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Holly: Hi, welcome to the GuruFocus podcast. I’m here with Jim O’Shaughnessy. He is the CEO, CIO, Chairman, and Senior Portfolio Manager of O’Shaughnessy Asset Management. He is also the author of a very famous national bestseller, called What Works on Wall Street, and that has a thorough analysis of the best performing investment strategies since, I think, before the Great Depression. So it’s quite a feat. Hi, Jim, welcome to the program.
Jim: Hi, Holly. Thank you for having me on.
Holly: Great. Okay. Well, I wanted to ask you first-- we usually ask almost all of our guests how they got started in investing. Can you give us a little idea?
Jim: Sure. So when I was a teenager, I was fascinated because my parents and some of my uncles were very involved in investing in the stock market, and they used to argue about it all the time. And generally speaking, the argument went, which CEO did they feel was better, or which company had better prospects. And I kind of felt that that wasn’t the right question, or questions to ask. I felt it was far more useful, or, I believed at the time that it would be far more useful to look at the underlying numbers and valuations of companies that you were considering buying, and find if there was a way to sort of systematically identify companies that would go on to do well, and identify those that would go on to do poorly. And so I did a lot of research, and ultimately came up with the structure for the book, What Works on Wall Street. And by looking historically at how stocks with defined characteristics, things like high P/E, or low P/E, or high EBITDA to enterprise value, low EBITDA to enterprise value performed, historically, we got a good sense for how they would do going into the future. Now, of course, we didn’t have any sense for how they might do in the next month, or even the next year. But we had a very good sense how they would perform over long periods of time, and that’s the way that we invest today, completely un-emotionally. We base all of our investment decisions on very long-term tests, of a variety of factors that we combine to get down to the type of stock we’re looking for, depending on the portfolio’s objective. And one of the things that we really look at is the base rate for success.
Jim: And a base rate is just like a batting average. Essentially, how often did any strategy, historically, do better than its benchmark, and by what magnitude? And just as importantly, how often did it fail to meet its benchmark, and by what magnitude? And so we always wanted to find the strategies that had the highest win rate, sort of the most reasonable draw-downs. And what we found is that historically speaking, our real-time results are very, very similar to the ones we found in the tests that we ran. And we kind of believe that the reason behind that is that we are very unemotional in our decision making. It is done sort of automatically by the models that we run.
Jim: And I may have an opinion on a stock, and hate that stock. But if it shows up in a model, we’ll buy it.
Holly: I was wondering about that because whenever people would seek to learn about how you do this, and maybe try and do this for themselves-- whenever you filter through for the stocks, do you then make a qualitative analysis of the stock company? Or do you go ahead and cut through the emotion with your process, and go ahead and buy it?
Jim: We do not do a qualitative analysis. We have found, through a variety of tests conducted by our firm, and many, many other firms, that essentially when you bring qualitative analysis into a well-diversified portfolio, your chances of going with your gut on a stock that has great numbers generally underperform. We used to play a game at my original company, O’Shaughnessy Capital Management, where we had a 50 stock portfolio. And I would ask my analysts, “Okay, so pick the 10 stocks that you think are going to do the best, and pick the 10 you think are going to do the worst.” And I think you can probably see this coming a mile away, the ones that they picked as the worst performers ended up being, most times, the best performers, and the ones that they picked as the best did very poorly. And that’s just human nature. If you understand behavioral economics or psychology, you know that we all suffer from something called the recency bias. And that simply means we recall much more easily that fact that we recently came across. And when you’re looking at these stocks and trying to make a decision emotionally, or qualitatively, typically you’re drawn to the stocks that you might have just read something really positive about that name, and you’re drawn away from the stocks where you might have read something negative. What we’ve found is that sort of point in time is useless in trying to make a good long-term decision. So we don’t do qualitative analysis at all. We strictly go with probabilities. But importantly, we understand that if we’re buying, say, 65 stocks, that a certain percentage of them just aren’t going to work out. And we’re okay with that, because if more work out than don’t, we can do better than our benchmarks over time, and that’s what we’ve seen happen.
Holly: Nice. That is very interesting and seems to do something kind of going against the grain of, well, definitely going against the grain of what is human nature. And so you’re also speaking at the GuruFocus conference, I believe, coming up, during Warren Buffett (Trades, Portfolio)’s shareholder meeting.
Holly: And I looked over your presentation, and a lot of the intro is about the biases that we experience. And you talk a lot about not predicting markets. I think you said that 50%-- you did a study, and 50% of prognostications did not come true from famous market investors, but I’m wondering--
Jim: Yeah. And that’s being generous. Many studies, particularly those done by an author named Philip Tetlock, found that you actually were better off having a monkey flip a coin, determining on which forecast was going to work, and which wasn’t. And yet, the problem is that’s one of the basic problems of human nature. We are, by our very nature, story-loving animals, and we create stories to create narratives that help us make sense of what is going on around us in the world, and many times, those stories are wrong. And so from our perspective, trying to make a successful forecast, short-term forecast, is a virtual impossibility, because, in the short term, there’s quite a bit of noise in the marketplace. And people mistake noise for signal, and they have a narrative about it, and it’s very believable, but unfortunately, often wrong. So we don’t make forecasts in terms of what the market’s going to do over short periods of time because quite frankly, we don’t know. And if others were honest, they would have to admit that they don’t know, either. However, we do make forecasts based on very long-term time in the market.
Holly: That’s what I was wondering.
Jim: Since the founding of the New York Stock Exchange in the late 1700s, US stock returns have been positive 71% of the time, negative just 29% of the time, and that’s a great probability to have on your side.
Holly: I see. Yeah, I was wondering, from a quant perspective, I believe that you talk about seeing what works during different time periods. Does this time period look like any other time in history? The way that you thought stocks would go up after 2009 because they tended to go down after about 10 years, I believe, or after 10 years, they would start to go back up, so--
Jim: Yeah. Well, one of the things that we published was, I guess you could see it as a forecast, it wasn’t really meant as one, it was simply an observation. What we did was we looked at the 50 worst 10 year periods for the stock market, going back to 1871. And the interesting thing that we found when we wrote that paper was that the 10 years ending February 2009 were the second worst 10 years in more than 100 years. More important to us, though, was what happened afterward. And we believe strongly that markets are mean reverting, and that investors always go to excess, both to the upside and to the downside. And so we looked at the periods where we had the information for. What happened one year later, three, five, seven, and 10 years later? And what we found was very illuminating. We found that in all 50 of these periods, when you got out to three years, there was not a single negative return. In other words, the market-- when you’re looking at that really intensely poor performance, typically what happens is the market has way overdone it, and it reverts back to the upside. So we’re still in that cycle right now. The end of that 10 year period happens in 2019, and we think that the market has demonstrated that upward trend that we believed would happen beginning in March of 2009. We think that right now markets are, especially in the United States, probably pricey. It wouldn’t surprise us at all if there was a correction.
Jim: There’s a whole group of young investors, who, if they started after 2009, have never really experienced one, or if they did, it was short. And we look at corrections as buying opportunities, because it’s always better to pay less and hopefully, over time, get more. And unfortunately, corrections tend to put fear as the central emotion in investors’ minds, and so we always sort of are amused by those who say, “Well, if the market goes down, 10, or 15, or 20%, then I’ll buy.” Well, that invariably happens, and we find no one buying, [laughs] because they’re very frightened at the-- again, that’s that recency. But we definitely think that if you’re a long-term investor, i.e., you have more than five years, stocks are the best place for you to have your money invested.
Holly: And one of the critical things to understand about your book, for people who are listening, is that you found that one particular ratio does not have an advantage over a composite of ratios.
Jim: Yeah. That’s absolutely correct. And so in my original book, which was published in 1996, so a long time ago, we looked at the ratios as very separate. And we came to understand that it’s always a horse race, and it depends on when you’re doing your research, which ratio comes out as the top dog. So we began experimenting with using several ratios together in a composite. What we found was that we got a much better sense-- so let’s take value, for example. A lot of people, when they think about value, they think about P/E ratio, or price-to-book ratio, or something like that.
Jim: We don’t think about it that way. The way we think about it is, we rank stocks on a variety of variables. So, for example, our value composite uses price-to-sales ratio, it uses EBITDA to enterprise value, it uses price to earnings, it uses free cash flow to enterprise value, and it uses shareholder yield, which is dividend yield plus any buyback yield. We find that this multiple-pronged approach to value which, if you think about it, really covers the balance sheet from top to bottom, offers us a much better assessment of which stocks are true values, and which are not. One example, in 2007 or 2008, Citibank, for a classic deep-value investor, would have looked really appealing, because it had scored-- it had one of the lowest P/Es, it had a super high dividend yield. But on the overall value composite, it had some problems. What’s more, we also add to value things like quality, and financial strength. The thing that knocked Citibank out for us was it had the worst financial strength of any of the stocks that we were looking at. So we think that we’ve advanced-- I guess we would call this What Works on Wall Street 3.0-- by combining these various composites, and looking at also things like financial strength and quality, you get a much better sense for the overall attractiveness of the stock than you would by looking at any one specific variable.
Holly: And one of the things that I noticed that was new about your book, in this edition, is that you had replaced the P/S ratio, which you used to call the, quote, “king of multiples,” with the EBITDA to enterprise value. You said that that was more important, and I’m wondering why you did that. And also because I’ve heard Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) discuss why EBITDA is a meaningless term, so can you explain a little bit about that?
Jim: Sure. And that goes to what I was saying earlier about why we moved from a single ratio to many in a composite.
Holly: I see.
Jim: And look, we are simply making our assessments based on what the data tells us.
Jim: So we’re not saying that EBITDA to enterprise value is the one that is the best. What we’re saying is, at the time we were writing the book, it had done very well over the previous, say, 10 or 20 years. Much like when we wrote the earlier books, price-to-sales had been the one that had done the best over the previous 10 or 20 years. That was the very reason why we included and came up with the value composite, because we understood that had I been writing the fourth edition now, it might be a different ratio, right? It might not be EBITDA to enterprise value, it might be price-to-sales again, or P/E ratio. So one of the things that we tried to make clear in the book was, yes, on a stand-alone basis, at that point in time, EBITDA to enterprise value was working better. And I think that Buffet’s comments and Charlie Munger (Trades, Portfolio)’s comments may be misinterpreted because the way we look at it, this is a very valuable ratio. We would never use it alone, right, because we’ve graduated to using all of these variables together, and we found that that works so much better. But it certainly deserves a place in our composite, whereas, for example, something like price-to-book does not. So there’s a lot of large investment firms and indexes that use price-to-book to determine value. And one of the things that we found in this edition, where we got the data from the Chicago Center for Research and Security Prices, that went back in the late 1920s, was that price-to-book, between 1927 and 1963, where our original data began for the earlier editions of the book, didn’t work at all. And, in fact, it was inverted. The lowest price-to-books had the worst performance, and stocks with the highest price-to-books had better performance. And, of course, when you think about that, it makes a lot of sense, because we had the Great Depression in the ‘30s. And another thing that you could think about, price-to-book, is as a proxy for chance of bankruptcy. If a company is trading at a very, very low price-to-book, what it really is signaling, in normal times, is potentially it’s cheap, but in extraordinary times, like the Depression, it’s saying this company’s going to go bankrupt, and that’s, in fact, what happened. As I read off the factors that we use in the value composite, you see price-to-book is not one of them. And that’s because, as the chapter on price-to-book in What Works explains, it just does not have the kind of consistency, over very long periods of time, that we really require before we will use a factor in any one of these composites.
Holly: That’s very interesting. Yeah, one of the things that I loved about the book is how you can see, over history, these concrete examples of what really is effective, and isn’t. And also, with the nuance in there of why we would understand things differently based on the short-term periods. So it was just fascinating to look at that.
Jim: Well, thank you.
Holly: Sure. And I was also wondering why you thought shareholder yield is so important? And what does that say about a company, because it seems like they would be giving away money, not reinvesting it? I saw that you really thought that was super important.
Jim: Sure. So there’s a couple of reasons. If you want to do a really deep dive as to why we like shareholder yield, I would point listeners to our website, which is OSAM.com, and under the commentary section, you’ll find a lot of papers that we’ve written about why shareholder yield works so well. And the reason we like shareholder yield has two components. Number one, we have found that historically, companies that pay a significant amount out to their shareholders just do better than companies who don’t, because they are also making a very disciplined choice. They’re saying, “Look, we can’t find any interesting investments that beat our hurdle rate, and so we’re not just going to just go and acquire other companies, or do capital spending if we don’t think that we can get over our hurdle rate.” And, as a matter of fact, in one of the studies that is included at the OSAM website, you see that companies that, what we call empire builders, those who go out and acquire a lot of other companies, actually do quite poorly. And the same is true for people who spend a tremendous amount on CAPAX. In our opinion, if we were just trying to explain it, that’s showing a lack of discipline on management’s part if they’re willy-nilly just doing a lot of capital expenditures that really don’t meet their hurdle rate. So we think that the shareholder yield, which is the dividend yield of the stock, or the cash paid out to shareholders, plus any net buyback activity that the company engages in-- historically, over the last 80 plus years, that is a strategy that didn’t fail to beat large stocks in any single decade, so ‘30s, ‘40s, ‘50s, ‘60s, ‘70s, and on, it did better. And the reasoning behind that is because it is sending the most cash back to shareholders. Now, we don’t just do shareholder yield, right?
Jim: What we want to find are very, very cheap companies, so the companies that score very well on our value composite, that have good earnings quality, and good financial strength, that are doing what we call significant buybacks, so 5% or more. We have found that companies who do buybacks that are expensive, and/or don’t have good financial strength, don’t do nearly as well as companies that are cheap, and have good financial strength and high quality. So we also adjust for any company that’s taking on debt to do a buyback. That’s a big no-no. We want to see companies financing buybacks through their existing cash on hand. So there are a lot-- like everything, right, there are a lot of nuances to the kind of company that you would be interested in, with a high shareholder yield. You’d want to see those other things present, as well. But the numbers are the numbers, and they are a stark reminder that what we often think should make sense, right-- like, boy, shouldn’t this company be acquiring-- you know all the stories about Apple (AAPL, Financial), why don’t they buy Tesla, why don’t they buy Tivo, or why don’t they buy Netflix, et cetera. Well, there’s probably a good reason for that, and that’s because the folks at Apple are looking at the hurdle rate, and they’re saying, “We don’t see where it fits.”
Holly: Okay. And we’re running low on time, but I wanted to get to ask you, is applying your strategy, or something similar to your strategy, something that a normal investor can do at home, or do you have to be this expert quant-nerd to be able to put all of this together?
Jim: I think that the most difficult thing about applying our strategies is having the emotional discipline not to override them, especially when they’re underperforming. And I think that that truly is the hardest thing. There’s all sorts of websites where you can run these factors that we’ve been discussing, in fact, several of them are called “O’Shaughnessy Value, O’Shaughnessy this.” And you can run that, and you can see the stocks, or you can buy them through a discount broker. So, no. To your first question, can investors at home do this? Absolutely they can, and the caveat that I would add is that, don’t fool yourself. If you lack the emotional fortitude to stick with it through thick and thin, you’re probably better off not trying to do it on your own.
Holly: Okay. And then, of course, invest with you, that’s what they should do. [laughs]
Jim: Well, I used to joke with people, if you don’t invest with us, then just index your portfolio. [laughs]
Holly: I see, okay. And lastly, what are some good stocks out there that you like right now?
Jim: Sorry to tell you, we don’t talk about specific stocks. We talk about strategies. But I can tell you that investors-- I can give you advice more globally.
Holly: Sure. That’d be great.
Jim: So investors should, if they don’t have an international or an emerging market component to their equity portfolios, they should have that. We think, and are big believers in-- we don’t want to steal my son’s phrase, “portfolio patriotism,” and most people do it. So most American investors only invest in American companies, most British investors only invest in UK companies. We think that’s a mistake, we think right now emerging markets look very cheap, and international markets have not done nearly as well as the US. So if you don’t have a global component, I would advise all your listeners to get one.
Holly: Awesome. Okay, well, thank you so much for your time. This has been great. I loved hearing more about-- hearing somebody talk about the concepts you established in your book. And again, we are on with O’Shaughnessy Asset Management founder, Jim O’Shaughnessy, and he’s going to be speaking at the GuruFocus Value Conference, so you can hear more from him there.
Jim: Thanks a lot, Holly.
Holly: Thank you.
Jim: Take care.
Holly: Alright, have a great holiday.
Jim: Really enjoyed it. You, too. Bye bye.
Holly: Okay. Bye bye.