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Trending Value Portfolio Stock Screen Overview

Current Holdings
 

Average Annual Return of Trending Value Portfolio

Per subscriber request, we have created a stock screen based on Jim O'Shaughnessy's Trending Value Portfolio as featured in the 4th edition of What Works on Wall Street, which happens to be one of our favorite investment books. Over a 45-year period, the portfolio produced annual average returns of 23.04% (equivalent to a compounded return of 21.19% annually). Here are more details of the portfolio's returns versus the average stock during those 45 years.

Portfolio Average Annual Return (arithmetic) Average Annual Return (geometric)1 Median Annual Return Standard Deviation Downside Deviation No. of Positive Periods2 No. of Negative Periods Maximum Peak-to-Trough Decline Beta Sharpe Ratio3
Trending Value Portfolio (25-Stock Version) 23.04% 21.19% 29.20% 17.44% 13.71% 373 179 -50.55% 0.81 0.93
Trending Value Portfolio (50-Stock Version) 21.48% 19.85% 26.63% 16.51% 12.87% 369 183 -49.64% 0.78 0.90
All U.S. Stocks4 13.26% 11.22% 17.16% 18.99% 13.90% 329 223 -55.54% 1.00 0.33

1All data is from the 4th edition of What Works on Wall Street. Return data from January 1, 1964 to the beginning of 2010. The book was published shortly thereafter. The geometric average is the average annual compound return over the period.

2Rolling 12-month periods.

3The Sharpe ratio was developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. Higher is better as it means returns were higher per unit of risk.

4All stocks trading in the U.S. with an inflation-adjusted market cap of $200 million or more.

***

Average Annual Compound Rates of Return by Decade:

Portfolio 1960s5 1970s 1980s 1990s 2000s6
Trending Value Portfolio (25-stock version) 18.08% 18.85% 23.53% 22.05% 22.27%
Trending Value Portfolio (50-stock version) 16.89% 18.09% 23.92% 19.20% 20.06%
All U.S. Stocks7 13.36% 7.56% 16.78% 15.35% 4.39%

5Returns for January 1, 1964 to December 31, 1969. Dates prior to 1964 were not tested due to a lack of monthly data.

6Returns for January 1, 2000 to December 31, 2009.

7All stocks trading in the U.S. with an inflation-adjusted market cap of $200 million or more.

***

As you can see from the tables above, the Trending Value Portfolio achieved higher returns while assuming less risk. For example, the 25-stock version of the Trending Value Portfolio:

  1. returned more per year (21.19% annually) versus the average stock (11.22%)
  2. had less volatility as measured by standard deviation (17.44% versus 18.99% for the stock market as a whole) and beta (0.81 versus 1.00 for the average stock)
  3. had more rolling 12-month periods of positive returns (373 versus 329 for the stock market as a whole)
  4. had fewer rolling 12-month periods of negative returns (179 versus 223 for the stock market as a whole)
  5. exposed investors to less risk as evidenced by the lower maximum peak-to-trough
  6. performed even better in the 2000s than it did in the 1960s and 1970s

So how often does the Trending Value Portfolio outperform the market? Well, it outperformed the market in 85% of the rolling 12-month periods during the 45-year test. Over three year periods, it outperformed 99% of the time, and over five, seven and ten year periods it outperformed 100% of the time.

***

Background:

Note: before we get into the background of the Trending Value Portfolio, I highly recommend that you purchase Jim and Patrick O'Shaugnessy's What Works on Wall Street, 4th edition. Both authors have been gracious in answering my questions about the book. And if you want a free education in finance, follow both authors on Twitter. They provide links to many great articles and learning resources. Investors who don't want to dive into the stat-heavy What Works on Wall Street should consider Patrick O'Shaughnessy's Millennial Money, another excellent book.

In their book What Works on Wall Street, 4th edition, authors Jim O'Shaughnessy and Patrick O'Shaugnessy set out to find out which factors (such as price-to-earnings, profit margin, etc.) are best at finding stocks that will outperform the average stock over the next twelve months. Here are just a few of the factors that they tested:

Factors Tested in What Works on Wall Street (partial list)
Price-to-Earnings (PE)
Profit Margins
Return on Equity (ROE)
Return on Assets (ROA)
Price-to-Cash Flow
Price-to-Sales
Price-to-Book Value
EBITDA-to-Enterprise Value
Dividend Yield
Buyback Yield
Shareholder Yield
Cash Flow to Debt
Debt to Equity
External Financing
Changes in Debt Level
Etc.

Testing PE Ratios:

Here is an example of their findings. One might think that buying companies with the lowest price-to-earnings (PE) ratios might lead to great returns for investors. To test this, the O'Shaughnessy's divided up all stocks (with an inflation-adjusted market cap of $200 million or more) and grouped them in deciles from lowest PE ratio to highest PE ratio. The 10% of the stocks with the lowest PE ratios were assigned to decile 1, the next 10% were assigned to decile 2, etc., with the stocks with the highest PE ratios being assigned to decile 10. Here is what he found: during the test period (which spanned 45 years), investors who simply bought the 10% of stocks that had the lowest PE ratios went on to produce an annual compound return of 16.25% over the next twelve months. In comparison, the average stock during that 45-year period produced an annual compound return of 11.22%. The stocks with highest PE ratios (decile 10) produced a paltry 5.53% per year.

Best Factor and Best Multi-Factor Model:

So which single factor was the best at finding stocks that would outperform over the next twelve months? It is EBITDA-to-enterprise value. EBITDA is earnings before interest, taxes, depreciation, and amortization. But more importantly, the O'Shaugnessy's found out that by combining six factors, they produced an even higher return (17.3% per year) with less volatility than EBITDA-to-enterprise value. The factors that comprise the multi-factor model are listed below.

Components of Best Multi-Factor Model
Price-to-Book
Price-to-Earnings
Price-to-Sales
EBITDA-to-Enterprise Value
Price-to-Cash Flow
Shareholder Yield8

8Combines dividend yield with buyback yield

The O'Shaughnessy's called this best multi-factor model Value Composite 2. It is important to note that after the publication of the book, Jim O'Shaugnessy published an article in the October 2013 edition of AAII Journal showing that he found (and is using) an improved version of the Value Composite 2. The factors that comprise the multi-factor model are listed below (you can also find them listed on page 2 of this link).

Improved Version of the Best Multi-Factor Model9
Price-to-Earnings
Price-to-Sales
EBITDA-to-Enterprise Value
Free Cash Flow-to-Enterprise Value
Shareholder Yield

9Published in the October 2013 edition of the AAII Journal two years after the 4th edition of What Works on Wall Street was published.

The authors dropped price-to-book and substituted free cash flow-to-enterprise value for price-to-cash flow because the free cash flow factor worked better in multi-factor models.

Adding Momentum (Relative Strength) To The Best Multi-Factor Model

Momentum, or relative strength, is another anomaly that efficient-market theorists can't explain away. Simply put, if you bought the 10% of stocks that had the largest price change (momentum) in the last six months, those stocks would have produced a return of 14.11% per year, which is over three percentage points higher than the average stock. The O'Shaughnessy's wondered what would happen if you added a screening criteria for momentum to their best multi-factor model. When they did, the annual returns of 17.3% for the multi-factor model were boosted to 21.19% per year. This became the Trending Value Portfolio.

The Criteria For The Trending Value Portfolio

Here are the criteria each stock must pass to be included in the Trending Value Portfolio:

1) First, we must screen out any stock not having an inflation-adjusted market cap of $200 million or more. It's very important to continually adjust for inflation after December, 2008. For example, in 2009, the market cap was adjusted upwards to $205,442,662.25. Back-testing prior to December 2008 means you must adjust the market cap downward by the rate of inflation. For example, if back-testing to 1964, the minimum market cap is $29,682,059.48. Failure to adjust for inflation means you will be using a different universe of stocks and the resulting stocks will differ.

2) Stocks must also be in decile 1 (the 10% with the cheapest valuation) of Value Composite 2, which was the best multi-factor model. Note: we use the improved version of the composite per Jim O'Shaugnessy's article in the October 2013 edition of the AAII Journal. This means we use PE, price-to-sales, EBITDA-to-enterprise value, free cash flow-to-enterprise value, and shareholder yield.

3) After screening for the first two criteria, rank the stocks from highest 6-month price change to lowest. Buying the 25 stocks with the highest 6-month price change resulted in a annual compound return of 21.19%. If you instead bought the 50 stocks with the highest 6-month price change, you would have earned 19.85% per year.

The end result is a list of value stocks whose momentum is trending positive in comparison to other value stocks. To view the 50 stocks passing the criteria, click the link below.

Current Holdings
 


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