This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

  1. Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
  2. Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
  3. Value and Momentum both work as strategies. They work best together.
  4. He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

  1. Low P/B
  2. Low P/E
  3. Net Insider Buying
  4. Significant Declines in the Stock Price (anti-momentum)
  5. Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.

Good investors are typically skeptical. They don’t buy every idea that comes their way, but they test and probe to find ideas with compelling value that are misunderstood by others. That said, the best investors are prudent risk-takers. They continue to search for good investments even in environments that seem to have a negative investing climate.

Skepticism can degenerate to permanent pessimism, particularly because most news coverage tends toward the negative. How does an investor remain bullish in the face of news flow that is predominantly negative? By looking at the broader tendencies of equity markets to flourish in the face of troubles over the long run. One good book for that is Triumph of the Optimists. [TOTO]
TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

  1. Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)
  2. This was true regardless of what presently developed nation you looked at. (Note: survivor bias… what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)
  3. Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)
  4. Returns were higher globally in the last quarter of the 20th century.
  5. Downdrafts can be severe. Consider the US 1939-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.
  6. Real cash returns tend to be positive but small.
  7. Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.
  8. Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)
  9. International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.
  10. Small caps may or may not outperform large caps on average.
  11. Value tends to beat growth over the long run.
  12. Higher dividends tend to beat lower dividends.
  13. Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even…)
  14. Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.
  15. Returns in the latter part of the 20th century were artificially high.

The statistical chapters on the 16 developed markets are amazing, but now almost seven years dated. Still, you can glean a lot from them.

This is an expensive book, and one that may not be for everyone. A cheaper book that covers many of the same issues is Stocks for the Long Run, by Jeremy Siegel. Now going into its fourth edition (I have a signed first edition), it covers many of the same issues, but with more of a US-centric approach, and going back another 100 years (with spotty data).

As I like to say, stocks do well, absent war on your home soil, out-of-control socialism, and severe recession/depression. These books will help you stay in the market even when times are hard. After all, who can tell when the market will turn up? Or down?

Dimson, Marsh and Staunton

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Jeremy Siegel

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Full disclosure: I get a small commission from any book sales through these links.

I have not been tempted to nibble at homebuilders yet. Take one look at the chart of TOUSA, and you can see why:

TOUSA always looked cheap, but the level of leverage was way too high. Falling housing prices would have a larger negative effect on them.  Now they are staring at bankruptcy.


As it is, housing prices probably have another 10-15% to fall on average before this cycle ends.  There will be more bankruptcies among homebuilders before all of this is done.  When the cycle is done, there will be a few signs amidst the wreckage:


  • Surviving builders trade at 50-75% of written-down book value.
  • Earnings are negative, but no longer getting worse.
  • Early value investors will have given up on the sector.
  • Bond managers will reinstate the “no homebuilder bonds” rule.
  • Leverage will be similar to today, but on smaller companies.
  • Financial magazines will run articles on how smart MDC Holdings was during the “bad old days” of 2004-2006.
  • Old standards will return for loan underwriting.  Financial magazines will talk about prudence in borrowing against residential real estate, and how it is not a “one way ticket” to riches.
  • Inventory levels decline 20% from their peak levels.


Anyway, that’s what I expect.  At that time, or slightly before, I would probably buy two of the best capitalized homebuilders.  That’s what I try to do in investing… arrive slightly before the point of maximum pessimism.

Fifteen years ago, my mom gave me a book that would change my life: The Intelligent Investor, by Benjamin Graham. Prior to that time, I was primarily investing in mutual funds, and did not have a coherent investment philosophy. The Intelligent Investor provided me with that philosophy.

What are the main lessons of this book?

  1. Don’t overinvest in equities. Markets wash out occasionally, and it’s good to have some bonds around.
  2. Don’t underinvest in equities. Bonds can only do so much for you, and it is good to deploy capital into equities when they are out of favor.
  3. Stocks provide modest compensation against inflation risks.
  4. Avoid callable bonds. Avoid preferred stocks.
  5. Be conservative in bond investing. Read the prospectus carefully. Often a bond is less safe than one would expect, and occasionally, it offers more value than one would expect.
  6. Purchase bargain issues on a net asset value basis when you can find them, but be careful of quality issues.
  7. Volatility of stock prices can be your friend if you understand the underlying value of a well-financed corporation.
  8. Having a longer-term investment horizon is valuable, because one can take advantage of short-term fluctuations in price.
  9. Growth is worth paying up for, but be disciplined. Don’t overpay.
  10. Be wary of mutual funds.
  11. Be wary of experts.
  12. Pay attention to the balance sheet; don’t invest in companies that are inadequately financed.
  13. Review average earnings of cyclical companies.
  14. Buy them safe and cheap. Don’t overpay for growth and trendiness.
  15. Avoid highly acquisitive companies.
  16. Watch cash flow, and question unusual accounting treatments.
  17. Be careful with unseasoned (new) companies.
  18. Strong dividend policies, in companies that can support the dividends, are an indicator of value.
  19. Aim for a margin of safety in all investing.

That’s my quick synopsis of the book. Though I am not a strict Graham-and-Dodd investor (who is?), I apply the basic principles to most of what I do. This is still a relevant book today because the principles are timeless. If you want the updated version with writing from Jason Zweig, that’s fine. You gain in current relevance, and lose a little in nuance. Graham was a very bright guy. I give Zweig credit for trying, but aside from Buffett or Munger, who would really be adequate to revise The Intelligent Investor? I don’t think I would be adequate to the task….

As Revised by Jason Zweig:

I own three nonsponsored ADRs, and the liquidity of them is relatively poor: Royal Bank of Scotland [RBSPF], Dorel Industries, and Lafarge SA.  I have an opportunity now to improve the liquidity of Royal Bank of Scotland now.  They have recently created a sponsored ADR [ticker RBS].  I wrote Investor Relations at RBS to see if I could exchange my nonsponsored ADR shares for the new sponsored shares.  This is what they wrote back:

Dear Mr Merkel,

Thank you for your email regarding your RBS shareholding.

In order to convert your RBSPF ADRs your broker will need to contact our US depositary and paying agent, the Bank of New York who can transfer your shares to their CREST account and issue you with new ADRs. Contact details for the Bank of New York conversion desk are as follows:

Jaswinder Goraya or Rubely Marte – tel no 212 815 4502 / 2724

Your broker will also need to advise the Bank of New York’s Manchester office of the deposit into their CREST account.

Contact details:

Luke Owen or Mike Ashcroft – tel no. 0161 725 3433 / 3438

Please note that Stamp Duty Tax will need to be paid on each share as well as an ADR conversion fee. With the US share price currently at US$9.24 the conversion fee would be 4 cents per ADR (Please see attached Standard Fee schedule).

If you require further information please do not hesitate to contact me.

So, I contacted Fidelity, and we are doing this.  One down, two to go.  Perhaps my next move is to contact Dorel Industries and see if I can exchange my illiquid ADRs for shares that trade in Toronto.

Full disclosure: long RBSPF, DIIB, and LFRGY (pink sheets all)

Okay, so we got the bounce.  Or, at least the start of it; the market is not short-term oversold anymore.  The reasons behind the rally are a lot smaller than the run we had today; chalk it up to a previously oversold market.

So where do we go from here?  I’m not sure.  None of the long term problems that the market faces have changed, but neither has the relatively low yields of investment grade corporate debt.

One stock that lagged today was National Atlantic.  After the close they announced that they had appointed Bank of America to look into strategic options.  Not sure why they chose BofA; Citigroup brought them public, and kept coverage on them amid their stumbles, not like some.  National Atlantic should jump a little tomorrow.  (Boing!)  Personally, I view the odds of an outright buyout as low, but who can tell here?  The discount to book is significant, and I regard the DAC and tax assets as valuable; they should be included in tangible book.  At this point also, the reserves are clean; they’ve been scrubbed every which way, and should be regarded as sufficient.

National Atlantic is my largest position, and I expect to realize something over $10 before this is done.  Be aware that the stock is illiquid, and that operating results have been uneven over time, to put it mildly.

Full disclosure: long a very illiquid little stock, NAHC

Over at, Jim Cramer occasionally talks about the “oscillator” during times of market stress.  Well, I will offer you my guess at what the oscillator is: a 10-day moving average of NYSE & Nasdaq up volume, less NYSE & Nasdaq down volume.  When that figure gets too high, the market is short term overbought, and when that figure gets too low, the market is short term oversold.  We are close to that oversold level now.

That doesn’t mean that the market is a long-term buy, but that sellers are getting short-term tired.  As the market has fallen, my own cash position has shrunk from 17% of assets to 11% of assets.  I have added gradually to out-of-favor positions, and will add more if the market declines further.

Miscellaneous note: some readers asked what relative strength figure I use.  Typically, I use 14-day RSI.  Why?  It’s the default on Bloomberg.

In The Art of War, Sun Tzu makes a great deal out of concealing one’s intentions, even to the point of making it look like you are dumb.  Value investing has elements of that, though we are not trying to deceive anyone.

Most investors fall for the idea that rapidly growing companies will produce greater returns.  Sadly, that’s not true most of the time, because investors usually overpay for growth.  That leaves investors like me puttering over companies that have grown slowly and have modest valuations.  They are in boring industries: cement, insurance, shoe retailing, etc.

This is a major reason that I like value investing.  It doesn’t appeal to most people.  Buying exciting companies with great stories is a lot more fun than buying slow-growing companies at modest multiples of earnings.  Sad, but the growth investor will earn less over the long haul.

My way of managing money will go out of favor someday.  That’s the nature of money management, though for the last seven years I have been immune to troubles.  I keep applying my strategy, because over the long run it will out perform indexes.  Courage is most needed, and least available, during the bear phase.

Sorry, but off on church business for two days.  As a parting shot, this is what I wrote on RealMoney yesterday:


David Merkel
What Do You Say When You Are Wrong?
11/8/2007 5:34 PM EST

Well, I say I was wrong, then. Wrong about National Atlantic. Ordinarily, reserving at short-tail insurers is hard to mess up, because the claim cash flows quickly reveal mistakes. This is one of the exceptions to the rule.I hate losing money; the only thing I hate more is losing money for others. My sympathies to anyone who has lost along with me. I am still playing on this one, because the company is valued as if it will never make money again, and my opinion is that they will make money again, or, there might be M&A activity.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: still long NAHC, longer even

David Merkel
How Do You Minimize The Costs Of Being Wrong?
11/8/2007 6:40 PM EST

You diversify. Even with National Atlantic, my portfolio was even with the market today. Though it was my largest position, it was still only one of my positions, at less than 5% of the portfolio. Diversification is underrated, and we neglect it to our peril.Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long NAHC

Here’s another recent post from RealMoney:

David Merkel
Contemplating Life Without the Guarantors
11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.  On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.  MBIA reinsures Ambac, and vice-versa.   RAM Holdings reinsures all of them.  The guarantors provide a type of “branding” to obscure borrowers in the bond market.  Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.  In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.  Mark to market losses don’t affect them, they can just pay along with cash flow.  The only trouble comes if they get downgraded, and new deals become more scarce.  Remember CAPMAC?  MBIA bought them out when their AAA rating was under threat.  Who will step up to buy MBIA or Ambac?  (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.  Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.  This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.  If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).

Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.  Also, stable value funds are big AAA paper buyers.  They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.   All in all, this is not a fun time for AAA bond investors.  A lot of uncertainties are surfacing in areas that were previously regarded as safe.  (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.  Keep your eyes open, and evaluate guaranteed investments both ways.  I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.