What Works on Wall Street

A Guide to the Best-Performing Investment Strategies of All Time


  • On Amazon
  • ISBN: 978-0071452250
  • My Rating: 6/10

In What Works on Wall Street the author backtests different investment strategies over a period of about 50 years and presents the results.

What Works on Wall Street is an informative book. But it is also quite boring to read because most chapters are very similar to each other, just with different numbers. One flaw of the approach chosen by the author is that he completely ignores transaction costs. Those costs would probably have had a big impact on the performance of the tested strategies because most strategies buy 50 stocks and all rebalance them yearly. And with a start capital of $10'000 you would likely have been hit by minimum transaction costs, too. Still, I think the results might be useful when making investment decisions, even if it is "only" to select funds/ETFs to invest in.

My notes

Stock Investment Strategies: Different Methods, Similar Goals

Active investors are guided by styles, broadly called growth and value. What type of stock they buy depends largely on their underlying philosophy. Growth investors buy stocks that have higher-than-average growth in sales and earnings, with expectations for more of the same. Growth investors believe in a company's potential and think a stock's price will follow its earnings higher. Value investors seek stocks with current market values substantially below true or liquidating value. [...] Value investors believe in a company's balance sheet, thinking a stock's price will eventually rise to meet its intrinsic value.

Indexing to the S&P 500 works because it sidesteps flawed decision-making and automates the simple strategy of buying the big stocks that make up the S&P 500.

Systematic, structured investing is a hybrid of active and passive management that automates buy and sell decisions. If a stock meets the criteria, it's bought. If not, not. No personal, emotional judgments enter the process. Essentially, you are indexing a portfolio to a specific investment strategy and, by doing so, unite the best of active and passive investing. The disciplined implementation of active strategies is the key to performance.

Everyone wants to believe that "it's different this time" and extrapolate current trends in the market ad infinitum. But the facts are irrefutable – strategies that demonstrate a consistent ability to outperform over the long-term tend to return to doing so just as everyone has lost faith in them.

The Unreliable Experts: Getting in the Way of Outstanding Performance

Generally, predictions are made in two ways. Most common is for a person to run through a variety of possible outcomes in his head, essentially relying on personal knowledge, experience, and common sense to reach a decision, This is known as a clinical or intuitive approach [...].

[...] when people are confronted with vast amounts of data, their brains create mental shortcuts to make decisions. These shortcuts, called heuristics, are the rules of thumb on which most intuitive forecasters rely when making any number of complex decisions or forecasts in their field.

The other way to reach a decision is the actuarial, or quantitative approach. Here, the forecaster makes no subjective judgments, nor does he rely on a rule-of-thumb heuristic. Rather, only empirical relationships between the data and the desired outcome are used to reach conclusions. This method relies solely on proven relationships using large samples of data, in which the data are systematically weighted and integrated.

The only way anyone will pay 100 times a company's earnings for a stock is if it has got a tremendous story. Never mind that stocks with high PE ratios beat the market just 35 percent of the time over the last 52 years [...].

When making an investment, we almost always do so stock-by-stock, rarely thinking about an overall strategy. If a story about one stock is compelling enough, we're willing to ignore what the base rate tells us about an entire class of stocks.

We also prefer the complex and artificial to the simple and unadorned. We are certain that investment success requires an incredibly complex ability to judge a host of variables correctly and then act upon that knowledge.

Rules of the Game

As long as people let fear, greed, hope, and ignorance cloud their judgment, they will continue to misprice stocks and provide opportunities to those who rigorously use simple, time-tested strategies to pick stocks.

Names change. Industries change. Styles come in and out of fashion, but the underlying characteristics that identify a good or bad investment remain the same.

Each era has its own group of stocks that people flock to, usually those stocks with the most intoxicating story.

Ranking Stocks by Market Capitalization: Size Matters

Investors should be wary of small-stock strategies that promise high returns simply because they invest in smaller issues. The numbers show that the smallest stocks – those with a market capitalization below $25 million – account for the lion's share of the difference between small- and large-stock returns. They're impossible to buy and are therefore shunned by mutual funds and individual investors alike.

Price-to-Earnings Ratios: Separating the Winners and Losers

[...] whereas you would not want to buy small stocks with very high PE ratios, you might not want them too low, either. Because low PE ratios indicate lower investor expectations for earnings growth, a small company with a low PE might have very limited prospects.

Buying high-PE stocks, regardless of their market capitalization, is a dangerous endeavor. You shouldn't let the flash of the latest glamor stock draw you into paying ridiculous prices for earnings, yet investors do so frequently.

Price-to-Book Ratios: A Better Gauge of Value

Essentially, investors who buy stocks with low price-to-book ratios believe they are getting stocks at a price close to their liquidating value, and that they will be rewarded for not paying high prices for assets.

Over the long-term, the market rewards stocks with low price-to-book ratios and punishes those with high ones.

Like high-PE stocks, stocks with high price-to-book ratios are generally bad investments.

A high price-to-book ratio is one of the hallmarks of a growth stock, so a somewhat high price-to-book ratio alone shouldn't keep you from buying a stock. But the long-term results should caution you against the highest price-to-book ratio stocks.

Price-to-Cashflow Ratios: Using Cash to Determine Value

[...] investors reward stocks with low price-to-cashflow ratios and punish those with high ones.

[...] we see that stocks with high price-to-cashflow ratios are usually bad investments.

Price-to-Sales Ratios: The King of the Value Factors

[...] of all the value ratios, [the price-to-sales ratio] is the most consistent and best guide for future performance.

Dividend Yields: Buying an Income

Investors who want to use yield as a sole determinant should stick to large, better-known companies because these usually have the stronger balance sheets and longer operating histories that make higher dividends possible.

The Value of Value Factors

Discovery consists in seeing what everybody has seen and thinking what nobody has thought.

Albert Szent-Gyorgyi

Remember that high risk does not always mean high reward.

A strategy won't do you any good if you can't stick with it, so you must look for consistency over time.

Value strategies work, rewarding patient investors who stick with them through bull and bear. But it's sticking with them that's extraordinarily hard. Because we all filter today's market performance through our decision making process, it's almost always the glamorous, high-expectations, high-ratio stocks that grab our attention. They are the stocks we see zooming up in price, they are the ones that our friends and fellow investors talk about, and they are the ones on which investors focus their attention and buying power. Yet they are the very stocks that consistently disappoint investors over the long-term.

In no period over the last 52 years did the high flying, richly valued stocks stay ahead over the long-term. They always ended up crashing and burning. The hot stocks of 1997-2000 were technology and Internet issues, but the hot stocks of tomorrow will quite likely come from a different industry with a new hot story. Remember that the market always reverts to basic economics and that it will be no different for those future hot stocks than it was for those in the past.

Do High Earnings Gains Mean High Performance?

Buying stocks simply because they had great earnings gains is a losing proposition. Investors get overly excited about companies with dramatic earnings gains, projecting these earnings assumptions too far into the future. It's interesting to note that those stocks having the highest one-year earnings gains almost always have the highest PE ratios, another indicator that poor performance lies ahead.

You're not much better off buying stocks with the worst earnings changes. Although their returns are slightly higher than those with the best earnings changes, no compelling reason to buy them exists. History suggests you should not make investment decisions based on either one of these variables.

Five-Year Earnings-Per-Share Percentage Changes

Much like the 50 stocks with the highest one-year earnings gains, investors get dazzled by high five-year earnings growth rates and bid prices to unsustainable levels. When the future earnings are lower than expected, investors punish their former darlings and prices swoon.

Profit Margins: Do Investors Profit From Corporate Profits?

History shows using high profit margins as the only determinant in buying a stock leads to disappointing results.

Return on Equity

[...] the 50 stocks with highest ROE are only a good investment 50 percent of the time.

Relative Price Strength: Winners Continue to Win

And while people think they can cope with volatility when a strategy is doing well, they have the wind knocked out of them when their volatile strategy declines 30 percent in a bull market. The emotional toll this takes is enormous, and you must understand it before embracing a highly volatile strategy. [...] you should have some exposure to volatile strategies, but it should never comprise the majority of your portfolio.

The advice is simple – unless financial ruin is your goal, avoid the biggest one-year losers. Buy stocks with the best one-year relative strength, but understand that their volatility will continually test your emotional endurance.

One of the central tendencies of financial data series is regression to the longer-term mean, where outstanding long-term performance is followed by more modest returns, and poor long-term results are followed by better than average performance. The longer the period you consider, the more regression to the mean you see. We do, in fact, begin to see a regression to the mean after about five years. This supports the contrarian practice of buying stocks that have been seriously beaten up over the past several years. So, although the performance of stocks with strong one-year positive or negative relative strength tend to keep heading in the same direction, the opposite is true when looking at five-year periods. Stocks that have exhibited five years of strong relative strength – either positive or negative – are usually on the brink of a turnaround.

Using Multifactor Models to Improve Performance

Using several factors allows you to dramatically enhance performance or substantially reduce risk, depending on your goal.

Generally, combining a value factor with a growth factor leads to the most improvement [...].

I believe that adding relative strength to a value portfolio dramatically increases performance because it picks stocks just after investors have recognized that they are bargains and are buying them once again. All the value factors that make them good buys are still in place, but the addition of relative strength helps pinpoint when investors believe the stocks have been oversold.

Dissecting the Market Leaders Universe: Ratios That Add the Most Value

Market Leading companies are nonutility stocks with greater than average market capitalization, shares outstanding, cashflows, and sales of 50 percent greater than the average stock. [...] It is important to note that Market Leaders allow the inclusion of American Depository Receipts (ADRs), which are dollar-denominated overseas shares that trade in the United States. [...] This is an important distinction, especially when comparing performance with the S&P 500, which is made up of only U.S. companies.

Also important to note is that the Market Leaders universe is equally weighted, whereas the S&P 500 is cap-weighted, giving far greater weight to the largest companies in the index. Over longer periods, equal-weighted indexes have outperformed cap-weighted indexes [...].

Dissecting the Small Stocks Universe: Ratios That Add the Most Value

The degree of one's emotions varies inversely with one's knowledge of the facts – the less you know, the hotter you get.

Bertrand Russell

Even great strategies can have breathtaking declines. The strategy of buying stocks with price-to-cashflow ratios less than average and good price appreciation was a winner over time, yet plunged 87 percent from peak to trough between February 2000 and February 2003.

Small capitalization stocks are inherently more volatile than larger cap stocks – a very important thing to remember when embarking on a small-cap strategy.

Finally, think very carefully about volatility before using a more concentrated version of these small-cap strategies – concentration enhances both return and volatility, but it is the volatility that you should think about most deeply. Many an investor has been lured by performance, only to crack and throw in the towel when the strategy takes a dive. Always look at the worst-case scenario for any strategy before you take the leap.

Everyone thinks they are ready to withstand it, and perhaps intellectually they are, but you have to watch out for emotions when the going gets rough. Think hard about how you might react if your portfolio lost 25 percent in a month while the general market edged higher. If you honestly believe you could stay the course, then a more concentrated strategy might be right for you.

Searching for the Ideal Value Stock Investment Strategy

Companies have two basic ways to make payments to shareholders. The first is paying cash dividends as a distribution of their share of the company's profits. But companies can also support their stock prices by buying up their own stock, thereby reducing the number of shares outstanding and shoring up the company's stock price. Thus, to create shareholder yield, you add the current dividend yield of the stock to any net buyback activity the company has engaged in over the prior year. If, for example, a company trading at $40 a share is paying an annual dividend of $1, the company would have a dividend yield of 2.5 percent. If that same company engaged in no stock buybacks over the year, its shareholder yield would equal 2.5 percent, the same as the dividend yield. If, however, the company had 1'000'000 shares outstanding at the beginning of the year and 900'000 at the end of the year, the company's buyback yield would be 10 percent. Adding this to the dividend yield of 2.5 percent, you would get a total shareholder yield of 12.5 percent.

Searching for the Ideal Growth Strategy

Always review a strategy's downside before proceeding – it makes no sense for investors to put a lot of money into a strategy that they will ultimately abandon when the going gets rough.

The best time to buy growth stocks is when they are cheap, not when the investment herd is clamoring to buy.

Uniting Strategies for the Best Risk-Adjusted Performance

Joining growth with value substantially reduces the volatility of growth strategies while increasing the capital appreciation potential of the less volatile value strategies. It also ensures a diversified portfolio, giving you the chance to perform well regardless of what style is in favor on Wall Street.

New Research Initiatives

The difficulty lies not so much in developing new ideas as in escaping old ones.

John M. Keynes

One of the greatest mistakes many investors make is to assume that short-term conditions will continue to prevail over the long-term and that they will be able to bounce back from any setback they may endure in the market.

One of the tenets of asset allocation is that you should build a portfolio of stocks that cover different styles of investing and different market capitalizations. The theory behind this is that you always want to have some part of your portfolio invested in a style that is currently working well.

Ranking the Strategies

By examining how investment strategies perform in many different market environments, we prepare ourselves for what might come in the future. No doubt the names of the securities and the industries they are in will change in future years, but the underlying persistence of what works and what doesn't will continue.

Getting the most out of your Equity Investments

To think is easy. To act is difficult. To act as one thinks is the most difficult of all.

Johann Wolfgang von Goethe

You'll get nowhere buying stocks just because they have a great story.

Investors who look only at how a strategy has performed recently can be seriously misled and end up either ignoring a great long-term strategy that has recently underperformed or piling into a mediocre strategy that has recently been on fire.

[...] you should always guard against letting what the market is doing today influence the long-term investment decisions you make.

Consistency is the hallmark of great investors, separating 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.