James P. O'Shaughnessy is the author of a new McGraw-Hill book, "What Works on Wall Street," which tells what investment strategy works best, based on study of 40 years of stock-market data. Jim is president of O'Shaughnessy Capital Management. He was online with Fred Jespersen, Scoreboards editor of BW.
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OnlineHost: Welcome to Business Week Online! Tonight we talk about the best strategies for your investments, with James P. O'Shaughnessy (OCMInc), author of "What Works on Wall Street," published by McGraw-Hill and now No. 8 on BW's Best-Seller List. Jim heads O'Shaugnessy Capital Management. Here with him is Fred Jespersen (FredJBW), Scoreboards editor of BW. Jack Dierdorff (JackBW), consulting editor of BW Onlinem is moderator.
JackBW: Good evening to all of you on AOL, and welcome, Jim O'Shaugnessy. Hi, Fred Jespersen of BW.
For background, in doing his book Jim measured 40 years of market data from Standard & Poor's Compustat against a variety of investment strategies to see which ones performed best. And now on to questions about the book. Fred, you get the honor of tossing out the first question, just as if it were a ball at Yankee Stadium tonight.
FredJBW: Is investing an art or a science?
OCMInc: I think that for years, investing was looked at as an art. Yet Ben Graham, the founder of modern portfolio analysis, asked that we look at it in more scientific terms. That was the goal of my book. I think that now that we have the results, investing will be approached in a far more methodical way.
JackBW: Try this one next.
Question: Did you have any preconceptions on what would be the winning strategies before you started to crunch the numbers? How did the actual results correlate to your initial thoughts?
OCMInc: Yes, I did. I felt that all of the classic styles would emerge as doing fairly well, but I was not prepared for how systematically the market rewards low-ratio stocks (stocks with low price-earnings, price-book, and most importantly, price-to-sales ratios. Nor was I prepared for how consistently "story" stocks -- those with high p-e, price-to-book, and price-to-sales ratios would be punished by the market. I also thought that there would be more of a bias toward the small-cap side of the market than we saw with the results.
JackBW: BobAB from Teaneck, N.J., sends us the next question.
Question: Jim, what do you think is the best investment strategy, year in and year out? And what strategy is best for a market at this stage of the economic and market cycles?
OCMInc: It depends on how aggressive or conservative you are. For aggressive investors, the best simple strategy is buying stocks with price-to-sales ratios below 1 and the best relative price appreciation. For conservative investors, buying large, well-known stocks with high dividend yields provided the best risk-adjusted returns.
JackBW: Geopages in the AOL audience has a basic question for a young investor.
Question: I'm relatively young and want to start an investing plan. How aggressive should I be?
OCMInc: Very. The younger you are, the more aggressively you should invest. Over long periods of time, aggressive strategies like the one just mentioned have compounded capital at over 18% a year. That doubles your moeny every four years.
JackBW: Fred wants to ask one next.
FredJBW: What is the biggest mistake an individual investor tends to make when starting to invest?
OCMInc: Listening to stories about indivdual stocks and not looking at the underlying strategy and its long-term performance.
JackBW: Geopages has another good question.
Question: Isn't it true that most investment advisers are lucky if they match the S&P 500's return? Why shouldn't everyone just invest in index funds, which are cheap to maintain, and you don't end up paying lots of service fees and commissions?
OCMInc: Simple strategies when rigorously followed perform much better than simple S&P index funds.
JackBW: Fred is up again -- Fred Jespersen of BW, that is.
FredJBW: How can you tell if your strategy is a sound one, or just lucky?
OCMInc: Anything can work for short periods of time. When you analyze a strategy over more than four decades, it is virtually impossible for bad strategies to perform. Yet, over short periods, ANYTHING can look good. I have one strategy that buys stocks with tickers that are vowels (a, e, i, o, u, y). In 1988, that beat the S&P 500 -- but that does not make it a good strategy! You need at least 25 years to see if something is worthwhile or not.
JackBW: LOL. And now for Jim...
Question: Does any one strategy work for four decades, or should investors shift with the times?
OCMInc: People change. Industries change. Fashions change. But the underlying factors that make an investment strategy work really don't change. Buying stocks with great relative price strength that nevertheless are cheap works well almost all the time. It's just that the names of the stocks change. In the '50s it was one type of stock, now it's another.
JackBW: That logically leads to this question.
Question: Is there a single best investment strategy? Like a simple strategy that yields better-than-average results?
OCMInc: Yes. I would recommend marrying our best conservative strategy (buying the 50 highest dividend-yielding stocks from a group of market leaders) with our best aggressive strategy, buying stocks with low price-to-sales ratios, back-to-back earnings gains over the last five years, and great relative strength. That combined strategy gives you a style-diverisifed portfolio that does outstandingly well in most types of markets.
FredJBW: But the key is to stick with a sound stragegy, even if it occasionally loses?
OCMInc: Yes. The key to outstanding investment success is consistency. Never let the news of the moment sway your thinking. "Got a hunch, bet a bunch" investing is responsible for a lot of losses.
FredJBW: What are some other mistakes investors tend to make?
OCMInc: They invest in stories, not strategies. They believe it really IS different this time. They think that they have the unique ability to pick the next Microsoft, even though everyone goes about it the same way, and 80% lose to the simple single factor -- S&P 500.
JackBW: This next question might lead to a lighter moment.
Question: What's the dumbest (worst or most ridiculous) investment strategy you ran across while doing your book?
OCMInc: Wow, that IS a tough one. The absolute worst performer was buying last year's biggest losers. That turned $10,000 invested in 1951 into just $20,000 at the end of 1994.
JackBW: TMT3645 in Tulsa wonders if you caught James Grant in The New York Times this morning. If not, we'll go on to the next question.
Question: Any comment on today's op-ed piece in the New York Times on the stock market?
OCMInc: I saw the Wall Street Journal and Investors Business Daily.
JackBW: So much for Grant, for now. Sorry, TMT.
JackBW: Fred had asked whether institutional investors made the same mistakes as individuals.
OCMInc: Yes, the same. Just bigger!
Question: Do the best investing methods differ by a person's age? For instance, what's the best method for a 30-year-old with two young kids? For a 50-year-old with two young kids? Same method, or different?
OCMInc: Absolutely. Once again, it depends on one's tolerance of risk and volatility. If an investor only cares about total return and not the ride along the way, then Cornerstone Growth makes sense. However, if an investor cannot stand the volatility that is associated with growth investing, then Cornerstone Value makes sense.
JackBW: Here's a question about market timing.
Question: What's the best strategy for spotting turns in the market (since professional analysts often seem to miss them)?
OCMInc: There is a reason why professionals often miss market turns -- because it is nearly impossible to do. That's why investors need to think about investing for decades and days.
JackBW: This question would interest a lot of people who use AOL for investment help.
Question: Are you familiar with the Motley Fools here on AOL? What do you think of their investment strategies? Will they work in a down market?
OCMInc: I'm a big fan of the Fools' Dow dividend strategy. I was the first person to test that back to 1928 when the modern Dow was expanded to 30 stocks. It beat the S&P 500 in every decade from the '30s to the '90s, with only two rolling 10-year periods that didn't do as well as the S&P 500. I myself am a bigger fan of the total-10-stock method because it is less volatile in down markets.
JackBW: Next, from Fred Jespersen of BW.
FredJBW: Where should an investor go to get information needed to make educated choices?
OCMInc: The best thing investors can do is look at the long-term record of the strategy that they want to use. Don't listen to hype, and don't be too concerned with a stock's movements day to day. If you stick with the long term, you'll always be looking at the forest instead of a single tree.
JackBW: I thought you were going to suggest reading your book, Jim!
OCMInc: <smile> That would help, too!
JackBW: Ah, the dartboard theory comes up next.
Question: I have relatives who've made decisions such as: Everyone has to eat, so let's buy food-company stocks. And they've made lots of money. Is a dartboard as good as a carefully crafted strategy sometimes?
OCMInc: Over the long term, no dart board can beat well-thought-out strategies. But remember that you must stick with them. That is the hardest part. As someone said, "Thinking is easy. Acting is hard. To act like you think is virtually impossible."
JackBW: Jim, what prompted you to write this book?
OCMInc: I thought it was time to really know if all our favorite ways of picking stocks were valuable or valueless. I would never go to a doctor who said he was going to wing my treatment, yet many entrust their money to people who have done no long-term tests to see if their method for stock selection works or not. We cannot invest that way any longer.
JackBW: You might add something about the software that's also available.
OCMInc: We also developed software based on the findings of the book that lets the user build a portfolio of up to 10 strategies and then compare how they have performed against the S&P 500 or any other benchmark that you wish to use. For instance, you can look at the worst bear market in the last 50 years and test a strategy to see how it holds up. The best thing to do is look at the returns from 1969 to 1974 for a short look and then expand your time horizon to look at the power of the market from 1969 to 1995.
JackBW: Fred? Your question?
FredJBW: Were you surprised to see how poorly earnings-growth models did? It's such a keystone of growth stategies.
OCMInc: I was surprised. For years money managers harped on the value of earnings gains. I found in Cornerstone Growth that earnings persistence was more valuable than absolute gains.
FredJBW: Have you looked at any sales-growth strategies?
OCMInc: Yes, sales growth did not prove to be a valuable way to select stocks in and of itself.
JackBW: And now for the gambler in us.
Question: Did your research find that really risky strategies -- futures, for example -- make much sense?
OCMInc: Generally, it's a mistake to invest in the riskiest strategies. You can do much better in strategies that don't take such high risks. The other problem with the riskiest strategies is that investors tend to abandon them near the bottom of their cycle, leading to truly horrible long-term results.
JackBW: Next...
Question: What was the biggest surprise that came out of your research for this book?
OCMInc: That the small-cap effect owes almost all of its performance advantage to so-called micro-cap stocks (those with caps below $25 million). $10,000 invested in 1951 in those micro-caps zoomed to over $29 million by the end of 1994. The problem is, you really can't buy these tiny stocks. Market impact and other bid-ask distortions would have a huge impact on your profits. Yet, most studies fail to remove these stocks. When you look at just those stocks investors can really own, the difference between large and small is much smaller.
JackBW: Here's a kind of devil's advocate question.
Question: Do you really think that investing can be reduced to methods? If everyone tries to adopt what you've found to be the most successful methods, won't they cease to be as effective (since there must be both winners and losers for the market to function)?
OCMInc: As long as the madness of men prices stocks, there will be a place for methodical investors. The traditional approach obviously doesn't work. 80% of the mutual funds in Morningstar fail to beat the S&P 500. yet you can duplicate its performance simply by buying all the stocks in the Compustat database with a market cap greater than the mean. Other strategies do much better. The big problem is sticking with them and not letting your emotions dictate what you will buy and sell. Remember, an ounce of emotion equals a pound of facts!
JackBW: And now for our final question of the evening.
Question: Are you still looking at different strategies? Is there anything new you've learned?
OCMInc: Our research continues, but the numbers keep coming back supporting what is reported in "What Works on Wall Street."
JackBW: Thanks to James P. O'Shaughnessy, author of "What Works on Wall Street," for this discussion of the best investment strategies.
OCMInc: Thanks, everyone!
JackBW: Thanks also to Fred Jespersen of BW, and special thanks to the audience for questions. Remember that transcripts of this and all BW Online conferences are available soon after the event. Look under Talk & Conferences on our opening screen. Thanks again, and goodnight to all!
Copyright 1996 by The McGraw-Hill Companies, Inc. All rights reserved.
