The Value of Value Factors 157

High Yield 45

High PSR 6

Low PSR 50

High P/Cashflow 15

Low P/Cashflow 48

High P/Book 19

Low P/Book 46

High PE 24

Low PE 41

All Stocks 46

0 10 20 30 40 50 60

F I G U R E 10-2
Sharpe ratios for the various strategies applied to the All Stocks universe, 1951–2003. (Higher is
better.)

IS IT WORTH THE RISK?

Risk is a powerful predator, culling the weak strategies from the herd. Buying
the 50 stocks with the lowest PSRs and the 50 stocks with the lowest price-
to-cashflow ratios were the only two strategies that beat the All Stocks uni-
verse on a risk-adjusted basis. The 50-stock low price-to-book portfolio
matched the All Stocks’ Sharpe ratio of 46; whereas the 50 stocks with the
lowest PE ratios and highest dividend yields came in several points lower than
the All Stocks universe. The Sharpe ratios for the deciles of these ratios shows
that sticking with the lowest decile generally offers a higher Sharpe ratio than
the 50-stock portfolio strategies. For example, the Sharpe ratios for decile
one (the lowest) for both price-to-book and price-to-cashflow are 54 and 56,
respectively.
Strategies that buy stocks with high PEs, price-to-book, price-to-cash-
flow, or PSRs have abysmal risk-adjusted returns. This is true both for the 50-
stock portfolios and the decile analysis. It’s like enduring a violent and stormy
night at sea on a rickety ship, only to be dashed upon the rocks before reach-
158 WHAT WORKS ON WALL STREET

ing shore. Nothing demonstrated this more forcefully than the performance of
the strategies since 1997. During the stock market bubble of the late 1990s,
investors pushed the prices of richly valued stocks to unprecedented levels. An
investor who believed the market-bubble mantra that it was “different this
time,” and who focused on buying the “story” stocks with no earnings, little
sales, but great stories about a bright future (think Anything.com) would have
done extraordinarily well in the three years after the revised edition of What
Works on Wall Street came out in 1997. An investor who stuck with the time-
tested strategies featured in my book would have felt like a fool comparing her
portfolio’s performance to the high-ratio “story” stocks in March of 2000, at
the top of the stock market bubble.

High Yield 13.35%

High PSR 1.25%

Low PSR 15.95%

High P/Cashflow 5.16%

Low P/Cashflow 15.47%

High P/Book 6.52%

Low P/Book 15.95%

High PE 8.78%

Low PE 13.77%

All Stocks 13.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

F I G U R E 10-3
Compound average annual rates of return for the 52 years ending December 31, 2003. Results of
applying strategies on the All Stocks universe.

Between January 1, 1997 and March 31, 2000, the 50 stocks from the
All Stocks universe with the highest PE ratios compounded at 46.69 percent
per year, turning $10,000 into $34,735 in three years and three months. Other
speculative names did equally as well, with the 50 stocks from All Stocks with
the highest price-to-book ratios growing a $10,000 investment into $33,248,
a compound return of 44.72 percent. All the highest valuation stocks trounced
All Stocks over that brief period, leaving those focusing on the shorter term to
The Value of Value Factors 159

T A B L E 10-1
Average Annual Compound Rates of Return by Decade, All Stocks Universe

Portfolio 1950s* 1960s 1970s 1980s 1990s 2000s**

All Stocks 19.22% 11.09% 8.53% 15.85% 14.75% 5.91%
50 low PE 21.84% 13.96% 8.89% 7.56% 13.58% 33.55%
50 high PE 19.27% 10.96% 2.26% 7.99% 16.99% –14.73%
50 low price-to-book ratios 18.86% 11.49% 17.06% 13.15% 15.83% 25.68%
50 high price-to-book ratios 22.32% 13.13% 0.82% 1.97% 18.03% –31.17%
50 low price-to-cashflow ratios 18.71% 15.41% 13.57% 12.53% 12.86% 21.23%
50 high price-to-cashflow ratios 19.30% 8.02% –3.03% 8.77% 12.77% –27.77%
50 low price-to-sales ratios 20.85% 11.15% 14.80% 20.43% 13.80% 19.94%
50 high price-to-sales ratios 14.96% 11.99% 5.82% –2.02% 2.46% –42.37%
50 highest-yielding stocks 20.29% 10.54% 6.55% 11.20% 16.25% 23.17%
*Returns for 1952–1959.
**Returns for 2000–2003.

think that maybe it really was different this time. But anyone familiar with
past market bubbles knows that ultimately, the laws of economics reassert
their grip on market activity. Investors back in 2000 would have done well to
remember Horace’s Ars Poetica, in which he states: “Many shall be restored
that are now fallen, and many shall fall that now are in honor.”
For fall they did, and they fell hard. A near-sighted investor entering the
market at its peak in March of 2000 would face true devastation. A $10,000
investment in the 50 stocks with the highest PSRs from the All Stocks uni-
verse would have been worth a mere $526 at the end of March 2003; worth
just $1,081 if invested in the highest price-to-book stocks; $1,293 invested in
the highest price-to-cashflow stocks, and $2,549 if invested in the 50 stocks
with the highest PE ratios. The devastation was so severe that even a $10,000
portfolio invested in 1997 and comprised of the highest price-to-book, price-
to-cashflow, PSR, and PE stocks—while growing to $30,000 at the bubble’s
peak—would have been worth just $4,500 by March 2003.
You must always consider risk before investing in strategies that buy
stocks significantly different from the market. Remember that high risk does
not always mean high reward. All the higher-risk strategies are eventually
dashed on the rocks, as Figure 10-5 makes plain.

EMBRACE CONSISTENCY

It’s also important to keep the base rates of a strategy in mind. A strategy
won’t do you any good if you can’t stick with it, so you must look for con-
160 WHAT WORKS ON WALL STREET

sistency over time. All the value strategies covered here beat the All Stocks
universe more than 50 percent of the time over all rolling 10-year periods, yet
the records are mixed. Buying the 50 stocks with the lowest price-to-book
ratios and the 50 stocks with the lowest PSRs had identical returns of 15.95
percent between 1951 and 2003. Yet, if you bought the 50 lowest price-to-
book stocks annually, you’d underperform the All Stocks universe during 48
percent of all rolling five-year periods. Only the low PSR strategy shows
enough consistency to be worth betting on. All the high ratio strategies have
horrible peak-to-trough declines and should be avoided. Figures 10-4 and 10-
5 summarize the results for the All Stocks universe.

High Yield 21.81%

High PSR 34.51%

Low PSR 27.40%

High P/Cashflow 32.87%

Low P/Cashflow 27.15%

High P/Book 32.69%

Low P/Book 30.11%

High PE 32.05%

Low PE 27.39%

All Stocks 20.11%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00%

F I G U R E 10-4
Standard deviation of return for strategies from the All Stocks universe 1951–2003. (Higher is
riskier.)

LARGE STOCKS ARE MORE CONSISTENT

When looking at the Large Stocks universe, we see the same results as for All
Stocks. All the value strategies with low ratios beat the market, and all the
The Value of Value Factors 161

–57.23% High Yield

–95.94% High PSR

–52.15% Low PSR

–88.19% High P/Cashflow

–44.22% Low P/Cashflow

–89.19% High P/Book

–48.55% Low P/Book

–75.06% High PE

–50.76% Low PE

–50.12% All Stocks

–100.00% –90.00% –80.00% –70.00% –60.00% –50.00% –40.00% –30.00% –20.00% –10.00% 0.00%

F I G U R E 10-5
Worst-case scenarios—maximum percentage decline for strategies from the All Stocks universe
1963–2003.

strategies with high ratios do considerably worse. All the high-ratio strategies
had higher standard deviations of return than their low-ratio counterparts—
and performed significantly worse. But the absolute amounts are more mod-
est. With Large Stocks, the best-performing strategy is to buy those 50 stocks
having the lowest price-to-cashflow ratios, with a $10,000 investment on
December 31, 1951 growing to $16,060,150 by the end of 2003. We also see
high dividend yield and low PE ratio stocks beating the Large Stocks universe
by wide margins. Figure 10-6 shows the returns of $10,000 invested on
December 31, 1951 in the various value strategies.
The base rates for the Large Stocks value strategies are far more consis-
tent than for those in the All Stocks universe. All the Large Stocks value
strategies beat the universe at least 86 percent of the time over the 43 rolling
10-year periods. All the high-ratio strategies fail to beat the Large Stocks uni-
verse a majority of the time over all rolling 10-year periods, with the most
successful beating the Large Stocks universe just 44 percent of the time.
162 WHAT WORKS ON WALL STREET

High Yield $7,715,190

High PSR $339,189

Low PSR $10,412,591

High P/Cashflow $459,556

Low P/Cashflow $16,060,150

High P/Book $1,201,082

Low P/Book $13,569,058

High PE $635,293

Low PE $11,502,432

Large Stocks $3,173,724

$10,000,000

$12,000,000

$14,000,000

$16,000,000

$18,000,000
$2,000,000

$4,000,000

$6,000,000

$8,000,000
$0

F I G U R E 10-6
December 31, 2003 value of $10,000 invested in the various strategies using the Large Stocks
universe. Initial investment made December 31, 1951. 1951=$10,000.

T A B L E 10-2
Average Annual Compound Rates of Return by Decade, Large Stocks Universe

Portfolio 1950s* 1960s 1970s 1980s 1990s 2000s**

Large Stocks 15.33% 8.99% 6.99% 16.89% 15.34% 2.40%
50 low PE 16.12% 11.14% 12.64% 16.19% 15.38% 18.36%
50 high PE 14.77% 10.94% 0.93% 14.11% 13.24% –14.90%
50 low price-to-book ratios 15.41% 9.57% 13.95% 19.99% 18.28% 8.99%
50 high price-to-book ratios 16.55% 11.30% –0.60% 14.40% 24.87% –22.38%
50 low price-to-cashflow ratios 17.28% 10.36% 15.40% 17.31% 18.03% 11.46%
50 high price-to-cashflow ratios 14.85% 12.35% –1.85% 13.29% 17.21% –23.76%
50 low price-to-sales ratios 16.39% 9.48% 10.90% 20.09% 17.19% 9.86%
50 high price-to-sales ratios 13.21% 11.73% 3.23% 9.54% 22.56% –36.87%
50 highest-yielding stocks 15.20% 9.82% 11.44% 17.15% 13.89% 16.56%
*Returns for 1952–1959.
**Returns for 2000–2003.
The Value of Value Factors 163

IMPLICATIONS

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 mak-
ing 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.
All the Large Stocks value strategies beat the Large Stocks universe on
an absolute and risk-adjusted basis, and they did so at least 86 percent of the
time over all rolling 10-year periods. That’s an extraordinary track record.
The decile analysis confirms our 50-stock findings, showing that you are
almost always better confining your search for market-beating stocks to the
lower deciles of each of the ratios. Figures 10-7 through 10-10 summarize the
returns from the Large Stocks universe.

High Yield 52

High PSR 19

Low PSR 51

High P/Cashflow 22

Low P/Cashflow 53

High P/Book 28

Low P/Book 53

High PE 24

Low PE 50

Large Stocks 45

0 10 20 30 40 50 60

F I G U R E 10-7
Sharpe ratios for the various strategies applied to the Large Stocks universe, 1951–2003. (Higher
is better.)
 High Yield 13.64%

High PSR 7.01%

Low PSR 14.30%

High P/Cashflow 7.64%

Low P/Cashflow 15.25%

High P/Book 9.65%

Low P/Book 14.88%

High PE 8.31%

Low PE 14.51%

Large Stocks 11.71%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%

F I G U R E 10-8
Compound average annual rates of return for the 52 years ending December 31, 2003. Results of
applying strategies on the Large Stocks universe.

High Yield 18.19%

High PSR 33.81%

Low PSR 21.47%

High P/Cashflow 26.30%

Low P/Cashflow 21.94%

High P/Book 28.31%

Low P/Book 21.60%

High PE 23.20%

Low PE 21.93%

Large Stocks 16.84%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00%

F I G U R E 10-9
Standard deviation of return for strategies from the Large Stocks universe, 1951–2003. (Higher is
riskier.)
164
The Value of Value Factors 165

–28.95% High Yield

–93.36% High PSR

–40.41% Low PSR

–84.35% High P/Cashflow

–39.33% Low P/Cashflow

–80.79% High P/Book

–42.84% Low P/Book

–74.24% High PE

–39.71% Low PE

–46.59% Large Stocks

–100.00% –90.00% –80.00% –70.00% –60.00% –50.00% –40.00% –30.00% –20.00% –10.00% 0.00%

F I G U R E 10-10
Worst-case scenarios—maximum percentage decline for strategies from the Large Stocks
universe, 1963–2003.

High-ratio strategies (e.g., high PE, high price-to-book, etc.) consistently

underperform their universes over the long-term. They take more risk and
offer less reward. This is true for both the 50-stock portfolios and the high-
ratio deciles. They have some spectacular runs that encourage investors to
pay unwarranted prices for the stocks with the best story or most sizzle. But
they consistently disappoint and should be avoided unless extremely com-
pelling strategic reasons exist for buying the stock.

LEARNING TO FOCUS ON THE LONG TERM

Let’s say you bought the second edition of this book in 1998 and truly under-
stood the dangers of investing in overvalued stocks. Yet, in real time, you
would have watched those very stocks soar—month in and month out—for
the next two years. Two years feels like an eternity to the average investor,
and I believe that even armed with all this information, you would have had
a tough time staying away from those high-flying story stocks. Yes, the long-
166 WHAT WORKS ON WALL STREET

term data say to avoid these issues, but gosh, they are the only ones moving
up in price—maybe there really is something to this “new economy” para-
digm shift that everyone is talking and writing about in the media.
If you were like the typical investor, little by little you would relax the
rules, becoming more and more willing to take a flyer on some of the rapidly
growing shares being touted on CNBC or in research reports. And then,
much like the drug user who thinks he’s just experimenting, you’d have been
hooked. Unfortunately, in all likelihood you’d have gotten hooked nearer the
end of the speculative market environment—and it would have cost you a
fortune. To truly take advantage of the evidence presented in this book, you
have to internalize this message and stay focused on the much longer 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. Only then will you be able to take full advantage of all the
long-term evidence presented in this book.
Now let’s turn to growth variables and look for any compelling strate-
gies that might overcome the horrendous returns from high-ratio stocks.