Concrete rules for investing on Wall Street

Buying and selling stocks should be a rules-based process that isn't based solely on gut instinct

Brendan McDermid/Reuters/File
Traders work on the floor of the New York Stock Exchange. Along with esteemed broker James O'Shaugnessy, Brown argues that "trending value"–a measure of both the value and momentum of certain stocks–is one of the most reliable trading metrics available.

Last week Barry and I were thrilled to have the chance to host James O’Shaughnessy, legendary equity portfolio manager and a quant before there even was such a thing, up at Fusion HQ.

James is out with the fourth edition of his classic What Works on Wall Street, a book that both Barry and I frequently reference and go back to.  The book is here at Amazon, if you don't already have a copy, this is your chance to own the updated version.

In the meantime, James did a column for MarketWatch today in which he lays out some of his most important metrics to find winners in the market.  Check this out:

With this new research, we have refined the way that we measure characteristics in a way that boosts returns. We found that an updated combination of value and momentum strategies — a tactic we call “Trending Value” — is the best performing strategy since 1963.

Its annualized return of 20.58% through Sept. 30 crushes the All Stocks benchmark (an equally weighted benchmark of stocks with an inflation adjusted market cap great than $200 million), which has a return of 10.71%. Plus, the Trending Value approach achieves its return with a volatility of 17.69%, lower than the benchmark’s 18.26%.

The strategy makes use of one of the main innovations from the book: the use of a composite value factor. In the original publication, we identified price-to-sales as the most effective value factor. In this latest edition of the book, we have learned that a composite that combines several different value factors delivers stronger returns and more consistency than any individual factor.

By spreading our bets and ensuring that a stock is cheap in a variety of ways, we believe we can identify better stocks. One version of the composite value factor combines the following measures of value:

• Price-to-Sales

• Price-to-Earnings

• Price-to-Book

• Price-to-Cash Flow

EBITDA/Enterprise Value

• Shareholder yield (dividend yield + rate of share repurchases)

Each stock in the universe gets a score of 1 to 100 for each of these factors. The final value score is an average of these scores. The Trending Value portfolio narrows the investable universe to the 10% of stocks with the best score based on the value composite, and then selects a concentrated portfolio of 25 stocks based on trailing six-month momentum.

James is admirable to Barry and I in that his process is repeatable.  There are no gut instincts involved and every buy or sell is rules-based, which is the way we prefer our money managers to function.  O'Shaughnessy's stock picking is also completely divorced from the shenanigans that suck so many sell-side analysts in.  He hasn't listened to a quarterly conference call in a decade, he also sells at the first hint of trouble - late filings and earnings restatements are automatics 86's from his portfolios.

Check out his column for more on his Trending Value concept...

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