In the fourth edition of his bestselling value quant book 'What works on Wall Street', James O'Shaughnessy devised a new screen which is called "the top stock-market strategy of the past 50 years". Instead of focussing on a particular ratio, he ranks companies according to 5-6 ratios and then combines this with a momentum factor.
How does it work?
First the companies are split into 100 groups (percentiles) based on the following ratios:
- Shareholder Yield
If a company's price-to-book ratio is in the lowest 1% of the dataset, it gets a score of 1. For some ratios it's the other way around, for instance EBITDA/EV. If a company belongs to the highest 1%, it gets a score of 1. If a value is missing, it gets a score of 50. We repeat the same calculation for each of the ratios and then sum up these values. Companies are again divided into 100 groups based on this score. This final result is called value composite. A value composite of 1 means that the company belongs to the 1% cheapest companies according to these factors.
In a second step, we select the top 10% stocks ranked according to this value composite score. Then he filters these stocks by a momentum factor, i.e. the 6-month price index. The result is an extremely cheap group of stocks that have been on the rise during the last 6 months.
“Trending Value is the top stock-market strategy of the past 50 years.”
O'Shaughnessy tested 3 different value composite scores
- VC1: based on the first 5 ratios only, excluding shareholder yield. By using this ratio his backtests showed a return of 17,18% annually.
- VC2: based on all 6 ratios. O'Shaughnessy uses this ratio in his trended value screen since his backtests showed an improvement in overall annual compound return of 12 basis points to 17,3%, a reduced standard deviation, and downside risk.
- VC3: same as VC2 but the last ratio is replaced by buyback yield. Some investors are indifferent whether a company pays out a dividend or want to avoid these since they can be very heavily taxed. This VC generates an even higher return of 17,39% annually but with a slightly higher standard deviation compared to the VC2.
The trended value screener template is based on VC2, but you can change this very easily to use VC1 or VC2 by adjusting the primary factor.
While O'Shaughnessy recommends using the VC as the primary factor and then apply a value ranking, you can also choose to switch it around. Instead of starting with the VC, select the 20% stocks with the highest share price increase during the last 6 months and then sort these by one of the VCs. We have been using this strategy for our European and US newsletter portfolios and this has allowed us to find some real jewels and significantly beat the market.
In our glossary:
EBITDA/EVThis multiple is similar to Earnings Yield, but here we use Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) as Nominator). more...
O'Shaughnessy VC1Value Composite One (VC1) is a composite factor introduced by James O'Shaughnessy in the 4th edition of his book 'What Works on Wall Street'. more...
O'Shaughnessy VC2Value Composite Two (VC2) is an adaptation of the VC1 factor described above. more...
O'Shaughnessy VC3Value Composite Three (VC3) is another adaptation of O'Shaughnessy's value composite but here he combines the factors used in VC1 with buyback yield. more...
Price-to-SalesIn the original edition of 'What works on Wall Street', O'Shaughnessy wrote that the single-best value factor was a company's price-to-sales ratio (P/S). more...
Price-to-EarningsThis is undoubtedly the most popular value factor and for many investors the one true faith. more...
Price-to-BookP/B or Price-to-Book ratio used to find the value of a company by comparing the book value of a firm to its market value. more...
In our blog:
Which magic formula is the most popular<small>(Intro from the June 2014 edition of the systematic value investor newsletter)</small></p> Over the past 5 years we gathered quite a few screens and ratios. more...
New KPI : Value Factor One - BacktestThe problem with single-factor valuation ratios is that they move “in and out of favor” and can significantly underperform the overall market over any given 10-year period despite their long-term outperformance. more...
In our glossary :
Shareholder YieldShareholder Yield shows how much money a company is paying out to its shareholders through a combination of dividends and share repurchases to reduce the number of shares. more...
Buyback YieldShare buybacks have become very popular since the 1990s. more...