Courtesy of John Nyaradi.
“What Works On Wall Street,” an exclusive interview with best-selling author and financial expert James P. O’Shaughnessy
John Nyaradi: Hi everyone. I’m John Nyaradi, publisher of Wall Street Sector Selector, the financial media site specializing in exchange traded funds and global markets. Today, I’m really pleased to welcome our special guest, James O’Shaughenessy. James, welcome to Wall Street Sector Selector.
James O’Shaughenessy: Thanks for having me on, John.
John Nyaradi: Thank you. James is chairman and CEO of O’Shaughenessy Asset Management. He has been a portfolio manager and Senior Managing Director at Bear Stearns. He’s the bestselling author of “What Works on Wall Street: What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time.” He’s widely recognized as one of America’s leading financial experts and he’s known as the pioneer of quantitative equity analysis. Barron’s has called him a “world beater, a statistical guru, and a legendary investor.” Kiplinger’s Personal Finance magazine has said, “You ignore his message at the risk of your own future wealth.”
Today we’re going to talk about James’s new book and his view of the market. So let’s just start with a big picture of the book, James, “What Works on Wall Street,” the 4th edition of this book, “The Classic Guide to the Best-Performing Investment Strategies of All Time.” What’s your goal is here, what do you want people to get out of it?
James O’Shaughenessy: Well, my goal is for the reader to be able to have access to a long-term study of which factors and strategies work well in a variety of stock markets. This version of the book actually has data for some of the factors going back to 1926 so we actually are able to test some strategies through the Great Depression. We thought that was pretty important after 2008 turned out to be the second worst year since 1931. But what we really are trying to do is educate investors as to which strategies work, why they work, and how the investor can take advantage of them. We also have chapters on what the roadblocks are for success and investing, and typically, what we found was that the roadblock tends to be the investor themselves. When they let emotional decisions get in the way of good investing, they cost themselves a great deal in terms of wealth that they could have in the portfolio but don’t because they make decisions through their emotions rather than through their logic.
We have a new chapter talking about neuro finance, which is essentially scientists taking super fast pictures of the brain when people are making decisions, financial decisions under uncertainty. What we found from that was that it is not the prefrontal cortex which is firing during those decisions; it’s the emotional centers of the brain. And if investors can get their mind around that and figure out that we’re all the same, we all will react emotionally, and if they can conquer that, that’s one of the key roads to succeeding over the long term.
John Nyaradi: You’re a market historian and this book is over 600 pages just packed with data. As retail investors we hear, “Is this time any different, does history repeat, does it rhyme?” What’s your view of that?
James O’Shaughenessy: I think that history definitely rhymes. You have to remember that at the end of the day people will often say to me, “Well, you know, what use is looking at data from the 1930s or 1950s; the world is a completely different place?”
My response is always that the one thing that hasn’t changed is that human beings are the ones who price securities and we have not changed at all. So, you know, there’s a piece in the book showing the South Sea Bubble, which was an internet stock of Isaac Newton’s day, and you look at a graph of it, it goes straight up and straight down. Of course, Isaac Newton, one of the brightest men of all time lost a fortune and it caused him to lament that he could measure the motion of heavenly bodies but not the madness of men. But then right next to it, we have a graph of the NASDAQ 100 and guess what, they’re identical, they look exactly the same, and that’s because human beings were pricing those bubbles. They got inordinately excited about prospects for the investments. Those prospects didn’t pan out and, of course, they crashed.
What we have found is that there are good sound strategies that individual investors can use that work very well over time. I’ll give you an example. We have the ability to test investing in companies that are market-leading companies with sound financials and good economics that have high dividends. Well that strategy worked very well from the ’20s forward. It’s a fairly easy strategy to follow for the individual investor and it has paid, excuse the pun, wonderful dividends for the last 80 years.
John Nyaradi: You just mentioned that we’ve been through the second worst period since the 1900s. So should investors believe in stocks? I mean a lot of people have left the stock market, what do you think about this?
James O’Shaughenessy: I think absolutely they should believe in stocks. In the book, we covered the 50 worst ten-year periods since 1876, and the ten years ending February 2009 were actually the second worst ten years since 1876. The worst ten-year period was the one ending in May of 1920 so you had to go back a long way to get one that was worse. But what was more important to us than the damage that was done was what happened afterwards. So we looked at one year after, three years, five years, seven years, and ten years and what we found was really fascinating and very encouraging for equity investors. Once you get to the three-year mark, there are no negative numbers, not one. In any of these 50 worst periods, they are all followed for three, five, seven, and ten-year periods by excellent equity returns.
If you think about it, that makes a lot of sense. What happens after a horrible ten-year period? Valuations get compressed, PEs go down, and dividends go up. So investors find themselves in a position where the market itself is so much better priced for them to succeed and yet what’s holding them back is the fear that got generated by having to live through that rotten ten-year period so it’s a bit of a Catch 22. But what we’ve found was very encouraging in terms of equities. When you can look and see no negative numbers in 50 of the worst ten-year periods, that’s a very positive thing.
John Nyaradi: How about the bond market? People have fled to the bond markets in drove. What do you see there?
James O’Shaughenessy: I think that is classic investor behavior. What happens is investors run out of markets that have been disappointing and into the market that’s been doing very well, and traditionally that’s not a very good way to invest. I mean, think of the hapless investor who put all their money in tech stocks in the late ’90s and then that crashed and so they thought, well I’m going to put in real estate and then that crashed and then they put it in the bond market.
The thing about the bond market is it is coming off possibly its best 40-year period in history. What people don’t understand about bonds is that they can go down very rapidly, much like stocks if interest rates go the other way. So if we are entering a period where interest rates are going to go up, that pushes bond prices down. So I think that investors should be very wary of thinking that they have great safety in bonds when, in fact, historically, you can see that there have been 20, 30-year periods where bonds lost money on a real basis after adjusting for inflation. So I would be very wary of being in the bond market right now.
Instead, I would suggest that investors who are hungry for yield look to those high dividend stocks that we discussed a moment ago. Their balance sheets are in much better shape than the sovereigns are and we’ve kind of switched places here. You know, you have these corporations with the cleanest balance sheets that they’ve had in years and you have sort of government in disarray. I think that’s one of the things that investors will want to take or keep in mind is that the fact that bonds really have had, you know, an almost unprecedented rise. You can’t go below zero in the interest rate market. So when they’re rushing into the bond market, basically they’re rushing to something that is at or near the peak of where it’s going to be and they’re receiving very little compensation in the term of yields. I mean with the ten-year treasury well under 2% and when you get inflation back into the mix, that’s not going to be a pretty picture for individual investors.
John Nyaradi: In your book you have a dozen or so more different kind of strategies that people can use to analyze the market and then you mentioned that many strategies that people use are mediocre. Do you have a favorite strategy or a combination of strategies?
James O’Shaughenessy: Well, I have two for you. For conservative investors or people who are in retirement, the idea of finding market-leading companies with strong financial strength and good earnings quality that pay high dividends is an excellent strategy and fairly conservative. On the other end of the spectrum, one of the best things that we have found is marrying stocks that show great value characteristics like low PE ratios, low price to sales, etc, and then buying the stocks from that group that have great price momentum. That strategy actually proved to be one of the best performing of all the strategies. But the caveat that we like to issue there is it tends towards the smaller cap and mid cap space and it can be a lot more volatile. So it’s definitely a strategy for people who can stick with it when it’s not working and who have at least a five-year time horizon.
John Nyaradi: We’ve all heard various market clichés and one is the random walk. What’s your view on that? Is it random walk on Wall Street?
James O’Shaughenessy: It is absolutely not a random walk, it is a purposeful stride. You know in one of the chapters, we show what market volatility would have to look like if it was a random walk. What happens in the stock market is human beings price securities. Sometimes they get it very, very wrong and that’s a huge opportunity for those of us who have the patience and the diligence to go after those stocks that are mispriced.
John Nyaradi: This is the fourth edition of your book. The first one was in 1996 and now you can look back and the strategies that you outlined in 1996 walking forward in real time have actually outperformed and had good results. Can you just touch on that for a moment?
James O’Shaughenessy: One of the first things when we published the book was people said. “Well, you’re saying how to do it, it’s not going to work anymore,” and that has been very far from the truth. One of the things that we always want to underline for investors is there’s no single strategy that works all of the time. What you’re trying to find are strategies that work most of the time and work well and then you’ve got to make the bargain that when they’re not working well, you’re just going to stick with them. It’s the key of sticking with it.
The S&P 500 beats 70% of professionally managed mutual funds over any ten-year period and it does so not because it’s a great strategy, but because it never varies from that underlying strategy. It doesn’t wake up in the morning and say, “You know what, today I’m going to be a small cap index or today I’m going to be a bond index.” It just remains fully invested in those 500 large cap US companies and by doing so it puts time and history on its side. Time simply because of the compounding effects of your investment returns and history in that since the founding in the New York Stock Exchange, returns in the US have been positive 71% of the time.
But the key to it and the reason it beats the majority is because it doesn’t change. It sticks with it. So the S&P beats because it is a disciplined approach to investing. If you stick with other strategies in the same disciplined fashion, you can do considerably better than the S&P. As a matter of fact, in the book from one of the final chapters, we list all of these strategies by performance and what we see is the S&P comes in the bottom third of all the strategies we’ve tested. It’s beating that majority because it just stays the course.
John Nyaradi: I always like to end these conversations by asking if there’s anything else you’d like to add? Maybe one thing that’s maybe really on your mind right now? We’re talking in December of 2011, is there anything that people should be watching out for?
James O’Shaughenessy: Well I think we’ll end as we started. People have to watch out for themselves. Remember the Pogo cartoon that said, We’ve met the enemy and it’s us?” I think that the more people understand that it’s not just them who get emotional but it’s every human being. They’re proving it scientifically now with these brain scans and if we can understand that we all are going to have exactly the same reaction and then find a way to overcome that emotion, we’re going to succeed in investing.
I always say that the four horsemen of the investment apocalypse are fear, greed, hope, and ignorance and only one, ignorance, is not an emotion. The other three, fear, greed, and hope have wiped out more portfolio value than any bear market in history and the more people understand that, the more they’re able to get their emotions in line and understand that they’re not any different than anyone else. Everyone’s reacting the same. But if they can stay the course, they will succeed over time.
John Nyaradi: Folks, we have been talking to James O’Shaughenessy, chairman and CEO of the O’Shaughenessy Asset Management, previously managing director at Bear Stearns, bestselling author and widely recognized financial expert. At more than 600 pages, “What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time” is really like a Master’s Degree in finance or investing. It has received extremely positive reviews, it’s high on the investing and financial bestseller lists and all of that is certainly well deserved.
I’d like to add my humble endorsement to say it’s a very serious book for serious investors. Click on this link to learn more about “What Works on Wall Street: What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time.”
To learn more about James’s work, click here or just follow the link at the end of this interview. It has been wonderful chatting with you today, James. Thank you very much and thanks for joining us. I know we’re all looking forward to talking with you again soon.
James O’Shaughenessy: Thanks, John.
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(recorded interview, edited for clarity and length)
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