Trending Value: Breaking Down a Proven Quantitative Investing Strategy

The trending value strategy was developed by James O’Shaughnessy and detailed in his book What Works on Wall Street as one of the best performing strategies, using a combination of value and growth metrics.

Every metric in this strategy is commonly used by millions of investors every day; but when they are combined in a specific way, the results can be extraordinary.

O’Shaughnessy begins by backtesting strategies using one value metric at a time. For example, a strategy that is only invested in the stocks in the top decile (lowest 10%) of price-to-earnings ratios (P/E) and rebalanced every year. And likewise using price-to-book ratio (P/B), price-to-sales ratio (P/S), and price-to-cash flow ratio (P/CF). He also looks at enterprise value to EBITDA (earnings before interest, taxs, depreciation and amortization) ratio (EV/EBITDA), which was the single best performing value factor he backtested. (For each of these 5 factors, low values are better).

Another factor he looked at was shareholder yield (SHY), which is buyback (how many stocks are repurchased by the company (i.e., decrease in number of outstanding shares)) plus dividends divided by market capitalization. (For shareholder yield, higher is better). The results for the top decile of these factors (lowest (or highest for SHY) 10%, rebalanced annually) are below (with all stocks for comparison).

By themselves, all of these factors beat the overall stock market. But combining the factors, coming up with a composite score and investing in the top decile of composite scores, yields even better results. To develop the composite scores, a ranking for each factor is given to each stock in the universe of stocks. So the stock with the lowest P/E gets a score of 100, the stock with the lowest SHY gets a 1, and so on (this can be done with the PERCENTRANK function in Excel (or 1 — PERCENTRANK for SHY, since higher numbers are better), or much more seamlessly using a more powerful tool like Portfolio123).

The ranks for each factor of a stock are added up for its composite score. O’Shaughnessy looked at 3 different value composite scores: value composite 1 (VC1) used the factors described above except SHY, value composite 2 (VC2) add SHY to VC1, and value composite 3 replaces SHY with just buyback yield. The returns for top decile of each of these composite scores is below (rebalanced annually).

Each value composite is a significant improvement over any individual factor. Composites are more powerful than just screening for the best values of the individual factors because a stock that may be deficient in one metric but excellent in the others would get eliminated from consideration by screening (e.g., a stock in the top decile of VC2 may not necessarily be in the top decile for all of the individual factors).

To implement the trending value strategy, you simply invest in the top 25 stocks sorted by 6-month % price change (the “trending” part of the name) among the top decile of stocks ranked by VC2 (O’Shaughnessy chose VC2 over VC3 because of its slightly higher Sharpe ratio, a measure of risk-adjusted return).

The universe of stocks is limited to those with a market capitalization of more than $200M (in 2009 $) to avoid liquidity problems with trading smaller stocks. It’s a buy and hold strategy that is rebalanced annually with the following exceptions. If a company fails to verify its financial numbers, is charged with fraud by the Federal government, restates its numbers so that it would not have been in the top 25, receives a buyout offer and the stock price moves within 95% of the buyout price, or if the price drops more than 50% from when you bought it and is in the bottom 10% of all stocks in price performance for the last 12 months, the stock is replaced in the portfolio.

So what’s the catch? There are a few:

• The Data: While most of the metrics described are freely available from any number of online sources, some (e.g., buyback yield) aren’t as easy to come by, and I still haven’t found a free way to obtain all of the data for all of the stocks at once.

• Psychology: While the trending value strategy has never underperformed the market for any rolling 5-, 7-, or 10-year periods between 1964 and 2009, it has underperformed the market for rolling 1-year periods 15% of the time, and 3-year period 1% of the time. If you hit a few years with less-than-stellar performance, are you going to stick it out and trust the strategy, or are you going to jump ship to bonds (as many people did in 2009, missing out on the huge subsequent rebound) or another trendy strategy that seems to be performing better at the time?

• Commissions (for small-time investors): At $10/trade and 25 trades per year, you need a portfolio of $100,000 to keep your commissions to a reasonable 0.25%. (Hint: use Robin Hood)

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