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

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...