What Works on Wall Street

The premise is that most investors trail the market because they act on stories and emotion, and that a fixed, tested rule beats judgment. O'Shaughnessy sorts the US stock universe into deciles by single factors, from price-to-earnings and price-to-sales to shareholder yield and relative price strength, compares each decile's return, volatility and consistency with the market, and then combines the factors into multifactor strategies.

O'Shaughnessy founded O'Shaughnessy Capital Management in 1988, launched funds on the first edition's findings, ran systematic equity at Bear Stearns Asset Management, and in 2007 spun out O'Shaughnessy Asset Management. This fourth edition (2011) extends some tests back to 1926, runs through 2009 and adds composite value, financial-strength and earnings-quality rankings.

The findings: most strategies are mediocre, the best single value factor depends on the period, combining several value measures gives better long-term results than any one, and the best strategies pair price momentum with a valuation hurdle. CXO Advisory's review flagged the caveats: returns are gross of trading costs, which hit small caps and high-turnover momentum strategies hardest; many combinations were tested on the same data; the scope is US-only; and much of the cited research dates from around 1990.

It is long and table-heavy. Read it if you build factor screens or rules-based portfolios.

1. Write the rules down. The central lesson is that a tested rule applied without exceptions beat most discretionary approaches over long periods.
2. Cheap beats expensive, on average. Low price-to-sales and low EBITDA-to-EV were among the best single factors, while the most expensive deciles were consistently poor.
3. Combine factors. Because the top single factor changes by period, ranking stocks on several value measures at once gave steadier results than betting on one.
4. Momentum needs a valuation guardrail. The strongest strategies paired price strength with a cheapness screen; buying last year's losers or richly priced high-flyers did worst.
5. Mind the frictions. Back-tested returns are gross of trading costs and come from many tests on one dataset, so expect live results, especially in small caps and high-turnover strategies, to fall short of the tables.

The fourth edition builds from method to single factors to combined strategies.

1. Why discipline wins. O'Shaughnessy argues that overconfidence and storytelling undermine investors, then sets out his data, his all-stocks and large-stocks universes and his method of forming portfolios and rebalancing them annually.
2. Single value factors. He tests deciles sorted on earnings, book value, sales, cash flow, EBITDA-to-EV and dividend and shareholder yield, and finds cheap stocks generally beat expensive ones, though no single ratio wins in every period.
3. Composite value. He ranks stocks on several value ratios at once and shows the composite gives steadier, better risk-adjusted results than any one ratio.
4. Momentum, quality and strength. He examines price momentum, earnings quality, measured through accruals and changes in operating assets, and financial strength, measured through debt levels and external financing, as stand-alone factors and as filters.
5. Multifactor strategies. He combines value, momentum and quality screens into full strategies, compares their returns, volatility, worst declines and how often they beat the market over rolling periods, and closes with advice on applying them consistently.

A major contribution . . . on the behavior of common stocks in the United States. --Financial Analysts' Journal The consistently bestselling What Works on Wall Street explores the investment strategies that have provided the best returns over the past 50 years--and which are the top performers today. The third edition of this BusinessWeek and New York Times bestseller contains more than 50 percent new material and is designed to help you reshape your investment strategies for both the postbubble market and the dramatically changed political landscape. Packed with all-new charts, data, tables, and analyses, this updated classic allows you to directly compare popular stockpicking strategies and their results--creating a more comprehensive understanding of the intricate and often confusing investment process. Providing fresh insights into time-tested strategies, it examines: Value versus growth strategies P/E ratios versus price-to-sales Small-cap investing, seasonality, and more