Getting the most out of equities

To get the most out of their equity investments, investors should let good strategies work. Don’t second-guess them. Don’t try to outsmart them. Don’t abandon them because they’re experiencing a rough patch.

Understand the nature of what you’re using and let it work. This is the hardest assignment of all. It’s virtually impossible not to insert our ego or emotions into decisions, yet it is only by being dispassionate that you can beat the market over time.

Since 1996, we’ve experienced the most tumultuous markets since the 1920s and 1930s. Stocks soared between 1996 and March 2000, creating a market bubble the likes of which we had not seen since the late 1960s and the Roaring “20s. This bubble led many investors to throw out the investing rule book. The more ridiculously overvalued a company was, the more it soared.

Everyone talked of “the new economy” and how it really was different this time. Sticking with time-tested investment strategies during the stock market orgy was close to impossible. Month in, month out, reasonably priced stocks did nothing while the overpriced “story” stocks soared. And as so often happens with stock market bubbles, just as the last sane investors capitulated and learned to love the stocks with the craziest valuations, along came the reckoning — all the previously gravity-defying stocks came crashing back to earth. Fortunes were lost and millions of investors lost their faith in the long-term potential of stocks.

What’s worse is that after stocks recovered from the bear market of 2000-03, a new bubble appeared in real estate markets and the debt used to finance them. This new bubble popped in an even more destructive fashion than that of the dot-com stocks earlier in the decade and brought worldwide markets close to the brink of collapse. We entered the worst bear market for stocks since the Great Depression.

Investors’ faith in equity markets was almost completely destroyed by the great market crash of 2007-09. The S&P 500’s loss of 37% in 2008 was second only to its loss in 1931, when it plunged 43%. People were literally hoarding cash, terrified to make any investment in the stock market. And much as the bubble years gave birth to the idea that things really are different from the way they were in the past and we had emerged with a “new economy,” the bust years also gave birth to the concept of the “new normal.”

To its advocates, the new normal means that future returns will permanently be lower than in the past and that there is nothing we can do about it. Investors were desperate to avoid risk of any kind, and money poured out of equities and into bonds.

OCCAM’S RAZOR

In markets moving from extreme speculation to extreme despair, believing in Occam’s razor — that the simplest theory is usually the best — is almost impossible. We love to make the simple complex, follow the crowd, get seduced by some hot story stock, let our emotions dictate decisions, buy and sell on tips and hunches, and approach each investment decision on a case-by-case basis with no underlying consistency or strategy.

On the flip side, when equity returns are horrible over a long period of time, we are far too willing to assume that stocks will never generate returns comparable to those of the past and we abandon them for less risky assets such as bonds and money market funds. No wonder the S&P 500 beats 70% of traditionally managed mutual funds over the long term.

To use a metaphor, the market is like the water, overpowering all who struggle against it and giving those who work with it a wonderful ride. But swimming lessons are in order. You can’t just jump in; you need guidelines. Our historical study suggests that to do well in the market, you must do what follows.

You’ll get nowhere buying stocks just because they have a great story. Usually, these are the very companies that have been the worst performers over time. They’re the stocks everyone talks about and wants to own. They often have sky-high price-to-earnings, price-to-book and price-to-sales ratios. They’re very appealing in the short term, but they’re deadly over the long haul. You must avoid them. Always think in terms of overall strategies and not individual stocks. One company’s data are meaningless, yet can be very convincing.

Conversely, don’t avoid the market or a stock simply because things have been bad over the short term. Few investors could see the compelling valuation of the overall stock market in March 2009, yet it was at this time that stocks were screaming “buy” and about to embark on a huge rally. At that time, if you had a simple re-balance strategy in place which allocated between stocks and other investments, the strategy would have forced you to buy more stocks.

Unfortunately, acting is hard, and acting in line with what you think is almost impossible. If you can’t use strategies and are inexorably drawn to the stock of the day, your returns will suffer horribly in the long run.

If, try as you might, you can’t stick to a strategy, put the majority of your money in an index fund and treat the small amount you invest in story stocks as an entertainment expense.

Investors who look only at how a strategy or the overall market has performed recently often are seriously misguided by their focus on the short term. They wind up either ignoring a great long-term strategy that has recently underperformed or piling into a mediocre strategy that has been on fire recently.

Tragically, investors seem hard-wired to focus inordinately on very short periods of time, often completely ignoring how the strategy has done over long periods of time. As investors, all of our information about returns is focused on extremely short periods of time. Just look at how much air time and column inches can be expended on why the stock market has gone up or down in a single day!

Over very short periods of time, the stock market is relatively impossible to forecast, yet when you extend your horizon, the market becomes far more understandable. If you look at the 50 worst rolling 10-year periods for the stock market, there is not a single instance when over the next 10 years, the stock market failed to go up.

The point is that at some time in the future, any of the strategies in this book will underperform the market, and it is only those investors who can keep their focus on the very long term who will be able to stick with them and reap the rewards of a long-term commitment. You always should guard against allowing what the market is doing today to influence the investment decisions you make.

ROLLING BATTING AVERAGE

One way to do this is to focus on the rolling batting average of how your portfolio is performing versus its benchmark. Much as we focus on the rolling base rates for all the stock selection strategies we have tested in this book, you can do the same for your portfolio’s performance versus its benchmark. When you look only at how your investment portfolio has performed for the last quarter, year and three- and five-year periods, you are looking at a tiny snapshot of time. Of course, this snapshot might delight you if you’ve done particularly well for that particular period, but it also might make you want to abandon your strategy if you’ve done poorly, relative to other strategies. In both cases, I would argue that these snapshots are misleading.

Let’s look at a snapshot taken on Dec. 31, 1999. An investor who had loaded up on pricey dot-com and tech stocks over the previous five years looks like a genius and was no doubt planning for an early retirement. Conversely, an investor who had played it safe during those same five years and stuck to small-cap stocks and large-cap-value fare would have been wincing with disappointment about his portfolio’s prospects. Yet both snapshots were misleading.

In a few short months, the tech-heavy portfolio went on to crash and burn, and the small-cap and large-cap-value portfolios began to soar.

By focusing on how your portfolio is performing against a benchmark over rolling periods, you get a much better sense of how you are actually doing. You will be much more likely to stick with a strategy that may be underperforming recently but has an outstanding win rate versus the market over all rolling periods. It gives you continuous feedback that allows you to take the hills and valleys with greater restraint than if you simply looked at a snapshot of time. It also gives you perspective by letting you put a strategy’s recent performance into a historical context. With this information, you are much more likely to be able to stay the course.

Finally, this advice is equally useful after sharp drawdowns for stocks. In March 2009, I argued that many investors faced a once-in-a-lifetime opportunity to purchase equities at valuations not seen since the early 1980s. I urged middle-aged investors to increase the equity allocation of their portfolio to 70% to take advantage of the fear that permeated the markets. For the most part, the response I got was silence. People were so shellshocked by the market declines over the previous 15 months that no amount of data would move them to take advantage of the situation. That’s why ignoring the short term may be both the hardest — and best — thing you can do for the overall health of your portfolio.

USE ONLY PROVEN TACTICS

Always focus on strategies whose effectiveness has been proven over a variety of market environments. The more time periods you can analyze, the better your odds of finding a strategy that has withstood a variety of stock market gyrations. Buying stocks with high price-to-book ratios appeared to work for as long as 15 years, but the fullness of time proved that it is not an effective strategy.

Many years of data help you to understand the peaks and valleys of a strategy. What’s more, sometimes a strategy might make intuitive sense, such as buying stocks that have the greatest annual gain in sales, yet a review of the long-term data tells us that this is a losing strategy, probably because investors get so excited by those huge annual sales increases that they overprice the stocks accordingly.

Using strategies that have not withstood the test of time will lead to great disappointment. Stocks change. Industries change. But the underlying reasons certain stocks are good investments remain the same. Only the fullness of time reveals which are the most sound.

Remember how alluring all the dot-com stocks were in the late 1990s? Don’t let the investment mania du jour suck you in — insist on long-term data that support your investment philosophy. Remember that there always will be current market fads. In the 1990s it was Internet and technology stocks; tomorrow it might be nanotechnology or emerging markets; but all bubbles get popped.

DIG DEEP

Make certain to test any strategy over as much time and as many seasons as possible. Look for the worst-case scenario, the time it took to recover from that loss and how consistent it was against its relevant benchmark. Note the largest downside deviation it had against its benchmark and be very wary of any strategy that wildly deviates from it. Most investors can’t stomach being far behind a benchmark for long.

INVEST CONSISTENTLY

Consistency is the hallmark of great investors and it is what separates them from everyone else. If you use even a mediocre strategy consistently, you’ll beat almost all investors who jump in and out of the market, change tactics in midstream and forever second-guess their decisions.

Look at the S&P 500. It is a simple strategy that buys large- capitalization stocks. Yet this one-factor, rather mediocre strategy still manages to beat 70% of all actively managed funds because it never leaves its strategy. Realistically consider your risk tolerance, plan your path and then stick to it. You may have fewer stories to tell at parties, but you’ll be among the most successful long-term investors. Successful investing isn’t alchemy; it’s a simple matter of consistently using time-tested strategies and letting compounding work its magic.

BET WITH THE BASE RATE

Base rates are boring, dull and very worthwhile. Knowing how often and by how much a strategy beats the market is among the most useful information available to investors, yet few take advantage of it.

KNOW THE ODDS

Base rates essentially are the odds of beating the market over the time period you plan to invest. If you have a 10-year time horizon and understand base rates, you’ll see that picking stocks with the highest multiples of earnings, cash flow, sales or the lowest value composite scores has very bad odds. If you pay attention to the odds, you can put them on your side.

Don’t settle for strategies that may have done very well recently but have poor overall batting averages. Chances are, you’ll be getting in just as those long-term base rates are getting ready to reassert themselves.

There is no point in using the riskiest strategies. They will sap your will, and you will undoubtedly abandon them, usually at their low. Given the number of highly effective strategies, always concentrate on those with the highest risk-adjusted returns.

Unless you’re near retirement and investing only in low-risk strategies, always diversify your portfolio by investing in several strategies. How much you allocate depends on your risk tolerance, but you always should have some growth and some value guarding you from the inevitable swings of fashion on Wall Street. Once you have exposure to both styles of investing, make sure you have exposure to the various market capitalizations, as well.

A simple rule of thumb for investors with a time horizon of 10 years or more is to use the market’s capitalization weights as guidelines. Currently, 75% of the market is large-cap and 25% is small- and midcap. That’s a good starting point for the average investor.

Unite strategies so that your portfolio can do much better than the overall market without taking more risk. While this book covers only stocks that trade in the United States, you might think about having your portfolio aligned in a similar fashion to the MSCI All World Index. Currently, the United States makes up 35% of that index, with Japan, the United Kingdom, France and Canada rounding out the top five. If you include the next five countries by market capitalization, Hong Kong, Germany, Australia, Switzerland and Brazil, you would cover 74% of the total market capitalization in the world. The point is, these strategies work outside the United States, as well, and a well-diversified portfolio should reflect this.

Additionally, you should have a plan for your entire portfolio, not just the equity portion. One of the simplest and most effective strategies for your entire portfolio is to re-balance your allocations to various styles and asset classes back to your target allocation at least once a year. Figure out what makes the most sense for you and then follow your allocation. This effectively forces you to buy more of an investment style or an asset class when it has done poorly, and take money away from styles and asset classes that have performed well.

If you don’t have the time to build your own portfolios and prefer investing in mutual funds or separately managed accounts, buy only those that stress consistency of style. Many managers follow a hit-or-miss, intuitive method of stock selection. They have no mechanism to rein in their emotions or ensure that their good ideas work. All too often, their picks are based on hope rather than experience. You have no way of knowing whether performance is due to the result of a hot hand unguided by a coherent underlying strategy.

Don’t bet with them. Buy one of the many funds based on solid, rigorous strategies. If your fund doesn’t define its investment style clearly, insist that it do so. You should expect nothing less.

USING HISTORICAL DATA

The most ironclad rule I have been able to find studying masses of data on the stock market, both in the United States and developed foreign markets, is the idea of reversion to the mean.

If the general market has enjoyed outstanding results over a 20-year period, we generally spend the next 20 years reverting downward to its long-term average annual return. If, on the other hand, markets have generated disappointing results over the previous 20 years, they go on to do quite well in the ensuing 20-year period.

The same holds true on the strategy level. When strategies that have historically generated abysmal results are on fire, it’s fairly easy to forecast that they will go on to do quite poorly.

If we look at history, every bubble ends the same way — very, very badly. When you look at the annual returns for richly valued securities, those with the highest price-to-sales, price-to-earnings, price-to-cash flow, and price-to-book near the end of the Internet bubble, you will see why investors were so enthusiastic — the stocks with the highest price-to-book value, for example, soared 127% for the 12 months ending February 2000, while those with the highest price-to-sales ratios advanced an incredible 207%, the highest 12-month rolling return since 1964.

Ultimately, however, the Internet strategy and all others revert to their long-term average.

In 2002, I forecast that returns for the U.S. market would be comparatively low from 2000 to 2020, since for the 20 years ending March 2000, the market had earned its highest real rate of return in history. Little did I know that almost all of the downward movement and mean reversion would happen between 2000 and 2009.

The key to forecasting, therefore, is to strip emotion from the analysis and understand that it’s not different this time. Markets and strategies always, ultimately, revert to their long-term average.

THE MARKET IS NOT RANDOM

Finally, the data prove that the stock market takes purposeful strides. Far from chaotic, random movement, the market consistently rewards specific strategies while punishing others. And these purposeful strides have continued to persist well after they were first identified.

Now we must let history be our guide, using only those time-tested methods that have proven successful. We know what is valuable, and we know what works on Wall Street. All that remains is to act upon this knowledge.

The preceding is an edited excerpt of the fourth edition of “What Works on Wall Street” (McGraw-Hill, 2012) by James P. O’Shaughnessy, chairman of O’Shaughnessy Asset Management LLC.

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