If you want to beat the average, try what works on Wall Street: discipline

R.B Matthews

The Globe and Mail’s Strategy Lab, which pits growth, value and other stock-picking styles against one another, raises the essential question: What works in investing?

While there is never any shortage of opinions on this topic, scientific studies accessible to the general reader are few in number. A notable exception is James O’Shaughnessy’s book, What Works on Wall Street.

First published in 1996 to wide acclaim, 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 growth in earnings per share. Some of these strategies have worked well over time. Most have not. The fourth edition, which came out earlier this year, contains more data than previously and an improved format. All serious investors should read it.

Mr. O’Shaughnessy starts by laying out the framework for his thesis. He points out that, although investment results are unpredictable over the short run, it has been proven many times that, over longer periods of time, investing in companies based on the relationship of their market price to their economic fundamentals does pay off. Although most investment professionals underperform the market index, any disciplined investor who follows these strategies can far outperform the averages over time.

So why doesn’t everyone do this? Human nature gets in the way. We are hardwired to prefer listening to stories or following trends 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, sticking with winning strategies through thick and thin is far harder than identifying those strategies in the first place.

And just what are those winning strategies? Essentially, all you have to do is buy companies that are trading at low multiples of certain economic values – and wait for those multiples to revert to their long-term mean.

For the cognoscenti, the five key ratios Mr. 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 to enterprise value. Using a value composite of these ratios will yield much better results than will using just one ratio.

Long-term studies have also shown that even better results are obtained if you overlay on your value composite a screen for six-month price momentum. This last concept will be anathema to most value investors, who will choose to reject it, even while knowing that their rejection will likely result in lower returns.

Other parts of the book deal with the long-term returns investors have realized from investing in different business sectors, and which strategies are most appropriate for a particular sector.

Economics 101 teaches that when one business or sector produces above average returns, capital rushes in to finance competition for the outperforming businesses, which in turn reduces the profitability of those outperformers. That is not, however, what happens in practice.

Brands, patents and other factors provide to some companies an enduring competitive advantage, or economic moat, which allows them to outperform for many decades. Investing in these companies will result in higher investment returns. And not surprisingly, investors who restrict themselves to sectors such as consumer staples, where many of these companies are found, will generally outperform the broader market index.

Mr. O’Shaughnessy’s most interesting finding is not how to beat the market (although that is not without interest), but rather proving conclusively that the averages can easily be beaten.

His 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 adopt and stick to time-tested strategies based on rational methods for selecting stocks.

But very few will.