When Rebalancing Is Not Rebalancing

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JWR1945
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When Rebalancing Is Not Rebalancing

Post by JWR1945 »

I have just finished reading James O'Shaughnessy's book What Works on Wall Street, Revised Edition, copyright 1998. It is an excellent book. Its results are definitive on many matters. It shows among other things that some investment strategies consistently outperform the market as a whole while some other strategies consistently do worse than the market as a whole. O'Shaughnessy demonstrates through examples that accepting increased risk does not guarantee a reward. In fact, some strategies increase risk and lower returns at the same time.

His investigations were extensive. He presents detailed results. He makes use of Standard and Poor's Compustat database, the most comprehensive available, which extends back to 1950. [His research covers 1951-1996.] His is the first research to include this database.

He defines two stock universes. The All Stocks universe consists of all companies in the database with market capitalizations of $150 million or more. This includes 4000 to 5000 companies. The Large Stocks universe consists of 1200+ companies with capitalizations bigger than the average. This translates roughly to capitalizations of $1.0 billion and higher, which extends through the midcaps and down into some small caps.

He did examine the effect of excluding companies with capitalizations smaller than $150 million. They are illiquid. Some have bid and asked prices that differ by a factor of 2 or more. In essence, it is wrong to include them in studies because the prices assigned to them are unrealistic. The smallest group, with market capitalizations of $25 million and less, produce dramatically better results than all other capitalizations. But this is only an artifact rooted on illiquidity. This is the reason that academic studies have favored small cap stocks.

James O'Shaughnessy establishes explicit rules for each strategy and applies them consistently. He starts with an initial purchase of $10000. He makes no deposits and no withdrawals throughout the entire period. This seems like buy-and-hold. It is not.

Part of his procedure is to select fifty stocks when he applies his rules and then to rebalance his portfolio every year. The problem is that this kind of rebalancing is not rebalancing. It is trading.

O'Shaughnessy starts by buying equal dollar amounts of fifty stocks. One year later, he applies his rules to identify a new group of fifty stocks. The new group is selected from either the All Stocks universe or the Large Stocks universe. It is not limited to his original selection. He sells all of his previous holdings and buys equal dollar amounts of the new group of fifty stocks.

This procedure can result in an annual turnover very close to 100%.

O'Shaughnessy's standard procedure assigns no cost to this rebalancing and reallocation. A side effect is that relative strength looks much more attractive than it really is. [Relative strength is the price increase from the previous year compared to a larger group. Another factor such as the price-to-earnings ratio threshold is used as an initial screen. The fifty stocks that are selected come from those that remain. They are selected according to relative strength.]

Some Important Results

O'Shaughnessy reports that investing in the S&P500 index has worked in the past because it is one large cap strategy that is applied consistently. There is no style drift. His arguments are convincing, subject only to the limitations of his study. His blind spot is cost, which he models as zero. A large cap strategy, consistently applied, does work well provided that costs are contained. The genius of a capitalization weighted index fund such as the S&P500 is that it eliminates almost all transaction costs. Sales and purchases are needed only when stocks enter and leave the index. This occurs at the lowest dollar amounts possible.

With occasional qualifiers as to whether examining All Stocks or Large Stocks, traditional valuation measures work. Low valuations translate into improved performance compared to the market as a whole. High valuations bring about diminished performance, often dramatically so.

Selecting low single-year price-to-earnings ratios works with the Large Stocks, but not with the universe of All Stocks. [This might be interpreted as indirectly supporting Benjamin Graham's recommendation to average several years of earning when using the price-to-earnings ratio. The difference in behavior might have to do with the stability of earnings. Larger stocks have more consistent earnings.] The results warn those relying on low price-to-book ratios that this indicator failed throughout the 1950s and 1960s. Popular growth stocks typically have high price-to-book ratios. Value wins out eventually but it can take a very long time. Other value indicators include low price-to-sales ratios, low price-to-cashflow ratios and high dividend yields. The best single valuation measure was the price-to-sales ratio. Now that this is known, I would expect to see companies manipulate revenues. A company can always increase top line revenues by giving its product away (i.e., selling close to cost or below cost). High dividend yields worked in the Large Stocks universe but not the All Stocks universe. Considering that Large Stocks are defined as having capitalizations in the neighborhood of $1.0 billion and up, this limitation is not restrictive.

Combining traditional value indicators helps. The same companies usually satisfy several value criteria. There may be trouble when different value indicators tell different stories.

Treated separately, traditional growth indicators fared poorly. Big single-year earnings gains, big five-year earnings gains, high profit margins and high returns on equity all disappointed.

High relative strength worked. Such stocks carry high valuations. But typically, they do not carry the highest valuations. Buying the worst performing stocks, those with the biggest single-year losses, leads to financial ruin.

The combination of value screens and relative strength produced excellent performance. Temper this conclusion because of its tight connection to the annual rebalancing process (with its new stock selection). The relative strength indicator needs to add value for only one year.

Cornerstone Strategies

James O'Shaughnessy identifies Market Leaders as the roughly 570 Large Stocks (i.e., with market capitalizations of $1.0 billion or more) with more common shares outstanding and higher cashflow per share than the averages in the Compustat database with 1.5 times the sales of the average in the Compustat database. Somewhat arbitrarily, he excludes all utilities from this list.

To me, these Market Leaders sound a lot like those companies in the S&P500 that are making a profit on a cashflow basis (i.e., earnings before subtracting depreciation and amortization).

O'Shaughnessy identifies the 50 Market Leaders with the highest dividend yields as his Cornerstone Value portfolio.

He would have us buy equal dollar amounts of all of the stocks in his Cornerstone Value portfolio.

O'Shaughnessy selects growth stocks from the All Stocks universe. They must have higher earnings than one year earlier and they must have price-to-sales ratios below 1.5. He calls the 50 stocks with the strongest one-year price gains within this collection his Cornerstone Growth portfolio.

O'Shaughnessy would have us buy equal dollar amounts of all of the stocks in his Cornerstone Growth portfolio.

O'Shaughnessy favors splitting investments equally between Cornerstone Value and Cornerstone Growth to form a United Portfolio. He recommends higher a weighting of Cornerstone Value for retirees.

A Replacement for an S&P500 Index Fund?

O'Shaughnessy would have us believe that his Cornerstone Value portfolio would make a superior alternative to a low cost S&P500 index fund.

There are a number of holes in this kind of comparison. Because of the nature of the selection criteria, its turnover is likely to be much less than 100%. But its turnover is still likely to be significant. Even worse, the rebalancing process, with its equal dollar allocations, requires buying and selling a substantial number of shares of stock every year. In contrast, capitalization weighted index funds do not need to buy and sell any shares for rebalancing.

The biggest distinction is that the Cornerstone Value portfolio is a trading portfolio.

Have fun.

John R.
unclemick
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Post by unclemick »

? And perhaps a closet form of momentum investing? I believe Bogle has examined how sectors types have gone on a roll in various decades - energy before 1985, growth, value, small cap., etc.

All in all - I believe Ben Graham has stood the test of time - buy something in the middle - with reasonable growth, a good business, a common sense price. Many people reading Graham get wrapped up in the enterprising investor part or the numbers and miss the central message.

I'll be curious where Mr O's book stands - ten years down the road vs Bogle, Berstein, Graham. Intelligent Investor ed.'s have been in print since 1949 or so.
JWR1945
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Post by JWR1945 »

I have finished reading How To Retire Rich, copyright 1998, by James O'Shaughnessy. I am far less forgiving now than before when it comes to costs. I stated previously that cost was a blind spot. I now believe that it is an intentional blind spot. I will no longer cut him any slack.

Do not get me wrong. I think that O'Shaughnessy has a lot to offer. It is just that he withholds a serious discussion about a critically important issue. I find it hard to believe that he is unaware of the importance of costs. I find it hard to believe that he is unaware that the typical actively managed mutual fund lags a low cost index fund almost exactly by their difference in fees. [By typically, I am referring to the mean or median of many similar funds.] I find it hard to believe that he is unaware of the ease of front running publicly known, mechanical investment strategies such as he advocates. I find it questionable, at best, for him to advocate strategies with annual turnover rates close to 100%.

James O'Shaughnessy has an obvious conflict of interest. He has created strategy index funds with annual fees (apparently) of 1.25% (refer to page 120). His references to index funds are highly misleading. The qualifier strategy cancels it out completely. O'Shaughnessy has several mechanical investment strategies, which typically hold 50 stocks at a time and which replace all holdings once per year. Apparently, holding 50 stocks for a year that are selected by previously established rules is sufficient to qualify as a strategy index fund. The turnover can fall below 100% only when the same company meets the same selection criteria. This is from a universe of 500 or more stocks.

James O'Shaughnessy introduces five strategies. Two of them are for holdings of 25 or 50 stocks. What he now calls Reasonable Runaways was previously called Cornerstone Growth except that he now requires the price-to-sales ratio to be below 1.0 instead of 1.5. What he now calls Leaders with Luster was previously called Cornerstone Value.

He still recommends holding equal portions of Reasonable Runaways and Leaders with Luster, but he does not give the combination a special name. Previously, he had referred to United holdings.

His new portfolios are for holdings of ten stocks. They are the Dogs of the Dow, his Utility Strategy and his Core Value holdings. He continues his version of rebalancing. The turnover is likely to be less than 100% by nature of his selection criteria, especially for the Dogs of the Dow.

With the Dogs of the Dow, you buy equal dollar amounts of the ten highest yielding of the 30 stocks of the Dow Jones Industrial Average. Sell and replace annually. [Even if the same company appears on a newer list, he adjusts the number of shares so that each holding starts out with an equal dollar amount.]

With his Utility Strategy, his approach is very similar to his Cornerstone Value approach. However, utility stocks are no longer excluded. Other stocks are included as well. He buys equal dollar amounts of the 10 stocks with the highest dividend yields that have a Value Line safety rank of 1. He sells and replaces all of these annually. [Even if the same company appears on a newer list, he adjusts the number of shares so that each holding starts out with an equal dollar amount.]

With his Core Value Strategy, he starts with those stocks with the highest Value Line financial strength rating of A++. This leaves 40 stocks. Then he eliminates half of these stocks, retaining those with above average dividend yields [along with their A++ financial strength ratings]. That leaves 20 stocks. His final selection is the ten with the highest projected Dividend Growth Rates in 3-5 years according to Value Line. He buys equal dollar amounts of each. He sells and replaces all of these annually. [Even if the same company appears on a newer list, he adjusts the number of shares so that each holding starts out with an equal dollar amount.]

If you reflect upon these last three strategies, you will notice that they share some common features with his Cornerstone Value (now called Leaders with Luster) strategy and Lowell Miller's definition of Single Best Investment stocks. The first element is selecting from high quality large companies. He has singled out three different ways of doing this. The second feature is selecting among stocks with the highest dividend yields. The third feature, which is new for him, is to adopt Lowell Miller's formula in a slightly modified form. His modification is to make the process entirely mechanical, eliminating the subjective element.

Much of How to Retire Rich reads like a diet book, generating a lot of enthusiasm and building up confidence in O'Shaughnessy and his strategies.

Have fun.

John R.
Mike
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Post by Mike »

He has created strategy index funds with annual fees (apparently) of 1.25%
The last I heard he had switched to an on line newsletter format that tells you what to buy because of the funds high expense ratio. I think the funds still exist though.
JWR1945
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Post by JWR1945 »

Mike wrote:The last I heard he had switched to an on line newsletter format that tells you what to buy because of the funds high expense ratio. I think the funds still exist though.
What Mike says makes sense. James O'Shaughnessy spelled out all of the details in his book. There is no need for anybody to use his funds or any other of his services. He even tells people that much.

I think that there are many people who will pay for his newsletter and/or his funds regardless. He is their trusted expert who has looked at the data in depth. They look at the 7% 25-year historical performance edge of Reasonable Runaways versus the S&P500 index and they don't mind paying for a newsletter subscription and/or a 1.25% mutual fund fee according to their ability.

In addition, O'Shaughnessy makes a good argument that it really takes about 25 years to know for sure how well a strategy performs. It even takes 14 years just to begin to find out!

Have fun.

John R.

P.S. For unclemick: We have had more than 25 years to learn about Ben Graham. He knew what he was talking about.
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