The key to outstanding long-term performance is finding a strategy with the highest base rate and then sticking with it, even when it is underperforming other strategies and benchmarks. This is the hardest thing in investing — not finding the strategy, but surviving the inevitable periods when the strategy looks wrong and everything else looks right. Consistency is the hallmark of great investors, separating them from everyone else. If you use even a mediocre strategy consistently, you will beat almost all investors who jump in and out, change tactics midstream, and forever second-guess their decisions.
Simple Picture
There are two types of stocks: workhorses and show-horses. Show-horses are the ones written up in financial publications, run by celebrity CEOs, surrounded by stories of disruption and transformation. Everyone wants them. That demand pushes their prices to levels that consistently disappoint. Workhorses are boring. Nobody writes about them. They are cheap because nobody is excited about them — and that cheapness is precisely what makes them profitable. Value criteria act like a chaperone at a party, making sure you don’t fall for some sexy stock with a great story. They may keep you from some short-term fun, but over time they keep you from overpaying.
Price-to-Sales: The Popularity Meter
Of all the value ratios, price-to-sales (PSR) is the most powerful single factor. PSR measures the price of a company against its annual sales instead of earnings. Unlike earnings, sales are harder to manipulate with accounting tricks.
A stock’s PSR is an almost perfect measure of popularity. Only hope and hype will increase the price of a stock with a high PSR. High-PSR stocks consistently disappoint because the expectations baked into their price require everything to go right — and everything rarely does. Low-PSR stocks outperform because expectations are so low that any good news has an excellent effect on the price. By requiring a PSR of 1.0 or less, you wind up paying approximately 60 cents for every dollar of sales — buying companies where the market has essentially given up.
The reflexive loop explains why: a high-PSR stock is one where the story has already been priced in. The narrative has done its work — it has pulled future expectations into the present valuation. What remains is only downside risk, because the story can only be confirmed (no surprise) or disappointed (crash). A low-PSR stock is one where no story exists yet, which means any emerging narrative has maximum room to create value.
Even in sectors like Information Technology and Healthcare, where high PSRs are supposedly justified by growth potential, buying the highest-PSR decile consistently loses money. A high PSR remains toxic even in sectors where conventional wisdom says it should not be.
Momentum: Winners Keep Winning (Until They Don’t)
Over one-year periods, winners generally continue to win and losers continue to lose. Price momentum is real, and it makes efficient market theorists howl because it means past prices can predict future prices.
The mechanism: crowds have collective intelligence when four conditions are met — diversity of opinion, independence of members, decentralization, and a good method for aggregating opinions. Markets satisfy these conditions most of the time, with price as the aggregator. But during bubbles and busts, uniformity of opinion impairs collective judgment. The mimetic process takes over: diversity collapses, independence vanishes, and the crowd becomes a herd. Price momentum during these periods is not signal — it is the echo of mass imitation.
The crucial reversal: while one-year momentum persists, five-year momentum mean-reverts. Stocks that have exhibited five years of strong relative strength — positive or negative — are usually on the brink of a turnaround. The practical application: go to a fund screener, sort by five-year returns, buy the bottom categories and sell the top ones. This is deeply counterintuitive — most people flock to a strategy when its short-term performance is strong, which is exactly when regression to the mean is about to punish them.
The Impossibility of Sticking
The deepest insight is not about which strategy works. It is about why investors cannot stick with strategies that work.
A 10-stock concentrated small-cap strategy compounds at 21% per year — spectacular. But its maximum drawdown is 86%, and it has declined 39% in a single month. Imagine starting this strategy and finding your portfolio worth less than half twelve months later. Could you stick with it? The honest answer is no, absolutely not. And because you cannot stick with it, the theoretical returns are irrelevant. Two years feels like an eternity to the average investor. During that eternity, the only stocks moving up are the high-flying story stocks — and maybe there really is something to this “new economy paradigm shift” everyone is talking about.
This is the greed-fear cycle applied to strategy selection. You adopt a value strategy. It underperforms for 18 months while growth stocks soar. You feel foolish. The story stocks are making your friends rich. You abandon the value strategy and pile into growth — just in time for the reversion. The value strategy resurges. The growth strategy collapses. The Dogs of the Dow is the classic case: investors abandoned it in droves during the late-1990s tech bubble, presumably piling into large-cap growth. What happened next is what always happens: the Dogs surged while growth sank.
The non-ergodic frame sharpens this. Risk-adjusted returns are more relevant than absolute returns for the average investor — not because risk adjustment is theoretically correct, but because one bad month is enough to make investors abandon everything they know about long-term investing. A strategy with lower absolute returns but lower drawdowns will outperform a superior strategy with catastrophic drawdowns, because the investor will actually stick with the first one.
The Best Combined Strategies
Single factors are useful. Combined factors are powerful. The best approach uses factor summation rather than a funnel: rank each stock on multiple factors, sum the ordinal ranks, and buy the stocks that score best across all factors. A stock that scores 100 on price appreciation, working capital, and price-to-cashflow but only 20 on PE can still make the cut — the funnel approach would have knocked it out.
The Cornerstone Growth strategy crystallizes this:
- Market cap above a deflated $200M
- PSR below 1.5 (cheap)
- Earnings higher than previous year (improving)
- Three-month and six-month price appreciation above database average (momentum building)
- Buy the 50 stocks with the highest one-year price appreciation
The growth strategy includes a low PSR requirement — traditionally a value factor. The best time to buy growth stocks is when they are cheap, not when the herd is clamoring to buy. This strategy will never buy a stock at 165 times earnings. That is why it works: it forces you to buy stocks just as the market realizes they have been overlooked.
High Margins Are Not What You Think
Many believe that firms with high profit margins are better investments — industry leaders, moat-protected. History shows the opposite: using high profit margins as the sole factor leads to disappointing results. If anything, investors should simply avoid the stocks with the highest margins.
For small-cap stocks specifically, horrible margins can wipe you out. Smaller companies tend to be single-line businesses, and if margins are terrible, there is no business. But premium margins in large companies often signal that the company has become a capital management entity rather than a producer — it has optimized away the growth that made it valuable. The cash flow frame applies: what matters is not the margin but whether the cash flow is durable and growing.
Dimwit / Midwit / Better Take
The dimwit take is “buy what you know — invest in companies you love and products you use.”
The midwit take is “quantitative strategies are a black box — you need to understand the business to invest wisely.”
The better take is that the quantitative approach works precisely because it removes the human tendency to fall in love with stories. Last year’s biggest losers are among the worst stocks you can buy. Stocks with the best one-year increase in revenues have among the worst future performance. High-PSR stocks with exciting narratives consistently disappoint. Every one of these findings contradicts what feels right — and “what feels right” is the mimetic pull toward whatever story the crowd is currently telling. The quantitative investor automates the removal of this pull, which is not a weakness but the entire point. The S&P 500 index works not because it is “the market” but because it automates the simple strategy of buying big-cap stocks, sidestepping the flawed decision-making that would otherwise intervene.
Main Payoff
Value strategies work. Growth strategies that include value criteria work even better. But the real finding is not about which factors predict returns. It is about the impossibility of following through. The human mind seeks something more amusing than the truth, and the truth about investing is mainly uncomfortable and often dull. Glamorous, high-expectation stocks grab attention through spectacular runs that encourage investors to pay unwarranted prices. Value stocks are workhorses — profitable but boring, and boring is what the human mind cannot tolerate for long. The strategy that wins is not the one with the highest theoretical return. It is the one you can actually stick with through two years of underperformance while everyone around you is getting rich on stories. The chaperone at the party is not fun, but the chaperone is the one who gets you home safely.
References:
- James O’Shaughnessy, What Works on Wall Street