What Works on Wall Street

2. WHAT WORKS ON WALL STREET The Classic Guide to the Best-Performing Investment Strategies of All Time JAMES P. O’SHAUGHNESSY Fourth Edition

3. Copyright © 2012 by James P. O’Shaughnessy. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. ISBN: 978-0-07-175919-9 MHID: 0-07-175919-0 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-162576-0, MHID: 0-07-162576-3. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. To contact a representative please e-mail us at bulksales@mcgraw-hill.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, securities trading, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. —From a Declaration of Principles Jointly Adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations This book contains statements and statistics that have been obtained from sources believed to be reliable but are not guaranteed as to accuracy or completeness. Neither O’Shaughnessy nor the information providers can guarantee the accuracy, completeness, or timeliness of any of the information in the book, including, but not limited to, information originating with O’Shaughnessy, licensed byO’Shaughnessy from information providers, or

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6. To Lael, Kathryn, Patrick, and Melissa

7. ABOUT THE AUTHOR James P. O’Shaughnessy is the Chairman and CEO of O’Shaughnessy Asset Management LLC, a quantitative asset management company located in Stamford, Connecticut. He is the author of four books on investing. Long recognized as one of America’s leading financial experts and a pioneer in quantitative equity analysis, he has been called a “world beater,” a “statistical guru,” and a “legendary investor” by Barron’s. In February 2009, Forbes included Jim in a series on “Legendary Investors” along with Benjamin Graham, Warren Buffet, and Peter Lynch. O’Shaughnessy’s investment strategies have been featured widely in the media, including The Wall Street Journal, Barron’s, The New York Times, The Washington Post, The Financial Times, CNN and CNBC.

8. Wait for the wisest of all counselors, time. —Pericles

9. CONTENTS Introduction Acknowledgments Chapter 1 Stock Investment Strategies: Different Methods, Similar Goals Chapter 2 The Unreliable Experts: Getting in the Way of Outstanding Performance Chapter 3 The Persistence of Irrationality: How Common Mistakes Create Tremendous Opportunity Chapter 4 Rules of the Game Chapter 5 Ranking Stocks by Market Capitalization: Size Matters Chapter 6 Price-to-Earnings Ratios: Separating the Winners from the Losers Chapter 7 EBITDA to Enterprise Value Chapter 8 Price-to-Cash Flow Ratios: Using Cash to Determine Value Chapter 9 Price-to-Sales Ratios

10. Chapter 10 Price-to-Book Value Ratios: A Long-Term Winner with Long Periods of Underperformance Chapter 11 Dividend Yields: Buying an Income Chapter 12 Buyback Yield Chapter 13 Shareholder Yield Chapter 14 Accounting Ratios Chapter 15 Combining Value Factors into a Single Composite Factor Chapter 16 The Value of Value Factors Chapter 17 One-Y ear Earnings per Share Percentage Changes: Do High Earnings Gains Mean High Performance? Chapter 18 Profit Margins: Do Investors Profit from Corporate Profits? Chapter 19 Return on Equity Chapter 20 Relative Price Strength: Winners Continue to Win Chapter 21

11. Using Multifactor Models to Improve Performance Chapter 22 Dissecting the Market Leaders Universe: The Ratios That Add the Most Value Chapter 23 Dissecting the Small Stocks Universe: The Ratios That Add the Most Value Chapter 24 Sector Analysis Chapter 25 Searching for the Ideal Growth Strategy Chapter 26 Searching for the Ideal Value Stock Investment Strategy Chapter 27 Uniting the Best from Growth and Value Chapter 28 Ranking the Strategies Chapter 29 Getting the Most Out of Y our Equity Investments Bibliography Index

12. INTRODUCTION The Chinese use two brush strokes to write the word “crisis.” One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger—but recognize the opportunity. —John F. Kennedy This fourth edition of What Works on Wall Street has the dubious distinction of being published on the heels of the worst decade for U.S. stocks in 110 years! The first decade of 2000 began full of promise, with swarms of first-time equity buyers rushing into a market where the Nasdaq had increased nearly sevenfold (even after accounting for inflation) in the 1990s and the S&P 500 had risen nearly fourfold. As the first decade of the twenty-first century progressed, it became painfully clear that the early optimism investors had for equity returns was completely unjustified. The decade ended with a real loss of −3.39 percent per year for the S&P 500, where $10,000 invested on December 31, 1999, was worth just $7,083 after taking the effects of inflation into account by the end of 2009. It was even worse for large-cap growth stocks as measured by the Russell 1000 Growth Index, where $10,000 invested on December 31, 1999, was cut virtually in half by December 31, 2009, declining in value to just $5,190. The Nasdaq— the darling of investors in the 1990s—did even worse, losing 7.96 percent per year, turning $10,000 invested on December 31, 1999, into just $4,364 on December 31, 2009, a peak to trough decline between February 2000 and September 2002 of –76.59 percent, very close to that of the S&P 500 during the crash of 1929–1932. Only small stocks had a good run during the decade, with the Russell 2000 Index eking out a gain of 0.96 percent and the Russell 2000 Value Index returning 5.60 percent a year, the only broad U.S. stock index to beat U.S. long-term bonds, which returned 5.04 percent per year. Please note that for this introduction, I am looking at real returns after adjusting for inflation, since it allows me to use the returns generated by professors Dimson, Marsh, and Staunton for the 1900 through 1930 period and published in their excellent book, Triumph of the Optimists: 101 Years of

13. Global Returns. What’s more, I find the real rate of return to be far more informative than the nominal rate, since it takes the loss of purchasing power of the dollar into account and gives a more accurate account of how your portfolio really performed over time. Therefore, while we retain the conventional use of nominal returns for our reviews of each factor and multifactor strategy throughout the book, we include the inflation-adjusted rate of return for several of the strategies as well as other asset classes in Chapter 28, which summarizes our findings. To put all these data in perspective, there have only been two other decades since 1900 in which U.S. stock prices have had real declines in value —1910 through 1919 and 1970 through 1979, where the losses were −2.46 percent and −1.41 percent, respectively. Table I.1 shows the real average annual return for U.S. large stocks from 1900 forward, arranged by the best decade to the worst nine. When we look at all rolling 10-year periods between 1900 and 2009, we find the only 10-year period worse than the one ending February 2009 was the 10 years ending May 31, 1920. See Table I.2 for all of the other awful 10-year periods investors have had to endure since 1900. Two things are especially important about the information in Table I.2: First, note that following these atrocious ten-year declines, all returns for three years through ten years are positive, with an average ten-year real gain of 14.55 percent after one of these horrible ten-year periods. Second, the minimum ten- year real rate of return was a real gain of 6.39 percent for the ten years following the loss of 3.48 percent for the ten years ending November 1974. What’s important for this minimum return of 6.39 percent is that it dwarfed the returns for U.S. long-term bonds over the same period. An investor who got spooked out of the equity market in November 1974 and put his or her money in long bonds would have had a real loss of 0.27 percent per year for the same period. TABLE I.1 Real Returns for U.S. Large Stocks 1900–2009, Sorted by Best to Worst Return