OSAM on the Efficient Market Myth

While many believe that equity markets — particularly large-cap equity markets — are efficient, quantitative investing guru James O’Shaughnessy’s firm says the data shows otherwise.

“Our research shows that, with the right strategy and the right discipline, the U.S. large cap market remains very inefficient and — by selecting stocks using historically proven themes — investors can outperform it by significant margins,” writes Patrick O’Shaughnessy in a new research report from O’Shaughnessy Asset Management. In the report, entitled “The Myth of the Most Efficient Market”, O’Shaughnessy discusses how more and more investors are turning to index funds for the large-cap portion of their portfolios, since the vast majority of large-cap fund managers fail to be the market. But, he says, passive indexing approaches have a key weakness: “The stock selection and weighting criteria for the index are based on one factor: market cap.”

O’Shaughnessy talks about “proven factors” that OSAM has used to beat the market, like value and shareholder yield (dividend yield plus buyback yield). On top of those, OSAM overlays a “quality” test. “To replace market cap in the selection and weighting process, we’ve isolated the stock selection themes that are the most predictive of strong future excess return among U.S.-listed large cap stocks,” O’Shaughnessy writes. “Our research shows that we should favor companies with attractive valuations and strong shareholder yields and avoid companies with highly bloated and unsustainable balance sheets, poor earnings quality, and poor recent earnings growth trends. Each of these five themes can be measured objectively using data from financial statements and applied with the same discipline that characterizes the passive index investment process.”

The results, he says, have been stellar and show that the large cap market is not efficient. A live portfolio built with the above characteristics that was created in late 2001 has outperformed the Russell 1000 Value Index by an average of 5.5 percentage points per year, beating the benchmark in 96% of three-year periods. The same strategy beat the Russell 1000 Value by 5.0 percentage points annually and had a 95% three-year base rate when back tested from 1963 through 2012.

O’Shaughnessy also says that the current environment offers a particularly good opportunity for investors who focus on shareholder yield rather than dividend yield. With interest rates so low, high dividend yield stocks are trading at an 11% premium to the broader market as investors reach for income, he says. But high shareholder yield stocks trade at a 20% discount to the broader market. He also offers some intriguing data showing how high dividend stocks tend to perform in rising interest rate environments compared to high shareholder yield stocks. Bottom line: “We believe investors who index their large cap investments should instead consider an allocation to proven active strategies,” O’Shaughnessy says.