Investing – It’s All About Discipline

Longview Asset Management
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January 2013

At Longview, we spend a lot of time thinking more broadly about what works in investing. Happily, there have been, over the years, a number of excellent independent studies on this question. One of the better long term studies appears in the form of a book – What Works on Wall Street, by James O’Shaughnessy.

First published in 1996, this tome compares the returns, over the past several decades, resulting from about 20 of the best known investment strategies, such as buying only companies with a low price to earnings ratio or high historical growth in earnings per share. Some of these strategies have worked well over time. Most have not. The 4th edition of the book, which came out in 2012, contains more data than previously and incorporates an improved format.

O’Shaughnessy points out that, although investment results are completely unpredictable over the short run, they are highly predictable over time. Over longer periods, the ratios between the market price of a company and its economic fundamentals will fluctuate widely above and below a long term average to which it always returns. Value investing, which has proven to produce superior returns, is largely about taking advantage of this fact.

The five key ratios that O’Shaughnessy’s studies have identified are: price to book value; price to earnings; price to sales; price to cash flow; and earnings before interest, tax, depreciation and amortization (EBITDA) to enterprise value. Using a value composite of these ratios has proven to yield better results than using just one ratio.

Other parts of the book deal with the long term returns investors have realized from investing in different business sectors. For example, investments in companies in the consumer staples sector have outperformed investments in any other broad sector of the market. We learned in Economics 101 that when one business or sector produces above average returns, capital rushes in to finance competition, which in turn reduces the profitability of the outperformer. That is not, however, what always happens in the real world. Brands, patents and other factors provide some companies with an enduring competitive advantage, or economic moat, which allows them to realize higher profitability for many decades. So it is not surprising that investors who concentrate their investments in a sector where many of these companies are found, have outperformed the broader market over time.

So why doesn’t everyone do this? Human nature gets in the way. We are hardwired to prefer listening to a story or following a trend rather than studying numbers. And, even when we know intellectually that a strategy will do well over time, we will typically abandon it if it is not working in the short run. In fact, the discipline of sticking with winning strategies through thick and thin is far harder than identifying those strategies in the first place.

O’Shaughnessy’s long term studies demonstrate that, over time, the movement of stock prices does not resemble a random walk. It is, in his phrase, more like a “purposeful stride”. Investors can do far better than the market average if they stick to time-tested strategies based on rational methods for selecting stocks. At Longview, that is what we are paid to do.