Winning from more than 300 strategies, how can the trend value investment method be applied?

James O'Shaughnessy's investment experience and philosophy

The investment market is unpredictable, so how can we find some rules in it? Quantitative analysis may have played a role.

Speaking of quantitative analysis, let me introduce you to James O'Shaughnessy (James O'Shaughnessy), a pioneer in quantitative stock analysis in the US. Forbes once referred to him as a “legendary investor” along with Benjamin Graham, Warren Buffett, and Peter Lynch.

So how did this “legendary investor” come about? In fact, O'Shaughnessy's fascination with the stock market began at a very young age. He began tracking the common characteristics of the 30 companies in the Dow Jones Industrial Average in the early days, and later obtained a bachelor's degree in economics from the University of Minnesota (University of Minnesota).

He has been working in the financial industry since 1983, and founded his own mutual funds and fund companies. He was the director of systems securities and senior management director of Bear Stearns Asset Management (Bear Stearns Asset Management), and later the chairman and chief investment officer of O'Shaughnessy Asset Management LLC (OSAM)).

Whether in his career or in his personal research, quantitative analysis and investment management are areas he is deeply involved in. Based on his research, he has published four best-selling books. One of the most well-known ones is “What Works on Wall Street (4th Edition)” (What Works on Wall Street).

This book is full of empirical evidence. Based on more than 40 years of data from authoritative databases (Standard & Poor's database and CRSP database of the Securities Price Research Center), it has verified the effects of various single factors and comprehensive factors for different investment strategies, and can be said to have high practical application value.

In his view, in most cases, a passive, mechanized investment system would defeat a human investment system, even for fund managers. He advised investors to use strategies that have been proven over a long period of time and combine multiple factors, ignoring short-term, long-term, and stable investments.

James O'Shaughnessy's Trend Value Investment Act

Specifically, what kind of stock selection philosophy did this “statistical geek” summarize? We can find answers in the book “Practical Analysis of Investment Strategies (4th Edition)”.

He divided stocks into 2 categories. One category is stocks with a market capitalization of more than 200 million US dollars (all stocks for short), and the other are large-scale and well-known stocks (large capitalization stocks for short). Microstocks were excluded because they lacked trading liquidity. These two stock types are selected by combining various single or multiple factors to form various investment strategies and combinations.

For each investment strategy and combination, the book counts their overall returns, highest returns, and lowest returns over the decades from 1927-2009 or 1964-2009.

Among these factors, the best 10% was also compared with the worst 10% (such as the 10% stock portfolio with the lowest price-earnings ratio vs. the 10% stock portfolio with the highest price-earnings ratio), and some also divided the specific factors into 10 tenths (for example, dividing the price-earnings ratio from low to high into the top 10%, 10% to 20%, 20% to 30%... 90%-100%) to compare the returns of these 10 tenths of investment portfolios.

I have to say, it's an extremely large sample and statistical analysis! So what exactly are the factors? What conclusion did you get? Let's take a look at the details below. In fact, the factors he mentioned are far more than the following, but here are some parts that are more relevant to the ultimate winning strategy to explain.

I. Single value factor

1. Market capitalization: The absolute return of a “small-cap” portfolio is high, but the risk is high, and investors should treat it with caution. The performance of “leading stocks” (here refers to well-known “large-cap stocks”) is also relatively outstanding, and the risk is relatively low.

2. Price-earnings ratio: Combinations of high price-earnings ratios all lag far behind the overall market. The combination of low price-earnings ratios far surpassed the overall market performance.

3. EBITDA/EV: This is the ratio of profit before interest, income tax, depreciation, and amortization (roughly replacing operating cash flow) to the value of the enterprise. Many investors think this is a better valuation indicator. In his empirical evidence, the stock portfolio with the highest EBITDA/EV ratio performed the best in absolute returns compared to other value ratio combinations.

4. Current market ratio: This is the ratio of stock price to cash flow (price-to-cash flow ratio). Statistics support that, unless there are other good reasons, investors should focus on stocks with lower current market ratios.

5. Price-to-sales ratio: This is the ratio of stock price to sales (price-to-sales ratio). Empirical evidence shows that stocks with low market-selling rates can continuously beat the market, and the 10% stock portfolios with the highest market-selling ratio perform extremely poorly.

6. Net market ratio: This is the ratio of stock price to book value (price-to-book value ratio). Empirical evidence shows that overall, buying stocks with a low net market ratio is indeed effective, but at some points it is not that effective.

7. Dividend rate: Investment choices based on high dividend rates alone don't seem to be supported by sufficient empirical evidence.

8. Repurchase yield: It is equal to the amount of shares reduced in the current year. Divided by the number of shares in circulation a year ago, a positive ratio indicates that the repurchase was carried out in that year; negative indicates that the company issued additional shares in that year. Empirical evidence shows that the return performance of the stock portfolio with the highest repurchase yield far exceeds the overall performance of the market, while the performance of the stock portfolio with the lowest repurchase yield is very poor.

9. Shareholder return: It is equal to the dividend rate above plus the repurchase yield. Shareholder returns and repurchase returns both outperformed dividend rates.

II. Multi-factor models

In addition to considering a single value factor, it would be better if multiple value factors were considered together.

The book explores three multi-value models: the first consists of net price-earnings ratio, price-earnings ratio, EBITDA/EV, and current market ratio; the second increases shareholder return on top of the first; and the third uses repurchase yield to replace the second shareholder return.

When studying each multi-factor model, stocks in the “all stocks” and “large cap” portfolios are ranked by percentile, each factor is ranked and scored, then the scores of the single factors are summed up, and then the final ranking is made.

Empirical evidence shows that regardless of the multi-factor value model, buying an investment portfolio composed of the 25 stocks or 50 stocks with the highest score has excellent long-term performance when taking reasonable risks.

III. Specific stock selection strategies

Having said so much, we finally arrived at a specific strategy.

James used monthly earnings data from August 31, 1965 to December 31, 2009 to compare more than 300 strategies covered in the book.

After weighing factors such as risk and return, it was found that the “trend value portfolio” had the highest return. This is a strategy that combines value factors and growth factors. Simply put, it is a good underrated company seeking rising stock prices.

How exactly?

First, it is based on an “all stocks” portfolio, which means that stocks must meet a market capitalization of more than 200 million US dollars, as mentioned above.

Second, select the top 10% of stocks among value factors. The value factor used here is the second multi-factor value model mentioned above, which includes the six factors net market ratio, price-earnings ratio, price-sales ratio, EBITDA/EV, current market ratio, and shareholder return.

Finally, select the 25 or 50 stocks with the best price appreciation within 6 months.

How do we apply this strategy?

Next, how do you apply this “trend value” strategy? Let's look at it in 3 points.

1. Market capitalization > $200 million.

2. It is necessary to comprehensively consider the six indicators of net price-earnings ratio, price-earnings ratio, market-sales ratio, EBITDA/EV, current market ratio, and shareholder return. This is difficult to achieve in the initial screening. Then we can consider a few of them first, and consider the rest in further screening. For example, tools can be used to rank and screen price-earnings ratio PE, net price-to-market ratio PB, and market-sales ratio PS.

3. “Best price increase within 6 months”, which is also difficult to achieve during initial screening. Then, consider first screening stocks within a certain range of price increases or decreases within 6 months.

What else can be done in specific practical terms?

At this point, let's take US stocks as an example and use the Futubull and Bull Stock Selector to practice.

Forty-six stocks were selected (based on October 24, 2023 data). Of course, if the previous stock selection conditions were slightly different, the final screening results would also be different. It depends on how you understand and weigh these indicators yourself.

For these 46 stocks, if you follow James's strategy and want to select 25 to form an investment portfolio, how can you consider it again?

For example, look at the previous 3 indicators (EBITDA/EV, current market ratio, shareholder return) for these individual stocks one by one, and the price appreciation within 6 months.

Another example is to consider the selection and ratio of industries and topics. The book “Practical Analysis of Investment Strategies (4th Edition)” actually has a chapter dedicated to industry analysis. If you are interested, you can read more.

Or, consider additional financial indicators; the book also specifically talks about this section.

James O'Shaughnessy's strategy introduced today has indeed yielded good benefits in empirical evidence, but no strategy is risk-free. You need to know that historical returns do not guarantee the future, and good long-term returns do not mean that short-term investments will be profitable.

I hope today's content has inspired you.