In What Works on Wall Street, James O’Shaughnessy looked at how different factors fared within individual sectors of the stock market. He found the best performing factor for the utilities sector was a composite of several factors, called “value composite 2” (VC2), and the best performing factor for the consumer staples sector was shareholder yield (SHY). Both VC2 and SHY were introduced here.
To replicate the utilities value strategy, simply purchase the top 25 stocks in the all stocks universe (market cap >$200M in 2008 $) sorted by highest VC2 score. For the consumer staples strategy, purchase the top 25 stocks in the all stocks universe sorted by highest SHY. Both strategies rebalance annually, as with all the strategies in the book.
What’s amazing about these strategies is not only do they outperform the market, they do it at a lower risk.
Strategy Performance (1968 – 2009)
Both strategies outperformed the market with lower standard deviation (see out-of-sample, 2010-2016 performance here). A limitation of just looking at standard deviation is that it accounts for upside risk and downside risk, but since upside risk is a good thing, a more useful measure is downside deviation, which only measures downside risk.
The lower the downside deviation, the less likely the return will be lower than expected. In other words, the lower the downside deviation, the less risk the strategy has when stock prices are falling.
That’s all there is to it. If you have any questions, post them in the comments below.
If you read my last post, one of your first reactions might have been, “If these strategies are so effective, why isn’t everyone doing it?” Or, why aren’t you in charge of a big hedge fund, why isn’t every pension/trust fund using it, etc. (these are actual responses I’ve heard from people).
And while O’Shaughnessy covers this very question brilliantly in the first three chapters of What Works on Wall Street, I will make a feeble attempt in this post to begin to answer the skeptics. (He also has commentary on these topics, including “The Myth of the Most Efficient Market” and many others, on his asset management firm‘s website).
To begin, let’s review the obvious: everyone isn’t doing it, especially not managers of equity funds.
% of actively managed funds underperforming the S&P 500 on a 10-year return
On average between 1991 and 2009, 70% of actively managed funds had 10-year returns worse than the S&P 500. Vanguard has more recent (and more complete) data in its case for index-fund investing, shown below.
% of actively managed funds underperforming their benchmark on a 5-year return (click to enlarge)
For the data and time period Vanguard looked at, actively managed funds underperformed their benchmarks two-thirds of the time on a 5-year return (a pretty strong case to not invest in actively managed funds). So why, if strategies like trending value and the other 222 strategies that outperformed the S&P 500 between 1964 and 2009 are so lucrative, aren’t these equity fund managers able to beat the market? Identifying the factors that outperform the market is easy. It’s a welldocumentedfact that value investing over long periods of time will outperform the market (even Warren Buffet knows the value of value investing!). This is the basis for the trending value strategy I previously discussed. If the underlying indicators are obvious, who is left to blame? The investor’s brain is a good place to start. Indexing the S&P works because it’s a strategy that never varies. Day in and day out, it the S&P 500 is an index of large cap stocks. It doesn’t decide one year, “Oh small stocks are doing well recently, maybe I’ll become a small cap index!” No, it stays the course. As an individual investor (or as the manager of an equity fund, where it’s literally your job to not lose your clients’ money), would you have stayed the course through the 7 years between 1964 and 2009 that the trending value strategy underperformed the S&P 500?
Difference in CAGR, Trending Value Strategy minus All Stocks
When the strategy lags 20%+ behind the rest of the market (like it did in 1999 and 2009, shown above), are you really going to stick with it? Not likely — fear/risk avoidance is wired into the deepest parts of your brain, an extremely useful feature for species survival, but not so useful for being disciplined in your investment strategy. (And if you stuck with it as a professional asset manager, you’d be fired). A 2005 study found that brain-damaged people make better investment decisions than able-brained people, by being more willing to take risks and less likely to react emotionally to losses. The brain-damaged people ended up with 13% more money on average at the end of 20 mock investment rounds. This is a brilliant market-timing game that shows you just how difficult it is to try to beat the market on a short-term basis. If you don’t do well on that game, don’t feel bad, not even Isaac Newton could to outsmart the market in the short-term. Or millions of other investors, as evidenced by recent history.
At the bottom of the Great Recession in Feb/March 2009, there was a net outflux of equity of over $50B (in just those 2 months; $9B net outflow over the year), as the influx into the bond market that year was $375B. Those who sold at the bottom not only realized their 50% losses, but missed out on the 159% rebound since then. They did it despite decades of past data and experience suggesting that the market would rebound.
So what’s the takeaway? Discipline is the key to the individual investor hoping to implement a strategy proven to outperform the market over the long term.
“Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disclination to do so.” – Douglas Adams
$10,000 invested into the trending value strategy in 1963 became over $69M in 2009. The strategy was published in 2011 and has continued to work since.
What I’m about to introduce to you is not black magic. And I say that because if you’re a realist like me, anytime someone comes to you with something that sounds too good to be true, it’s almost always too good to be true (or a pyramid scheme). Update: see my post attempting to answer the skeptics.
But this strategy is rigorously backtested and rooted in common sense. It isn’t about finding correlations between obscure financial metrics and stock performance to formulate a otherwise seemingly random strategy.
Every metric in this strategy is commonly used by millions of investors every day; but when they are combined in a specific way, the results can be extraordinary.
The trending value strategy was developed by James O’Shaughnessy and detailed in his book What Works on Wall Street as one of the best performing strategies, using a combination of value and growth metrics, terms you’ve probably heard of or seen marketed in ETFs or mutual funds.
Value investing is a well-known investment strategy that aims to select stocks that the market has undervalued – that is, the stock’s price is lower than what its fundamentals suggest it is actually worth.
Another factor he looked at was shareholder yield (SHY), which is buybacks (how many stocks are repurchased by the company (i.e., decrease in number of outstanding shares)) plus dividends divided by market capitalization. (For shareholder yield, higher is better). The results for the top decile of these factors (lowest (or highest for SHY) 10%, rebalanced annually) are below (with all stocks for comparison).
By themselves, all of these factors beat the overall stock market. But combining the factors, coming up with a composite score and investing in the top decile of composite scores, yields even better results. To develop the composite scores, a ranking for each factor is given to each stock in the universe of stocks. So the stock with the lowest P/E gets a score of 100, the stock with the lowest SHY gets a 1, and so on (this can be done with the PERCENTRANK function in Excel (or 1 – PERCENTRANK for SHY, since higher numbers are better), or much more seamlessly using a more powerful tool like Portfolio123).
The ranks for each factor of a stock are added up for its composite score. O’Shaughnessy looked at 3 different value composite scores: value composite 1 (VC1) used the factors described above except SHY, value composite 2 (VC2) add SHY to VC1, and value composite 3 replaces SHY with just buyback yield. The returns for top decile of each of these composite scores is below (rebalanced annually).
Each value composite is a significant improvement over any individual factor. Composites are more powerful than just screening for the best values of the individual factors because a stock that may be deficient in one metric but excellent in the others would get eliminated from consideration by screening (e.g., a stock in the top decile of VC2 may not necessarily be in the top decile for all of the individual factors).
To implement the trending value strategy, you simply invest in the top 25 stocks sorted by 6-month % price change (the “trending” part of the name) among the top decile of stocks ranked by VC2 (O’Shaughnessy chose VC2 over VC3 because of its slightly higher Sharpe ratio, a measure of risk-adjusted return).
The universe of stocks is limited to those with a market capitalization of more than $200M (in 2009 $) to avoid liquidity problems with trading smaller stocks. It’s a buy and hold strategy that is rebalanced annually with the following exceptions. If a company fails to verify its financial numbers, is charged with fraud by the Federal government, restates its numbers so that it would not have been in the top 25, receives a buyout offer and the stock price moves within 95% of the buyout price, or if the price drops more than 50% from when you bought it and is in the bottom 10% of all stocks in price performance for the last 12 months, the stock is replaced in the portfolio.
So what’s the catch? There are a few:
The Data: While most of the metrics described are freely available from any number of online sources, some (e.g., buyback yield) aren’t as easy to come by, and I still haven’t found a free way to obtain all of the data for all of the stocks at once.
Psychology: While the trending value strategy has never underperformed the market for any rolling 5-, 7-, or 10-year periods between 1964 and 2009, it has underperformed the market for rolling 1-year periods 15% of the time, and 3-year period 1% of the time. If you hit a few years with less-than-stellar performance, are you going to stick it out and trust the strategy, or are you going to jump ship to bonds (as many people did in 2009, missing out on the huge subsequent rebound) or another trendy strategy that seems to be performing better at the time?
Commissions (for small-time investors): At $10/trade and 25 trades per year, you need a portfolio of $100,000 to keep your commissions to a reasonable 0.25%.
You can learn how to implement the trending value strategy here, so number 1 is solved. Number 2 is on you. And number 3 is covered here.