available on the firm’s website. “By doing so, they miss out on considerable investment opportunities abroad.” They say that emerging markets are compelling for three key reasons right now:

  • home bias, which has meant that many U.S. investors “have little to no direct allocation to emerging market equities”;
  • valuation (emerging markets trade at a 31% discount to U.S. stocks using the 10-year cyclically-adjusted price/earnings ratio);
  • “huge mispricings” that are the result of less attention among analysts and less scrutiny for EM firms’ financial statements

That last point makes EMs fertile ground for fundamental-focused investors, O’Shaughnessy and Viswanathan say. They looked at stocks in the U.S., other developed markets, and emerging markets from 1995-2012 to see how those that rated highest using OSAM’s fundamental stock-picking factors fared vs. market averages. They found that in the U.S., the top decile of stocks using a Momentum Composite outperformed the broader U.S. market by 3.3% annualized. Those in the top decile based on dividend yield outperformed by 1.3%, while those in the top decile based on OSAM’s Value Composite outperformed by 4.7%. In other developed markets, the outperformance was greater (6.8% for the high-momentum stocks; 8.7% for high-dividend stocks; and 9.2% for best-value stocks).

In EMs, the outperformance was all in all still greater. High-momentum stocks outperformed the broader EM market by 6.6%; high-dividend stocks did so by 10.6%; and best-value stocks did so by 11.9%. They found that within all the individual EM countries they examined, the outperformance also occurred.

“The important point is that while these factors work everywhere, they work best in what we would argue are the least efficient markets,” O’Shaughnessy and Viswanathan write. “We believe these factors are immune to socio-economic and political idiosyncrasies because they are driven by human nature. In every country, unloved stocks have been left priced too cheaply, allowing a valuation-based strategy to thrive.”

While EMs come with their own unique sets of risks and often have higher volatility than developed markets, OSAM concludes that investors would be wise to use a portion of their portfolios for fundamentally sound EM stocks.







Studies: It’s About Value, Not Quality

“High-quality stocks” sounds like something any investor would want to own. But in a recent column for Canada’s Globe and Mail, Norman Rothery points out just how difficult it is to succeed by focusing on quality.

Rothery says that with some notable exceptions — like Warren Buffett — investors who have keyed on quality metrics have by and large been unsuccessful over the long term. “This failure is hard to explain,” he says. “Quality stocks should represent highly profitable businesses with sustainable competitive advantages. But these sterling enterprises don’t seem to produce outsized returns for investors – at least, not for those who look for quality by the numbers.”

Rothery hypothesizes that “quality” may be difficult to pin down using quantitative metrics, or that it is “so obvious that everybody can spot it. If so, quality stocks may get bid up to the point where they can no longer generate market-beating returns.” But whatever the case, he says, the numbers don’t lie. He points to the research of James O’Shaughnessy, which found that a portfolio of large U.S. stocks with exceptionally high net profit margins actually would have lagged the broader market from 1964 to 2010. Portfolios of stocks with high returns on equity or returns on assets also lagged.

But, Rothery says that looking for stocks on the other end of the spectrum isn’t a good idea. ” Mr. O’Shaughnessy’s research shows that while firms with extremely high net profit margins, ROEs and ROAs don’t generate great returns, companies that score particularly low on these measure fare much worse than the market,” he says. “High quality stocks might not make you rich, but low quality ones have a good chance of making you poor.”

What does work, Rothery says, is value investing. Many strategies that involve buying stocks that are cheap relative to their underlying fundamentals have beaten the market over the long haul.





Active or Passive? Try (Parts of) Both

Should you choose actively managed funds for your investments, or passively managed funds? It’s one of the investing world’s great debates. And in a new research paper, James O’Shaughnessy’s firm says the answer is, perhaps you should use a little of both.

Passive funds, Patrick O’Shaughnessy writes in the report, have three key advantages over active funds: lower fees, reliable strategy, and in some cases better tax management. But, he adds, they have a huge weakness that trumps those advantages: “the inferior strategy used by most indices to select and weight stocks.” Most passive funds weight stocks based on market capitalization; the bigger the stock, the more you own of it. “But the long-term evidence makes it very clear that buying a stock — or holding more of a stock — just because of its market cap is a losing strategy,” O’Shaughnessy writes. As an example, he shows how, since 1963, the company with the highest market cap in each of the market’s 10 sectors has on average returned 8.54% annualized, lagging the S&P 500 by 1.3% per year. The best value in each sector (determined by using OSAM’s “value composite”), meanwhile, has averaged annualized returns of 14.6%. Those figures include much lower average passive fund fees for the market leaders and higher fees for the bargains, showing that “‘the tyranny of compounding costs’ cannot come close to diminishing the power of value investing.”

But O’Shaughnessy also says that investors are wise to include elements of passive investing in their approach, and use a strategy that “emphasizes discipline, a consistent strategy, and a long-term focus.” He looks at some examples of strategies that embody those qualities, but which don’t use market cap as their selection criterion. The top performer, the “Concentrated Value 50″, looks at the largest 500 U.S. stocks, ranks them by their valuations using OSAM’s “value composite”, and then chooses the top 50 bargains and equally weights them in an annually rebalanced portfolio. From 1963-2012, this portfolio returned 13.62% annualized (net), while a market cap weighted portfolio of the 500 largest stocks returned less than 9% annualized (net). That includes passive-level fees for the cap-weighted portfolio, and active-level fees for the Concentrated Value 50.

O’Shaughnessy says that when using these types of strategies, “discipline is as important as the investment strategy itself. Even though the Concentrated Value 50 strategy is very successful in the long term, it still loses to the Market Cap Weighted 500 strategy in roughly 25 percent of rolling 3-year periods. As we have experienced during periods of real time underperformance for the strategies that we manage at OSAM, it is difficult to stick to a strategy when it is doing poorly, but we do not waver. A disciplined approach is difficult mainly because as human beings, we cannot help but extrapolate short-term trends too far into the future. This often causes us to abandon strategy at the worst possible time.”

O’Shaughnessy says many active funds are “closet indexers” — that is, their holdings are very similar to the index against which they are benchmarked, leading them to generate similar gross returns as their benchmark, which then fall below the benchmark when fees are tacked on. He says investors should thus look for funds whose holdings tend to differ from an index.

OSAM: Global Dividends Looking Very Attractive

James O’Shaughnessy’s firm says that we’re in the most difficult environment for generating income in at least 140 years, and that the best place for investors to look for yield is international equities.

Since 1871, the average yield generated by a portfolio with 60% in stocks and 40% in fixed-income investments has been 4.4%, O’Shaughnessy Asset Management’s Ehren Stanhope and Travis Fairchild write in a research paper available on the firm’s website. At the end of 2012, the figure was just 2.0% — an all-time low.

Stanhope and Fairchild look at a dozen different income-generating asset classes, and find that the spectrum of current yields is “shocking”. Nearly all of the assets currently offer yields at or near their all-time lows. They also discuss the impact of interest rate risk on fixed-income assets — which they say is significant. The U.S.’s poor fiscal condition makes inflation a very possible scenario in coming years, they say, as policymakers try to inflate away our debt. “Though the Federal Open Market Committee has announced its intent to continue monetary stimulus, the impact of price declines — as measured by duration — from even modestly rising rates would, in most cases, dwarf any income received on those assets,” they write.

The fact that stocks have historically performed better than other assets during inflationary periods is one reason OSAM recommends global high-dividend stocks. A few more they offer:

  • Global companies provide access to growth at substantial discounts and higher yields than U.S. companies.
  • Dividend yield has historically been a superior factor for stock selection in global markets.
  • A global portfolio provides diversification of income generation across monetary, currency, and interest rate regimes.

“Given that domestic corporations are sourcing growth from a global opportunity set, we advocate that investors do the same,” write Stanhope and Fairchild. “Valuations of international equities are discounted, while yields are offered at tremendous premiums compared to the United States. Our research leads us to believe that high-quality, global, dividend-paying equities — often under-allocated in investor portfolios — will be an effective agent of income generation and growth of principal in investor portfolios for years to come.”

O’Shaughnessy: Focus On The Numbers, Not The Headlines

Quantitative investing guru James O’Shaughnessy says investors should “completely ignore” the headlines and buy stocks. “You should completely ignore them,” O’Shaughnessy said of headlines on The Wall Street Journal’s Markets Hub. “They really serve to get your mind all whirled up, and you start thinking emotionally, and we think emotional decision making is the bete noire of every investor.” O’Shaughnessy says investors should focus on stocks with high shareholder yield, which is dividend yield plus buyback yield. Among his favorites right now: Seagate Technology.

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