The strategy that would have made you rich is the one you’d have quit in year two.
During the late-1990s tech bubble, investors abandoned the Dogs of the Dow in droves. The strategy simply buys the highest-yielding stocks in the Dow, which tend to be the unloved ones. While it lagged, investors presumably piled into large-cap growth. What happened next is what always happens: the Dogs surged while growth sank.
James O’Shaughnessy’s What Works on Wall Street tests decades of data to find which simple rules beat the market, and the rules turn out to be neither secret nor complicated. So why doesn’t everyone use them? The book’s deepest finding is about people rather than factors. The key to outstanding long-term performance is finding a strategy with the highest base rate and then sticking with it, even when it underperforms other strategies and benchmarks. Consistency is the hallmark of great investors, separating them from everyone else. Even a mediocre strategy used consistently will beat almost every investor who jumps in and out, changes tactics midstream, and forever second-guesses their decisions.
What the winning rules have in common
Most of the strategies that work share one move: they refuse to pay for excitement. O’Shaughnessy divides stocks into workhorses and show-horses. Show-horses are written up in financial publications, run by celebrity CEOs, and surrounded by stories of disruption. Everyone wants them, and that demand pushes their prices to levels that consistently disappoint. Workhorses are boring and cheap, 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.
The most powerful single factor is price-to-sales (PSR): a company’s price against its annual sales, which are harder than earnings to manipulate with accounting tricks. A stock’s PSR is an almost perfect measure of popularity. Only hope and hype will lift the price of a high-PSR stock, and that price already requires everything to go right. Requiring a PSR of 1.0 or less means paying roughly 60 cents for every dollar of sales, in companies where expectations are so low that any good news has an outsized effect. In reflexive terms, the high-PSR story has already been pulled into the price, so it can only be confirmed or disappointed, while the cheap stock has no story yet and room for one to form. A high PSR remains toxic even in sectors where conventional wisdom says it should not be: even in technology and healthcare, the highest-PSR decile consistently loses money.
Even growth investing works better through this filter. The book’s best growth strategy, Cornerstone Growth, requires a low PSR before it looks at rising earnings and price momentum, so it will never buy a stock at 165 times earnings. The best time to buy growth stocks is when they are cheap, not when the herd is clamoring to buy. The other findings run the same way. Last year’s biggest losers are among the worst stocks you can buy, the stocks with the best one-year revenue growth have among the worst future returns, and five years of strong relative strength usually precedes a reversal. Each result contradicts what feels right, which is why the quantitative approach works precisely because it removes the human tendency to fall in love with stories.
Why nobody sticks
Knowing the rules does not make them bearable. A concentrated 10-stock small-cap strategy in the book compounds at 21% a year, but its maximum drawdown is 86%, and it once fell 39% in a single month. Imagine starting it and finding your portfolio worth less than half twelve months later. Could you stick with it? The honest answer is no, and if you cannot stick with it, the theoretical returns are irrelevant.
The Dogs of the Dow investors hit the same wall more slowly. Two years feels like an eternity to the average investor. During that eternity the only stocks moving up are the high-flying story stocks, the story stocks are making your friends rich, and maybe there really is something to the “new economy paradigm shift” everyone is talking about. So you abandon value just in time for the reversion. That is the greed-fear cycle applied to strategies rather than stocks.
The same problem sets the strongest limit on the book’s own rankings. For the average investor, risk-adjusted returns matter more than absolute returns, 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 returns and shallower drawdowns will beat a superior strategy with catastrophic ones, because the investor will actually stick with the first. As reasonable beats rational puts it, the optimal plan loses to the plan you can execute.
The human mind seeks something more amusing than the truth, and the truth about investing is mostly uncomfortable and often dull. So the question to ask of any strategy is not how it did in the backtest but whether you would still own it after two years of watching everyone around you get 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