Wednesday, November 16, 2011

O’Shaughnessy, What Works on Wall Street

I can’t quite fathom how I missed the first three editions of this book, but James P. O’Shaughnessy’s best-selling What Works on Wall Street: The Classic Guide to the Best-Performing Investment Strategies of All Time (McGraw-Hill, 2012) is now in its fourth edition. It has been updated with new data covering the recent market turmoil, innovative strategies for investing success, and new material on sector analysis. One of the advantages of buying a book that has a large readership is that it is inexpensive—under $25 on Amazon for almost 700 oversized pages.

Backtesting investment strategies is an enterprise fraught with danger, and critics are only too ready to line up to shoot holes in the tester’s methodology, sample size or timeframe, or to decry the value of statistics in general. I, by contrast, am grateful that anyone undertakes a task for which I am ill equipped. For those who believe that history provides a guide to the future O’Shaughnessy’s massive work is an invaluable reference.

Confronted with such a large, data-heavy book, readers will be tempted to skip to the penultimate chapter: “Ranking the Strategies.” But this lazy approach will probably yield little because it is important to understand why certain strategies work better than others and why multifactor models, especially those that “marry both value and growth characteristics, … will go on to offer investors the best absolute and risk-adjusted returns.” (p. 470)

O’Shaughnessy analyzes all the popular metrics—among them, market cap, P/E ratios, EBITDA to enterprise value, price-to-cash flow ratios, price-to-sales ratios, price-to-book value ratios, dividend yields, buyback yield, shareholder yield, and accounting ratios. He looks at one-year earnings per share percentage changes, profit margins, return on equity, and relative price strength. He dissects the market leaders universe and the small stocks universe and describes the ratios that add the most value in each case. And he looks at how the factors he has examined perform on the sector level.

What Works on Wall Street is not a book you read straight through unless you are a possessed numbers wonk. Rather, it’s one you pick at—and the pickings are by no means slim—and put in a prominent place on your reference shelf.

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