Jim O’Shaughnessy  05:11

Well, thank you, I have a really large need to share. I think that most investors go about investing in exactly the wrong method. And I felt that if I could publish a book showing, factually, what were the best metrics to look at, that I would be able to help a large majority of investors. And I also knew that human nature being what it is, that they might get very excited about it. But the moment it stopped working, they would abandon it.

I mean, I’ve seen this time and time again. I’ve had investors who have been with me for years, getting great performance, and then suddenly we have a bad year or a bad couple of years, which we’ve told them about ahead of time because we can always show them that nothing works all the time. So I didn’t have any fear of releasing all of this data, simply because I knew that human nature was such that the moment it wasn’t working, they would abandon it. And that’s exactly what we’ve seen.

We see that, for example, people are judged on the wrong periods. I’ll give you a good example. So there was one five-year period in our study, where sales growth just swamped the S&P 500. I mean, it was amazing. And it’s a good story to write if you were going to go into a pitch and you’d say, “The key is sales growth. Companies that are growing their sales are going to be the best out there and they’re going to become the biggest companies out there.” It would be pretty compelling.

However, when you look at the fullness of time, sales growth is one of the worst metrics to look at. It does worse than T-bills. So I knew that we had to have a long period to be able to see what truly worked over many market cycles. And yet everyone is almost always looking at not even five years, but three years. There’s very little information in three years. And so another goal with the book was to try to demonstrate to people that you’re looking at the wrong time frame. You need a much longer time frame to see the efficacy of whether something works or not.

Preston Pysh  07:31

So for anybody out there that has not read Jim’s book, I cannot endorse this book enough, to be quite honest with you. I rarely tell people that this is a mandatory read, but I will say that when you see the analysis, and the amount of work that Jim has put into writing this book, you are going to be floored. You’re going to be absolutely blown away. So I can make that recommendation unequivocally. Go out and get this book because I promise you, it’s going to help you understand investing a whole lot more. And Toby has something that he wants to piggyback on that comment.

Tobias Carlisle  08:04

I just wanted to add that when I first read it but used it as an encyclopedia and went straight to what works parts of it. And when I came to write “Quantitative Value,” I wrote it without the benefit of having read the first part of the book. I went and got the newest edition of “What Works on Wall Street” when it came out and I read the very start of it. And I really wish that I’d read that before I wrote “Quantitative Value,” because I think that it encompasses everything that we discuss in “Quantitative Value,” and it does it in a readable way.

And I think that instead of buying “Quantitative Value,” you could just read the first portion of “What Works on Wall Street” and you get all of the same ideas that we were trying to cover in “Quantitative Value,” the ideas of the sort of having some humility towards the application of the process and relying on the process, and the reasons why you might want to do that because you make behavioral errors and we have cognitive biases.

Jim O’Shaughnessy  08:50

And I will also recommend your book, which I love. I think that the more you read this type of information, the more it sinks in And I think that we all should be able to look at the market you put it a little differently than I do, Toby. But the more you read the books that explain why this works, what it comes down to is human nature and our biases, which are very difficult to overcome.

Preston Pysh  09:20

We had Wes on the show, and he had a fantastic comment about basically front running expectations and how you can do that with value. But it’s exceptionally hard to do it with the quality metric, which a lot of people try to balance that value piece and the quality piece because they’re trying to take after Warren Buffett.

But Wes talks about how the quality piece is very hard for people to basically front run that expectation where they’re prone to do that, or who punish companies more in the price. And that’s easier for value investors to capitalize on. And Wes had a fantastic discussion on that. If people want to go back and listen to our second part interview with Wes Gray, he does a fantastic job explaining that idea.

But instead of focusing on that, I want to get to a question here for Jim. So you start off your book with this amazing quote. And I just love this quote that you have at the very start of the book. And then the quote reads, “The Chinese use two brush strokes to write the word crisis. One brush stroke stands for danger, the other for opportunity. And in a crisis, be aware of the danger, but recognize the opportunity.” And I just love this quote. I think it’s very fitting for the current market conditions just because things are getting a little interesting out there. And so I guess my question for you, Jim, is what opportunities do you think are out there today? And what new opportunities do you see really presenting themselves over the next year?

Jim O’Shaughnessy  10:47

Within the United States, we’re still getting excellent results, buying cheap companies with high shareholder yield, where they’re buying back their company’s stock. I would say, gingerly,  international markets, and emerging markets, they’ve gotten tremendously cheap. For those bold enough to have a five-year time horizon, now is a good time to be looking at those opportunities.

Preston Pysh  11:13

Jim, when you say that they’re cheap, we’re comparing that relative to interest rates, which we have. I mean, my personal expectation is that if the Fed does raise rates, they’re going to do it at such a minuscule level, and they’re not really going to be able to do it much more for a significant period. So that’s really the predicament. That’s where everyone in our audience is really concerned is, how long can they keep these interest rates low like this? And does that mean that these companies are actually maybe buying at a high price point because interest rates aren’t going to be able to adjust then this thing’s unraveling itself because of all the pressures we’re seeing overseas?

Jim O’Shaughnessy  11:50

Well, you saw what happened when the Fed failed to raise rates the markets sold off. The markets are expecting and anticipating the Fed to raise rates this year. And I’m not so certain that it will just be a minuscule adjustment. I think that basically, the Fed could send a message that the US economy is strong enough to normalize interest rates. Several things happen when that happens, the dollar goes up, making the emerging markets and foreign markets easier to export to the United States. So in a manner of speaking, I think that sort of ringing the bell and saying, “Hey, the US market is very strong right now. We’re growing very well. Let’s renormalize.” I think that if that happens, then it’s very helpful for both international and emerging markets, from an export point of view.

Stig Brodersen  12:47

Both Preston and I, and Toby, we read all the same books. We read everything that we could about Warren Buffett who was really big on the microeconomic factors. But recently, given the current environment, we will be looking into some of the metrics and factors. And it seems like it’s also something that you are paying attention to.

Jim O’Shaughnessy  13:04

Well, we pay attention to it. We don’t let it influence our models, right? So we use only data to inform our opinions. For a good example of that was in March of 2009, I wrote a paper called a “Generational Buying Opportunity.” And of course, all I heard was crickets. And I wrote that paper, not because I was insightful in terms of a market bottom. I wrote that book because all the data I had available to me said that we were at an inflection point, the 10 years ending February 2009, were the second-worst 10 years since 1870. And as quants, what do we do? We go back and look at all the other 50 worst 10 year periods and find out what happens afterward. Well, if you remove one year afterward, and you look at 3,5, 7, and 10-year returns, all were positive. We believe in probabilities, not possibilities. So that data was saying to us quite strongly that the probability of this occurring again was quite high, and thus the paper. So while we’re aware of macro events, we never let them override any of our models.

Preston Pysh  14:22

So Jim, your argument about being easier for foreign countries to succeed because the dollar is getting stronger. When we look at the US companies, it’s becoming harder for them to increase their top line and subsequently their bottom line because now the dollar is so much higher. And when we look at how much revenue is being produced by outside sales, and it is a huge portion of the top line and all these US companies. So as we look at that dollar, getting stronger, the Fed raising rates, and knowing that investors that are in the US are trading off a multiple of that earnings. If we see those earnings go down  my impression moving forward is that the US stock market is going to have a lot of trouble moving forward, especially going into the third quarter. I’m already hearing a 5% decline in top-line revenue in the third quarter.

So in the short term, and I know you don’t like to talk short term, but in the short term, do you see the US equity market really having some difficulty?

Jim O’Shaughnessy  15:24

You know, actually, I will be honest with you and say, I have no idea. I can tell you that we did a study looking at rising rate environments. And what we found was that high shareholder yield companies continued to do well, dividend companies did not do as well. So if that unfolds, as I think it might, we would tell investors to focus more on shareholder yield, which includes buyback and dividend and not just dividend alone.

Stig Brodersen  15:56

Just to follow up on this. Before, Jim, you also said that you pay attention to macroeconomics indicators. But if you don’t then override the models that you are having, I also guess that you must include the macroeconomic factors like the interest rate, for instance, in your models.

Jim O’Shaughnessy  16:11

We do not include interest rates in our models. We do test in various environments how our models perform. So we have information available for rising rate environments, declining rate environments. We have models tested against a stronger dollar, weaker dollar, but we’re just doing that so that we can anticipate how our particular models are going to perform during that environment.

Stig Brodersen  16:39

Jim, I have another question after reading “What Works on Wall Street.” You talk a lot about rebalancing. Basically, that’s the premise that we’re working with because we want to rebalance into say the cheapest decile at price to earnings so the cheapest decile in price to sales. Now a cost that would occur if you’re using that strategy is that you will have to pay commissions, you have to pay spreads, and so on. There’s always some transaction cost of doing that. So how do you access that? What is the optimal frequency if you think about that you getting a higher return, rebalancing frequently at but also higher costs?

Jim O’Shaughnessy  17:16

Well, we use something we call dynamic rebalance, and we do it monthly. Now obviously, as a firm that’s managing billions of dollars, our cost structure tends to be considerably lower than an individual investor. But we think that the dynamic rebalance allows us to get into higher conviction names.

So for example, if Seagate Technology shows up in all 12 sleeves, it ends up being like a 5% portion of the portfolio. Conversely, if a name only appears once and then no longer appears it’s de minimis in the portfolio. We have found this to be extremely helpful, in terms of having the ability to both have higher conviction in certain names, but also lower conviction in other names.

For an individual, I think there might be some firms out there that they could use, I’m thinking of some of the Robo advisors. But monthly rebalancing a strategy we have found to be optimal.

Tobias Carlisle  18:21

I think MATIF offers a similar service where it’s very cheap to rebalance in a very small portfolio, though, by fractions of shares. So I use that just to test little strategies all the time. You can see a tiny little portfolio and then you can play around with it as much as you like. I don’t get any money from pitching that back to our regularly scheduled programming.

Preston Pysh  18:44

So that’s some really interesting information there. We’ll definitely have more about MATIF in the show notes,   describing what it is and also the links to this, if people are interested in learning more. That’s awesome.

Tobias Carlisle  18:55

Jim, your son Pat, has been doing some incredibly interesting research that I’ve been following really closely. I think he’s sort of picked up where you left off in the book. He’s doing it in a live way on his blog, “Investor’s Field Guide,” which will provide a link to. I find it really interesting that it is very difficult to internalize some of these concepts for investors.

You were saying earlier that you’re happy putting that stuff out, because some will read it and then short soon enough, afterward, they abandoned it in favor of something else. That’s certainly not what Pat does. He’s stuck with it. And he’s doing I think, some of the most interesting research out there at the moment, and he does it in real-time. That’s what makes it so useful. I just wanted to know how you instilled in him that same ethos that you’ve got in a book. I’ve got little kids, I’d love them to sort of doing that.

Jim O’Shaughnessy  19:27

Well, I did it by never telling him what to think. I did it by teaching him how to think. There’s a big difference there. And  Patrick graduated from Notre Dame with a degree in Philosophy, which I think was one of the best degrees he could have ever taken because it taught him how to think.

Patrick always says that I was an incredible mentor to him, but that I never talked about things like price to sales or how to combine them to a better thing. He said he was struck by something I told him when he was 10 years old. And I said, “The reason why our type of investing works is that we were deterministic thinkers in a probabilistic world.” And he said, “Of course, at age 10, I had no idea what you were talking about. But as I got older and thought about that quote, it made me really realize that life is probabilities. And what you need to do to succeed is understand that and study what has the highest probability of success, and then go with that.”

20:57

What’s interesting is I grew up in a family business where they pressured me, they really wanted me to work at this company. It was an oil company. And so one of the things that I did was do the opposite. I never told Patrick that I wanted him to work in finance. I told him he had to find what his own passion was. And that way he would have a very enjoyable life. And sure enough, he got out of Notre Dame coming into OSAM as an intern. And it was funny because I said I went to one of my senior guys, and I said, “Patrick has an end date. It’s January 1 of 2008. And that’s it. We don’t want any nepotism.”

About two weeks later, the director of research and the president of my firm come into my office and they go, we have to hire him. So I thought that in those two weeks, he showed his mettle, and as you say, the work he is doing right now is just incredible. And it’s all for free all at “The Investor’s Field Guide.” And really it demonstrates to me something that I have always found important. You’ve got to learn how to look at things in a way that others don’t. There’s a conventional approach to looking at things. And Patrick has a real gift for saying, “Well, what about this? How about looking at it this way?” So I couldn’t be prouder of the work that he’s doing. And you know, he’s a principal and a Senior Portfolio Manager at the firm, and he’s earned every bit of it.

Preston Pysh  22:33

That’s awesome. I love that story. And I love the fact that this is your son that we’re talking about. We’ll definitely have a link. So for people, if they want to learn more about Patrick and the work he’s doing, we’ll definitely have that in the show notes as well.

So, Jim, I’ve got a question for you because one of the things that Stig and I have seen in our audience is this huge interest in this quantitative value investing approach. And so if people are getting ready to implement this approach,   stepping away from maybe the Warren Buffet style and definitely stepping more towards this quants approach. What are the two biggest mistakes that you find a lot of investors make whenever they start doing this mean reversion style value investing strategy?

Jim O’Shaughnessy  23:15

Well, I think the first mistake they make is they have never given it enough time to work. And you know, the minute you’re looking at your portfolio daily, you’re doomed because you’re just not going to be able to stick it out. The second mistake they make is if, and this sounds odd, but if it works for them brilliantly for the first like six months, nine months, 12 months. They’re going to walk around strutting around like a peacock saying, “Oh, I know how to do this. This is fantastic.” And that sets them up for the failure.

The amount of time truly is the thing that I think is the greatest failure. I’ve mentioned earlier about the stocks with the high sales growth having a great five year period. What I would advocate if they have access to tools where they can test things over a long period, look at the long period that this particular strategy that they’re using has and look at its ups and downs. Follow a strategy that has a fabulous long term track record, and wait for it to have a bad six month or one year period, and then implement the strategy. It’s the exact opposite of what most people do and yet it works well.

So not focusing on having enough time, number one, and lacking the patience to let the strategy work. And then finally, not having the courage to see a strategy that has done very well let’s say over the last 10 years, and has done horribly over the last year. Having the courage to go in and buy it that.

Preston Pysh  25:00

I just have a quick follow up. And I know this wasn’t something that we were planning on asking you. I’m just curious. You’re really the leading expert in this and you really initiated this whole field of study. But who else out there do you really admire that are doing this? If you could name two or three people that are taking on this quantitative approach, that you really admire and you’re quick to try to read anything that they come up with.

Jim O’Shaughnessy  25:22

Sure. Cliff Asness at AQR, the folks at LSB and then finally, not particularly quaint, but I love the way he thinks and it would be David Dreman. He talks a lot more about why as human beings we fail in investing. And then Joel Greenblatt would be another one that I would have people read. His models tend to be a little more simple than ours, but a great read.

Stig Brodersen  25:51

So going back to “What Works on Wall Street,” and I gotta admit, James, I was a bit late to the party. I actually read it within the last few months and the reason why I did that was that Toby forced me to. It’s a very interesting way of distributing books nowadays.

So all joking aside, I had this great chat with Toby. And he said, “Someone you should really get on the podcast that would be Jim O’Shaughnessy and you should really be reading ‘What Works on Wall Street’ first.” So, I bought it. I got home and it was really, really big. And as Jim said, just before we started the interview, you could also use it as a weapon. So it was a big book. And I’m still just *inaudible because I just saw the table of contents. Saw it as this is the best strategy. So I probably looked up on page 500. And so yes, I should do value factor one.

So what you actually doing was you were combining multiple value factors into one single factor. You’re not only looking at price to earnings, but you’re looking at price to book, price to earnings price to sales, so on and then combining it into one. Could you tell us about that process, but also how I can apply that as an investor?

Jim O’Shaughnessy  27:06

Sure. What we found when we were doing the previous editions of “What Works on Wall Street” was that the horse race always was changing, depending on what your end date was. It was either price to sales as the best single factor. More data and different end date, it turned out to be EBITDA to enterprise value.

And so I got the idea after reading a paper. What they did was they combined a couple of factors and they referenced me. I thought, well, what would happen if we put together all of the really popular value factors? And what happened was that we found that by combining them, and then ordinarily ranking them at the average of all of them, we could outperform any single value factor 82% of all rolling 10 year periods. Because what happens is, it’s just like anything else, things fall in and out of favor, right? So one thing I like to say is when you see a lot of academic research on a single factor, expect that factor to failing over the next five years, why not just put them all together, equal weight them, average and get a better picture of the true value of a stock?

You know, sometimes you’ll see a company that has a super low PE ratio, but it’s bad on every other factor, right? It’s got a very high price to sales ratio, very high on all of the other value factors. And by combining them that allowed us to see through.

Tobias Carlisle  28:42

In addition to combining value factors, you combine momentum with those value factors, you do it in two different ways. You have one that’s predominantly value with some momentum, and then you have a predominantly momentum strategy that has some value in it as well. Can you talk about when you examine those two strategies to sort of characteristics of the behavior of those strategies? And do you do them long, short as well?

Jim O’Shaughnessy  29:05

For momentum, for example, we found that by including volatility in our momentum composite, we could significantly reduce the volatility, but still take advantage of the momentum signal. One of the big problems with momentum is it’s very, very volatile. And so we thought, well, let’s add a volatility index and focus on the companies that are doing very, very well, but aren’t bouncing around a lot. So there’s an example of how we tried to correct the problems of momentum, after what we call almost a catastrophic bear market, which is a drop of 50% or more, momentum inverts. And all of the stocks with the worst momentum do very, very well. And all of the stocks that had been doing well during the crisis tend to do poorly.

Preston Pysh  30:01

How much of that correlates to today’s conditions, Jim?

Jim O’Shaughnessy  30:05

I think not very much. I think that we are in what I would call a normal market environment, where people freak out when they get their 10% correction, which we’ve just had, but you don’t remember the last one, which has happened in 2011. 10% corrections are, as a rule, a feature, not a bug. What’s different, though, of course, is how human beings behave. Everybody says, “I’m going to get back in the market. It’s just I’m waiting for that correction.” And then the correction comes, and they don’t buy.

Preston Pysh  30:37

So the one question that I got is really moving forward, the question I asked a lot of bulls at this point is, where’s that growth going to come from when we look at the upside and what that might be? And just so you know, to have some context, I’m a huge bear in current market conditions. I’m curious if you are a bull, where are you seeing that growth coming from? How are these companies actually going to increase their top line and subsequently their bottom line, whenever we’re in a condition where the dollar is really going to only get stronger if the Fed does make that decision to act? And even if they don’t, it seems like external forces are going to continue to put that pressure into the market. So I’m curious where you’re seeing upside outside of buybacks for companies to increase their EPS.

Jim O’Shaughnessy  31:20

We’re very rarely either extremely bullish or extremely bearish. And that’s because we think for the long term, and we also realize that our ability to forecast what’s going to happen over the next quarter over the next six months is nil, right? We know how little we know. The power of I don’t know is very good. And it allows people to focus on what their true goals are. So I don’t know what the market is going to do over the next quarter or half-year. But I do know what the market is going to do over the next 10 years, and I think it’s going to do very, very well. So the problem is unless circumstances are just so catastrophic like they were in March of 2009, or so euphoric. So we tend to just have a normal, even-keel approach to looking at investing. Do we try to remind all of our clients that what is your time horizon? That’s what you need to focus on.

Preston Pysh  32:22

Would it be safe to say that when you look at equities versus bonds at this point, you’re really seeing equities with about a 4% yield over the next 10 years in fixed income 10-year treasuries around 2%? Is that… you’re seeing that spread, and that’s why you’re still bullish on equities? Would that be a safe assessment?

Jim O’Shaughnessy  32:38

That’s a fair assessment. I think that… I also wrote another paper that didn’t come true, which was a generational selling opportunity for long bonds. I wrote that a couple of years ago, and ultimately, we are very bearish on bonds, particularly long bonds. We think that investors who are not over the age of 50 have never experienced a bearish bond market. And I’m 55. So I remember interest rates of 14%, 15% in the early 80s. That was, I guess, 35-40 year bear market in bonds.

Bonds are math. Interest rates start going up, holders of the current bonds are going to experience price declines. I think that in terms of a 2% yield on the 10 years and get a 4% yield on equities, I’m willing to take the risk on the equity side.

Preston Pysh  33:30

Fantastic. One of the most important questions we’d like to ask our guests is what books have really had the biggest impact on your investing career. And if you could just name a couple of those books and why they had such significant meaning to you, that’d be really awesome.

Jim O’Shaughnessy  33:44

Sure. Well, “Reminiscences of a Stock Operator,” the thinly veiled story of Jesse Livermore is as true today as it was when it was written. The quotes in there are incredible and they apply so much much today as they did then. A cautionary tale, Livermore ended up committing suicide in the Sherry Netherland Hotel in the men’s room, because he could not follow his own systems with a rigorous and unemotional approach.

Obviously, Ben Graham, I think you should read all of the stuff Ben Graham has ever written. He’s really the father of value investing. He was also the first to take a systematic approach to say, “Let’s get a checklist. Let’s make sure the stocks have this, this and this and then we’ll buy. If they don’t have all those things in place, we’re not going to buy it. We’re going to be patient, we’re going to wait.”

Stig Brodersen  34:42

I really, really love that you’re saying that James. And I think it’s such a strong point that you need to be humble. I think that the worst investment books that you can probably get are those investment books that really make you think that you’re smart. And I think that’s one of the problems with a lot of beginning investment groups that you think that after reading that book, you really got that figured out. And let me tell you, folks, no one investment book has everything worked out for you. That’s a painful lesson for all investors. And I would definitely suggest one of James’ book recommendations. That’s one of the first books to read when you ever start investing, just really to get humble. And really to get started on the right track.

Jim O’Shaughnessy  35:20

We always try to say that we are wise in the Socratic sense of knowing a little we know. And if you think that you’re smarter than the market, you are wrong. The market is always smarter than you.

Preston Pysh  35:35

And Toby, you even talk about that idea with Ben Graham really coming to that culmination right before his death, talking about that same idea were “Hey, I’ve just got to basically remove myself from this because I’m really the air at play. And I have to basically just do it off of pure data.”

Now we’ve seen Buffett obviously hasn’t implemented that approach, but it’s just a really interesting point that on Ben Graham, after he had written all this is basically, “Okay, you need to remove yourself and your biases towards selecting which metrics you like the most and really   leave it up to the data to close this down.” And Toby talks about that in “Deep Value” at the end of his book.

So, Jim, we can’t thank you enough for coming on the show. You don’t know how much this means to us personally. And I sincerely mean that it really means a lot to us for you to take an hour out of your day on a weekend to talk to us and just impart your knowledge to our audience.

For everybody out there listening, the name of Jim’s book is “What Works on Wall Street.” We highly encourage you to go out and get this book and when it arrives, you’re going to be amazed at how much knowledge and how much depth he has in this book. You’re going to be blown away, I promise you that.

Preston Pysh  36:42

Toby Carlisle, he has a website called the Acquirer’s Multiple. He has two books, “Deep Value” and “Quantitative Value ” also on the podcast. And you can see Toby’s brilliance with some of his questions as well. We just really want to thank both of you for coming on the show. And that’s all we have for you.

Stig Brodersen  36:56

Great, my pleasure. Have a great Sunday.

Preston Pysh  36:59

So that’s all we have for you guys this week, we really appreciate you tuning in. Make sure you check out our show notes so you can get a link to all these different topics and ideas that we were talking about. If you guys sign up on our list, you’ll get free book summaries that Stig and I do for each book that we read. They could potentially add a whole lot of value because you can cut out a lot of time on your reading. Our summaries are typically around five pages, we don’t charge anything for this. So just sign up on our email list. We don’t send any advertisements or spam through our email, we only send two emails every month.

Outro  39:48

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