In the previous article in this series, I described how an analysis of the assets on the balance sheet may reveal a company that is trading for less than its worth. However, there are a few issues with relying on assets alone for investing decisions. Firstly, the asset values may be overstated or the liabilities understated. Secondly, the strategy involves harnessing the power of capitalism to make unproductive assets productive again, and not every asset can be made so, nor is every management team committed to doing so. Finally, in investing, it is not enough simply to generate a positive return. To make it worthwhile to pursue an active strategy, an investor should generate a market-beating return. There is strong evidence that buying the set of lowest price-to-book stocks indeed beats the market. However, the outperformance seems to have weakened over time, and it is not the best performing of the purely quantitive strategies a value investor could pursue.
The question of which was the best-performing value strategy was a question that started to be addressed by the early quant investing practitioners in the 1970s & 80s. Perhaps the best-known of these are David Dremen and James O'Shaughnessy. In 1980, Dremen wrote a book called Contrarian Investment Strategy, which highlighted that a low Price-to-Earnings strategy was a better way to beat the market. In 1998, he followed this up with a book called Contrarian Investment Strategies: Beating the Market by Going Against the Crowd. He looked at more up-to-date data for Price/Earnings, Price/Cash Flow, Price/Book Value, and Dividend Yield, finding Price/Earnings to still come out on top.
O'Shaugnessy's book What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time was first published in 1997 and is now in its 4th Edition. O'Shaughnessy conducted a more thorough analysis and included the Sharpe ratio in his findings. The Sharpe ratio takes the excess return that a strategy generates and divides it by the volatility of those returns. The idea is that a higher return doesn't gain investors anything if it comes at the cost of higher volatility. If the Sharpe ratio of a strategy was the same as the index, investors could simply leverage up the index to get the same result with less effort. Although the idea isn't without its issues – leveraging the index is not cost-free, and investors don't mind upside volatility –…
