James O'Shaughnessy is one of very few investors who can truly lay claim to having changed the way people approach the stock market. He's also one of the nicest and most engaging people you could hope to meet.
O'Shaughnessy has spent more than 30 years researching equity market returns. His work has brought to the fore the power of what he calls 'fundamental quant'. His groundbreaking studies became a relentless pursuit of the factors that are most commonly associated with outperformance. And from that he built a fund management business with nearly $7 billion under management.
For most professional money managers, those achievements would probably be enough. But O'Shaughnessy is remarkably altruistic. Despite lucrative offers to keep his research private, he presented it to the world.
As the author of four books, it was the second - What Works on Wall Street - that transformed his career and very likely the fortunes of many others. In four editions published between 1997 and 2012, he set out his findings on how elements of value, quality and momentum combine to work in investing.
What set him apart was a willingness to follow the data, even if it meant tearing up previous conclusions. What he was left with was a set of strategies that he could stick with in good times and bad.
O'Shaughnessy's benevolence - his readiness to share his knowledge - is in his genes. His grandfather built what was once one of the world's largest privately-owned oil company before giving away 95 percent of his fortune during his lifetime. In fact, it was the family debates on how the enduring foundation should be invested that first got the 17-year-old O'Shaughnessy into studying markets.
Back then, all he had was a Value Line subscription, a large paper spreadsheet and a book on the Dow Jones Industrial Average. Some years later - after finishing college and getting married - he returned to those studies. With the help of computers and the advent of Morningstar, he started taking much deeper dives into the market.
Jim told me this story when I met him at a suitably exclusive, yet surprisingly relaxed and rules-free club in New York City. Having recently passed the leading role at O'Shaughnessy Asset Management to his son Patrick, I got the impression that he was very much enjoying a slightly more relaxed life…
Ben: Jim, what was the journey that took you from studying markets to actually investing and advising others about them?
I've always loved chamber music; and at the age of 25, I was on the board of the Saint Paul Chamber Orchestra. One of my colleagues was the general counsel of a company called Control Data, which was a conglomerate. It had bought disparate companies and had not yet made redundant some of the pension plans of the companies that it had purchased.
My friend said: "You've talked to me about your research in the stock market. If you start a company, I will hire you as a consultant immediately because we have no idea what's going on with these pensions plans. We have no idea whether the manager is honestly managing the money or not."
So I formed O'Shaughnessy Capital Management in 1987 and I looked at these seven separate pensions. What I did was very straightforward. I took their portfolios - both current and historical - and put them on the database and did what we would today call a factor profile. Then I created a normal portfolio, or clone portfolio, which was like a benchmark on steroids. It not only had similar factors to the underlying manager, it also looked a lot like the manager.
The point of a normal portfolio was to say: How much value is the manager going to add through their buying and selling? My "aha" moment was about one year in, when it became incredibly clear that the clones were killing the managers that they were cloning.
I'm like: "What is going on here!?" So I started doing research into actuarial decision-making versus regular human, or clinical, decision making.
I found a great book called "House of Cards: Psychology and Psychotherapy Built on Myth," by a fellow by the name of Robyn Dawes. He had a chapter in that book that was fabulous; it was all of the studies that had been done of actuarial and clinical approaches. They started these in the 50s, and they thought that what they would see is that the actuarial approach would be a flaw that the human forecaster would soar above. Well, what they found was it was a ceiling that the human forecaster could never touch.
Concurrently I was seeing this happen with the portfolios. My clones were doing so much better because they were not human beings. They were just buying and selling securities based on those factors, and those factors alone. There was no emotional override, there was nothing that would be inconsistent or any shade of grey. It was black and white; if you met the criteria you were bought, if you didn't you weren't. It was that simple.
Ben: It's reassuring that professional money managers suffer the same emotional flaws that everyone else does. Have those findings changed over time?
It led to my first book, which Patrick named his podcast after as an 'hommage' - "Invest Like the Best." In it I showed you how to clone your favourite manager. We haven't done it for a long time, but the last time we updated all the clones in that book they were killing the managers they were cloning.
That made me decide: "Okay, number one, I have to move into active management because this is unbelievable." At the same time we moved to New York and I became a consultant to Merrill Lynch, where I designed a popular growth-based portfolio.
At this same time I had convinced the people at Standard & Poor's Compustat to give me access to their database. They'd never given it to an outsider before in its entirety, because they viewed it as the crown jewels. But I convinced them that the only way that we're going to be able to sell more of it was to have an outsider prove to the world that it was in fact the gold standard.
I published a piece in Barron's about what came to be known in the US as 'Dogs of the Dow'. I reworked my earlier research and found that simply buying the 10 highest-yielding stocks in the Dow, holding them for a year, rebalancing the portfolio to again holding the 10 highest-yielding stocks in the Dow, did tremendously well over long periods of time.
Merrill had seen that article and they were doing a 'Dogs of the Dow' Unit Investment Trust. They also knew I was writing this book 'What Works on Wall Street', and so they wanted to hire me. So, 'What Works on Wall Street' came out, and literally, and inexplicably, became a bestseller.
Ben: You devoted much of your career to discovering what really works in the stock market. Why did you feel compelled to write about it when you could have quite easily kept it to yourself?
That kind of speaks to my fundamental beliefs. I believe that you need to add as much as you can to the public domain in terms of knowledge that allows other people to do better. I'd already kind of turned myself into a dyed-in-the-wool quant, and I knew that the majority of investors would reject that message. But I'm a huge believer in level playing fields, so that's why I published it.
After publication, O'Shaughnessy Capital Management quite literally had around $600 million come through the door - and we had no sales people. This is in early 1997, and it was all incoming calls. We went from being a consultant to Merrill, which was a sweet gig in itself, to a $600 million dollar asset manager. We were the fastest-growing Schwab institutional manager in the North East, and we were getting a lot of press at the time. It's hard to believe now, with the ascendancy of quant and everything, but back then that was really unusual.
Ben: I spoke to your friend Ted Seides and he suggested a question that I should ask you. It coincides with this time when your career was taking off. He suggested that I ask you about the time you appeared on Oprah!?
Ted would definitely say something like that! The Oprah thing was really funny. After 'What Works on Wall Street' became a bestseller, an agent called me, and the conversation went like this:
Agent: "You are in a very rare club; you are a bestseller. You've got to do another book, and we're going to auction it."
Jim: "What do you mean? I was writing these books just to advance knowledge."
Agent: "No, no, no. We have to write a book with mass-market appeal. You know, 'What Works on Wall Street' for dummies, for people who don't know anything about investing."
So we came up with the book 'How to Retire Rich', which was a bestseller. Then about four months later one of Oprah Winfrey's producers calls and says: "Hey, we'd love to have you on the show." I'm like: "Fantastic."
I had never seen 'Oprah', so I watched a couple of shows just to see what it was all about, and I thought: "I don't know how they're going to have me on this show." But it was devoted to finance, and how people could do better.
So I get to Chicago, and go on Oprah. At the time, the show was shot live, so when a commercial was on you would literally just sit and wait. The green room is very nice, but there's a space between the green room and the studio that is entirely black. It's blacked out because they don't want any light coming in. So we go from a very lovely lit environment to this pitch blackness. I'm surrounded by maybe five producers, and one is saying: "Hey, you're going to be great, and this is going to be awesome."
And then another one says: "Just one thing, Jim..."
Jim: "Yeah, what's that?"
Producer: "If... if you could not be technical that would be really good."
Jim: "What do you mean by that?"
Producer: "Well, don't say things like 'Dow Jones Industrial Average'."
James: "Oh! Okay, alright!"
So I go out, sit down - it's during a commercial break - and Oprah and I are chatting. She's very cordial, and she asks: "So... one line. What is this about?"
I said: "Well, Oprah, the message is: if you can change your focus, you can change your future." And Oprah loved that line. She's all about empowerment, which I think is great, and she loved that line.
So, we come on, and she looks like she's my best friend: "My next guest, he said - I love this - 'If you can change your focus, you can change you future'. You know how much I believe that!?" So we had this great back-and-forth, and I had all of five minutes on the show.
I learned a lot about the book business but after being on Oprah, and I also understood the true power of American media. I'm not kidding you; I walked out of the hotel in Chicago, and a woman walking on the sidewalk looked at me and said; "Oh, are you Jim O'Shaughnessy!?" I'm like: "Yeah!" She said: "I saw you on 'Oprah', you were great!"
It freaked me out. So I get to the airport and walk up to the American Airlines check-in desk, and without missing a beat the woman behind the counter says: "Welcome Mr. O'Shaughnessy."
It's like a Monty Python sketch. I'm like: "Okay". She says: "Wait, you're going to be escorted to the plane." I say: "It's okay, I can walk, I'm fine."
The pilot and the chief stewardess arrive, and the pilot doesn't know anything about Oprah. But the stewardess is like: "Oh my gosh, will you sign this for me!?"
I got to San Francisco: the same thing. I'm on one of the moving walkways at the airport and all of a sudden I become aware that a woman has been walking - but has stopped walking - right next to me. I'm looking, and she's just looking at me. And finally, I'm like:
Jim: "Can I help you?"
Woman: "I'm sorry, it's so rude what I'm doing... but are you Jim O'Shaughnessy?"
Woman: "Oh my God, I saw you on 'Oprah', you just made the biggest difference in my life."
Woman: "Will you sign this?"
It was wild. The lesson is that if you control the American media, you can do great things. As long as you don't ever say 'Dow Jones Industrial Average'!
Ben: Another of your friends, Barry Ritholtz, suggested that I ask you how 'What Works on Wall Street' changes the way money is managed in the US?" That's a big question.
When the CFA journal wrote a review of 'What Works on Wall Street' they said that theoretically its impact on the American money management industry would be immense. It wasn't immense but it certainly created a new niche for what I call fundamental quant.
If you go and talk to Cliff Asness, or you talk to the guys at LSV, all of those are PhD quants who manage money very differently than we do. We are hyper-fundamentalists, we're Ben Graham on steroids. Their alpha is better than smart beta, but a low tracking error and high information ratio are very important to them. What was more important to me was alpha. So it created a niche of discipline, evidence-based investing that has only grown in the US by leaps and bounds.
I have written an article with the title: 'Mistakes Were Made (And, Yes, By Me.)', which goes over some of the big mistakes that I made. One of the biggest mistakes was when ETFs were brand new and Gary Gastineau approached me, and he said he wanted to do an ETF for every one of the best strategies in 'What Works on Wall Street'." I said no because at the time no-one even knew what an ETF was. I would have had to have put up a lot of money to do it and I decided not to do it. But I should have done it.
I think that the effect that 'What Works on Wall Street' had on American money management was it helped to create what is now a very robust category. I'm very proud of that. I became aware in the mid-2000s that there was an enormous amount of money being managed according to 'What Works on Wall Street', that I knew nothing about. I got a call from somebody at the Bank of Ireland, and this was the conversation:
Bank executive: [by Jim in a perfect Irish accent] "I love your book you know, it's grand and everything, but we've got some questions."
Bank executive: "We're running a decent-sized portfolio around it."
Jim: "Ah, okay..."
Then I found that there were some other banks in the US and other parts of Europe doing the same, which I was totally okay with. If you have the guts to use the formulas, you're the ones taking the risk. There are a whole host of O'Shaughnessy screens printed by AAII, the American Association of Individual Investors. I think that's great for people who can actually use them. But what I also wanted to get into was the idea than innovation and constant research is absolutely required. And that brings me back to 'Dogs of the Dow'.
In the third version of 'What Works on Wall Street', I started doing much broader tests, testing a lot more variables. One that I was really enamoured with was shareholder yield, which is dividend yield plus buybacks. We found categorically that shareholder yield was better than dividend yield in the US.
So in the book, I said not to use dividend yield, and to use shareholder yield instead. But there was pushback on that because people had got familiar and bought into dividend yield. That really illustrates nicely for me the power of narrative, the power of a story. We are a story-telling creature; all of our original histories, poems and plays were an oral tradition before we developed writing.
It's in our genes that we want things a) to make sense, and b) to be something that we can say: "Oh yeah, I understand why that works." With 'Dogs of the Dow', buying the 10 highest dividend-yielding shares made sense. "Of course! If I'm buying the company that has a two percent higher dividend yield, I'm going to do better than the company that has a deficiency there. Plus cash makes sense; I'm getting paid actual money. What's the whole buyback? I don't know what that is?"
It really underlined for me, the idea that people get stuck in their beliefs. This is true everywhere - it's not just in the stock market, it's everywhere.
I found that really interesting; the reticence to accept new research from the same person that you believed the first time around. But if you compared our original models, from Market Leaders Value to the way we do it now, the foundation is absolutely the same. We are still concerned with value, we still are concerned with quality, with financial strength, with shareholder yield, but now we use composites.
Ben: One of the really fascinating aspects of 'What Works on Wall Street' is how you constantly re-assessed your conclusions. That was particularly the case when you switched from advocating a single factor to composite factors. What drove you to do that?
I believe in the truth above all else. That means that if I am wrong, I will change what I think. I told you about the piece I wrote, 'Mistakes Were Made (And, Yes, By Me.)' It was a rookie error in the first version of the book to declare one of the ratios the king; that was the price-sales ratio. That was naïve, because if you look, if you're time frames are different, it's going to be something else.
To say: "This is the right one, and here's why!" just seems so foolish. What I've found, and what the data tells us, is that it's a horse race, and it depends on when you start that horse race and when you end that horse race, which horse is going to win.
One thing we noticed that's very interesting is the single factor that's doing well suddenly has a bunch of academic papers being written about it, with everyone saying why this one's so much better. That almost always happens right as it slips and loses its crown, and another takes its place.
I actually got the idea from a paper that somebody had written about me, saying: "We think price-sales is good, but when it's combined with P/E it's even better - and here are the results."
I'm like: "That's a good idea." So, we ended up testing a variety of composites, and we found that composites were vastly better, they gave you a much better real sense for value, for example.
A colleague, Travis Fairchild, just published a piece about price-to-book called 'Veiled Value', in which he documents the fact that price-to-book is broken. It's broken not because of its faults, it's broken because the economy is completely different than it used to be. There's trillions of dollars being invested based on price-to-book, including the Russell indexes.
We are not afraid of challenging any of that and we think we're doing a service to investors. That has been our message. Certainly I made it my message with the fourth version of 'What Works on Wall Street'. Anything where we can innovate, where we can challenge, where we can improve; that's our mandate.
I don't think I'm being too boastful to say that OSAM probably has the sharpest definitions of the factors of any of the quants out there. We have that because we have a team that is intensely curious about this sort of stuff, and drills down, and then drills down, and then drills down further.
It's our mission to improve this way of investing. People always say: "This is a secret, so why would you?" The answer is that you could shout this from the rooftops, and no-one's going to believe you. If you have a really good idea, you're going to have to cram it down their throat. People are just naturally hostile to new ways of doing things.
Ben: To what extent do you think human behaviour and self control have a bearing on successful investing over the long term?
I gave a talk at Google, and I actually wrote a piece that's on 'What Works on Wall Street' (the blog), called 'Successful Active Stock Investing is Hard'. One of the studies I found was done by two researchers in Sweden, where they looked at the portfolios of identical twins. Obviously identical twins share 100 percent of their genome; they're copies of each other. The takeaway of this study was that up to 45 percent of investment choices are genetic, and you can't educate against them.
Isn't that true in so many different aspects of the world? People have heuristics and rules of thumb because we'd go crazy if we didn't have them. We only take in under one percent of the external stimuli that is currently around us. That's because our brain filters it all out, because we'd go mad, we wouldn't make sense of anything. It does it naturally, and we come with the code preinstalled.
We have interns at OSAM every year. I do lunches with them, and I talk to them, and they ask me: "What shall I study?" I say: "Evolutionary biology and psychology", and read the books A, B and C. The numbers are the easy part. If you really want to understand how to be good at this, how to be a success at this, it's the steadiness of the hand. My proudest thing is that I have not a single documented time when I ever overrode one of our models because of emotion or volatility, and that's hard.
Ben: Finally, the work you have done and the strategies that you have built presumably give you confidence in good times and bad? How do you handle difficult periods in the market?
I am not a religious person, but I read a lot of Taoist thought and a lot of Buddhist thought, and I think that I most closely identify with that. It's very helpful. The Roman Stoics are also fantastic because they taught me the lesson of "worry only about what you can control."
There's no use, no benefit, and no good comes out of worrying about something that is out of your hands. I've really applied that. Then there is the story of the king who wanted the wise men to write something that was always true and it could only be a single line. The wise man who came up with the winning sentence, wrote: "This too shall pass." That really guides the way I think.
I've been very lucky because this has been my entire adult life. I started very young, and this is part of me, it's part of my DNA.
On CDOs I was so incredibly bearish, anyone who knows me knows that I spent 2006 walking around, saying: "If I could short my house, I would." Had I not had such a quantitative approach to investing, I would have done my homework and said: "Oh, I can short my house!" I would have done it because, again the data was overwhelmingly compelling that leveraging illiquid, complicated derivative instruments forty to one is going to bankrupt you, always. Not sometimes. Always."
But I didn't do that, because I didn't have a 25-year stream of data that told me empirically that I could. There are upsides and there's downsides, but as far as the horrible times go, my wife has always remarked, and my parents remarked, that oddly I am at my best in a crisis. I get calm when everyone else goes crazy. I don't know why but I do.
I guess I've just mercifully been designed by nature that those kind of things just don't affect me. Maybe that's because I love to read, and I've seen this happen, the same play, different players. As long as we've had markets we've had these things happen. They happen all the time; they will happen in the future in a different set of circumstances, a different set of companies, same result. People will panic, stocks will decline precipitously, people will sell at the bottom, and the show goes on.
Ben: Jim, thank you very much for your time.