The four faces of James O'Shaughnessy - stocks - research - Insider Interview - Interview

Kiplinger's Personal Finance Magazine, Sept, 1998 by Fred W. Frailey

He's got one for each fund, and all are based on his own trailblazing research.

Here's a tantalizing thought: Just suppose that James O'Shaughnessy--the guy making faces at you on the opposite page--is not joking. Because if he's right, then the army of analysts on Wall Street that monitors the financial pulse of American corporations, not to mention thousands of stock-picking mutual fund managers and their millions of investors, are all wasting their time. You see, unlike everyone else, O'Shaughnessy has done his homework and claims to know what really works in investing.

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O'Shaughnessy owes his discoveries to having persuaded Standard & Poor, a unit of McGraw-Hill, to let him inside its Compustat database, which contains price histories of some 10,000 stocks from 1950 onward. O'Shaughnessy sifted this gold mine of data, testing the results of innumerable stock-picking strategies against more than 40 years of market ups and downs. His conclusions were assembled in the book What Works on Wall Street (McGraw-Hill, $29.95), a new edition of which has just been published.

Before O'Shaughnessy, nobody had exhaustively time-tested investment strategies over so long a period and with so large a universe of stocks. And he uncovered surprises that defy conventional wisdom. For instance, you'll get nowhere buying stocks of companies whose earnings rose the most the previous year--they're duds. But you should achieve sensational results with stocks whose prices rose the most the year before because it appears that what goes up keeps going up--for a while, at least.

Over and above all that, O'Shaughnessy's research offers investors the confidence that over the long pull, indexing strategies (besides simply owning an S&P 500 fund) will deliver handsome rewards--often, quite a bit more than the S&P 500 index itself. Moreover, in classic entrepreneurial fashion, O'Shaughnessy began four mutual funds (800-797-0773), two of which are explicitly indexed to strategies that he found particularly rewarding over time (see the box below). Our first question to him, at the offices of O'Shaughnessy Capital Management, in downtown Greenwich, Conn., was the one you would have asked.

Kiplinger's: Let's cut to the chase. Of all the ideas you've tried, what works best of all?

O'Shaughnessy: Buying cheap stocks on the mend. Specifically, buying stocks with the lowest ratio of price to sales.

Congratulations, you just named the one financial ratio that's hardly ever published.

But it works a lot better than buying stocks with the lowest price-earnings ratio. Earnings are very easy to manipulate. You can make the bottom line be anything you want it to be. But to paraphrase Gertrude Stein, a sale is a sale is a sale.

Everyone uses price-earnings ratios to identify an undervalued stock. Is that a reliable indicator?

Portfolios of the lowest-P/E stocks did all right. But you would do better focusing on stocks with low price-to-sales ratios.

What's an ideal price-to-sales ratio?

On a per-share basis, look for less than a dollar of price for each dollar of sales. The maximum number we use in O'Shaughnessy Cornerstone Growth fund is 1.5, but the average of all stocks in the fund tends to be about 0.88. If you're paying less than a dollar for every dollar of sales, you're talking about an undervalued company.

And what combination of strategies delivers the biggest return?

It's one that employs elements of both growth and value investing. First, a company's market capitalization has to be greater than $150 million, because if it's less than that, it's a nightmare trying to buy or sell shares. Second, the price-to-sales ratio must be less than 1.5. Third, earnings for the previous 12 months must have increased.

Stocks meeting those three conditions are then ranked by how much their price increased the previous 12 months, and you buy the 50 stocks with the greatest price appreciation. What I just described is the entire stock-selection process for Cornerstone Growth fund, and we redo the portfolio at the start of every year. This combination, over the 44 years ending in 1996, returned an annualized 18.8%, compared with 13.4% for all stocks in the Compustat database.

Don't you then look at the list and decide which companies have the best prospects?

No. We only weed out companies that are in the process of being taken over. This process gives you stocks you'd never think about, such as a bunch of title-insurance companies.

The fact is, you're not a big fan of active stock picking, are you?

Successful investing isn't rocket science. I can take a business card and fit most great investment strategies on the back of it. What gets in the way is implementation. Why can't 86% of fund managers beat the S&P 500 index? They're capricious, they're inconsistent. People want to believe that they're better, faster, smarter than other people. Take a roomful of money managers and everyone's going to be from Lake Wobegon--all above average. They think they can outguess everyone. But they can't.

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The four faces of James O'Shaughnessy - stocks - research - Insider Interview - Interview

Kiplinger's Personal Finance Magazine, Sept, 1998 by Fred W. Frailey

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