O’Shaughnessy impresses

Six years ago, New York money manager James P. O’Shaughnessy published a book entitled What Works on Wall Street.

It contains a wealth of information about stock market history and what it all means to investors. The book has earned a place on the shelves of many portfolio managers but a word of warning: it is extremely dense, packed with charts and tables alongside text that the lay reader may have trouble wading through.

A contributing editor to my Internet Wealth Builder newsletter recently read the book for the first time and was very impressed. He distilled O’Shaughnessy’s conclusions down to five basic points for our readership. Whether the author would agree with them is problematic; I spent a long lunch with O’Shaughnessy a few years ago and I can report from experience that he doesn’t like to simplify anything. But here’s what our editor took from the text.

1. Over time, large-cap stocks perform dramatically better than small-cap stocks.

2. The trend is definitely your friend. Or, as O’Shaughnessy says, the winners keep on winning.

3. The best overall value factor is the price to sales ratio (PSR measures the price of theompany against annual sales and steady earnings), and the lower the ratio the better.

4. Using a multi-factor value model when evaluating stocks is the best way to ensure a solid return. The most effective of these is to combine relative strength with a low price to sales ratio.

5. Dividends work but they work particularly well with large-cap stocks. But simply buying yield is not enough. If you bought 50 high-yielding large-cap stocks as opposed to just the 50 highest-yielding stocks of all types, your portfolio would perform almost twice as well.

About the time the book came out, O’Shaughnessy struck a deal with Royal Funds (now RBC Funds) to launch three mutual funds under his name. He said then that it might be five or 10 years before investors could accurately judge the degree of success of the portfolios. He even went so far as to say that anyone putting money into his funds would have to do so “on faith”.

The funds were started in September 1997, so we’ve now had almost six years to see how well his theories work in practice. The conclusion: very well indeed. All three funds have handily outperformed their respective peer groups over every time frame, and have done so with a better-than-average risk rating. All three funds received a top $$$$ rating in the 2003 edition of my annual Buyer’s Guide to Mutual Funds, which was published last fall. They will get the same top marks in the 2004 book. Here’s a summary of each fund.

RBC O’Shaughnessy U.S. Value Fund. The core strategy is described as “big stocks with big dividends”. O’Shaughnessy screens the stock universe for highly liquid large-cap companies that have above-average sales and cash flow over the previous 12 months. From this list, the 50 stocks with the highest yield are chosen for the portfolio. Right now that includes companies like J.P. Morgan Chase, Sears, RadioShack, and Marathon Oil. The results have been very good. Over the five years to June 30, the fund produced an average annual profit of 4.1%. During the same time frame, much of which was spent in the grip of a bear market, the average U.S. equity fund lost 5.2% a year while the S&P 500 dropped 3.2% annually in Canadian dollar terms. This fund only lost money in one calendar year, dropping 5.9% in 2002. This is an excellent choice for conservative investors.

RBC O’Shaughnessy U.S. Growth Fund. This fund is more aggressively managed. The core strategy is described as “cheap stocks on the mend” and the screens are adjusted to search for companies with rising annual earnings and a price-to-sales ratio below 1.5. Micro-cap stocks (defined as those with a market cap of less than $150 million) are excluded. The result is a portfolio that is weighted towards small and mid-cap stocks, most of which you’ve probably never heard of. As you might expect, this fund is more volatile than the companion Value Fund. However, over five years the average annual return is very close to its stablemate, at 4.6%. After a big advance in 1999, the fund recorded small gains in the next two years but then suffered a 15.5% loss in 2002. It’s back on track now, however, with a handsome 18.5% profit in the first half of this year. This fund is suited to more aggressive investors. Alternatively, hold it alongside the U.S. Value Fund to achieve style diversification in your portfolio.

RBC O’Shaughnessy Canadian Equity Fund. O’Shaughnessy’s strategies were developed for the much larger U.S. market, so the Canadian entry in this group is a hybrid. It combines a value/growth methodology, using what O’Shaughnessy calls “Strategy Indexing”. The portfolio consists of 100 stocks: 25 value selections from each of the U.S. and Canada and 25 growth stocks from each country. Current Canadian holdings that you may be familiar with are Cinram, Rogers Wireless Communications, Nortel Networks, Telus, CIBC, and Power Financial. The fund shows a five-year average annual compound rate of return of 6.4%, which compares to a virtual break-even position for the Canadian Equity category. The only losing calendar year was 2002, when it was down by 2%. To the end of June, the fund showed a 6.1% gain for 2003, and a strong performance in July pushed that to about 12%. Because of its value/growth mix, this fund is suitable for any middle-of-the road investor.

Investors who took O’Shaughnessy “on faith” back in 1997 must be delighted with the results. He protected their capital during the bear market and produced some modest profits as a bonus. Now, with stocks apparently in an upward phase, the funds are looking very strong.

You can buy them on a no-load basis at any branch of the Royal Bank. Ask your financial advisor if they are suitable for your needs. (Sept. 2003)

Adapted from an article that originally appeared in the Internet Wealth Builder, a weekly electronic newsletter the provides top-quality, conservative investment advice. To take advantage of a three-month trial subscription available to 50plus.com users for just $24.97 plus tax, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm