Summary
In this episode of The Acquirer’s Podcast Tobias chats with Jim O’Shaughnessy. Jim is Chairman and Co-Chief Investment Officer at O’Shaughnessy Asset Management (OSAM). He is also the author of the investment classic, What Works On Wall Street. During the interview Jim provides some great insights into:
– Why Clones Outperform The Managers That They Clone Everytime
– Investors Should Beware When We Start To See ‘Information Cascades’
– Investors Must Continue To Challenge Their Long Held Beliefs
– We Tend To Be Very Occam’s Razor At OSAM
– Expansion And Empire Builders Do Horribly
– History Shows That High Conviction Buy-Backs Create Shareholder Value
– As Long As Human Beings Price Securities, There Will Always Be Investment Opportunities
The Acquirers Podcast
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Full Transcript
Tobias Carlisle: Are you ready? Even though we’ve been recording for a little while.
Jim O’Shaughnessy: Sure, I can play along.
Tobias Carlisle: I’m Tobias Carlisle. This is the Acquirers podcast. My special guest today needs no introduction, but I’m going to give him one anyway. It’s James P. O’Shaughnessy. J.P. O’Shaughnessy, noted author, investor, entrepreneur, founder of the multi billion dollar O’Shaughnessy Asset Management. We’re going to talk to him right after this.
Speaker 3: Tobias Carlisle is the founder and principle of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers’ Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information visit acquirersfunds.com.
Tobias Carlisle: Hey Jim how are you?
Jim O’Shaughnessy: I’m doing well. Thanks Toby for having me. How are you?
Tobias Carlisle: I’m doing very well. You know, I almost put the black zip up on. I want with a gray at the last minute.
Jim O’Shaughnessy: Ah, well perfect.
Tobias Carlisle: I’ve even got the black shirt.
Jim O’Shaughnessy: My inspiration is Steve Jobs. I’m kidding.
Tobias Carlisle: Don’t do the turtle neck.
Jim O’Shaughnessy: Never.
Tobias Carlisle: It’s been sullied now by-
Jim O’Shaughnessy: I totally agree. Plus, I can’t pull off a turtle neck.
Tobias Carlisle: I don’t think anybody can honestly.
Jim O’Shaughnessy: You know what, I think he kind of did, but you know he was Steve Jobs. He had a reality distortion field.
Tobias Carlisle: Indeed. Well, I think you might have one too, Jim. I’ve been going through your… I’ve been spelunking on your history. There’s some good stuff for this. I’m really looking forward to it.
Jim O’Shaughnessy: Oh great. So am I.
Tobias Carlisle: There’s some really fun stuff.
Jim O’Shaughnessy: Where are you now physically?
Tobias Carlisle: I’m in Palos Verdes in California. This is actually my home office, but I have an office in Torrance which I can see from here because we’re up quite high you can see my spy glass.
Jim O’Shaughnessy: Yeah, very nice. I love California, you know. When I was still the principle sales person for O’Shaughnessy, I would go there every month and actually thought about getting an apartment there. I lived there for two years because I went to UC, but didn’t get it because I talked about it with my wife and she’s like “I know you. What’s going to happen is you’re going to be tired and say you know I’m just going to stay here over the weekend and it’s going to be February here and I’m going to get mad at you.” And I was like “Yeah, you’re right.”
Tobias Carlisle: If you’d bought in Santa Monica you’d be up ten fold probably on your purchase now.
Jim O’Shaughnessy: I know. I know. When I was at school at UCSD, I got into Cal having never gone there, I mean physically. I wanted to get in somewhere where it was just based on me and not based on my background and stuff. I go to Cal and I’m like “I don’t like this very much at all.” So I go to see my advisor and I’m like “What can I do?” And she goes “You were accepted here at Berkeley?” And I went “Yeah” and she goes “You can go anywhere in the UC system you want to go.” I went “Really?” and she goes “Yeah”. She goes “This is the hardest of the branches to get into. If you get into Cal you can go anywhere.” I was from the twin cities, what did I know. I looked at her and I said “Where would you go?” And she goes “Really?” And I went “Yeah” and she goes “I’d go to UCSD” which is in Lahoya. I went “Why?” And she goes “You’ll see.”
Jim O’Shaughnessy: I went down there and I lived there for two years and then transferred to the school of foreign service at Georgetown.
Tobias Carlisle: Your Wikipedia entry says that you graduated university of Minnesota.
Jim O’Shaughnessy: I did. The reason I graduated from U of M was because I met and fell in love with my wife now of 38 years over summer vacation. I loved the school of foreign services at Georgetown. I thought it was really great. Had really great teachers, professors. I fit in perfectly. I was very excited about it and everything else, but then my wife now, girlfriend then, had gone to Georgetown. Not the school of foreign service, but to Georgetown university. It turned out that we had two mutual groups of friends that for whatever odd reason we never overlapped and we should have. They’re like “Go talk to Missy Walker. She went to Georgetown.” The rest is history.
Tobias Carlisle: Hang on, so you were accepted into Cal, you went to UC San Diego, then you went to Georgetown. This is still undergrad?
Jim O’Shaughnessy: Yeah, oh yeah. Yeah, yeah, yeah.
Tobias Carlisle: And then you graduated from the university of Minnesota.
Jim O’Shaughnessy: Yes, yes indeed.
Tobias Carlisle: Did you do a different year in each one?
Jim O’Shaughnessy: No. I had a very desultory experience. Because of my family background, which I don’t know whether you know about or not, but-
Tobias Carlisle: I know that you’re the youngest of six.
Jim O’Shaughnessy: Yes. I’m the youngest of the grandsons. I have one cousin who’s a granddaughter who’s two years younger than I am. I was the tail end of the caboose. My grandfather was probably the most successful independent oil owner in the country, and at one point the world.
Tobias Carlisle: Wow.
Jim O’Shaughnessy: I love this, because he didn’t trust wall street. This is back during the 20s. Every one of his competitors are speculating on margin a nickel on the dollar. My grandfather is like “It’s all rigged. I know Joe Kennedy, I’ve met Joe Kennedy I wouldn’t do it, I wouldn’t do it, I wouldn’t do it. They all did. They all went bankrupt. He went and bought every one of them nickel on the dollar. He then proceeded to give away 95% of his fortune during his own lifetime. Which I’m incredibly proud of. Because of that, right, there’s an O’Shaughnessy hall in Notre Dame and my dad went to Yale because we did some stuff for them. I applied to Yale, got in, big surprise. Didn’t even have to apply to Notre Dame. Father Hapsburg was at our house for dinner and he goes “Aren’t you starting at Notre Dame in fall?” I was like “No, father Ted I’m not.” He goes “Why not?” I went “Because you’re asking me that question.” He was like “I like that answer.”
Jim O’Shaughnessy: Anyway, thus Cal right. No family connections, zero. I just wanted to see how good… back then, Cal was almost like an ivy. Very sequitous, but I’m sure other-
Tobias Carlisle: That would have been the late 70s approximately.
Jim O’Shaughnessy: Yeah, the fall of 1978. Yeah, I graduated in May of 1978 from high school and then started college in September of 78.
Tobias Carlisle: I think that’s such a good introduction Jim, I’m going to have to include that all in the actual podcast. I think we’re already rolling, so I think we should keep on doing it. I’ll record the intro afterwards if you want to keep going.
Jim O’Shaughnessy: Okay, whatever you want to Toby I’m down with it.
Tobias Carlisle: All right great. You’re the youngest of six and I read on your Wikipedia entry that you got interested in the stock market because you were tracking the 30 stocks in the Dow Jones. Tracking the characteristics of them. What were you looking for? What were you tracking?
Jim O’Shaughnessy: This fits in with the story about my grandfather. My grandfather gave away like I said 95% of his fortune during his own lifetime, but the little 5% that he didn’t give away became the O’Shaughnessy foundation which is a fairly large foundation even today. They used to have quarterly meetings for the foundation. It was my uncles and my aunts and my dad were the board. When I got old enough, right I was maybe 15 or 16, I got invited to the big table. Which I was very excited by because I loved all that stuff. I loved conversation and all that kind of stuff. I was listening to my dad and my uncle John argue about IBM. They were going back and forth you know, Irish family you can imagine. If there were 10 of us there, there were 12 opinions right.
Jim O’Shaughnessy: I’m listening to these guys, my dad and my uncle, argue. I’m thinking they don’t get this at all. I think that instead of talking about the CEO and whether he’s smart or dumb or you know whether he’s making good or bad decisions the way to look at IBM is what’s it paying? How much money do they earn? How much do they pay me to own it? Pretty simple, right? I went down to the James J. Hill, which is a research library and James J. Hill was one of the railroad barons who also, like my grandad, gave away a ton of his fortune during his life. It was a great research library. I was very ambitious. I was probably 17, 18 at the time.
Jim O’Shaughnessy: It got foreshortened because I was 17, 18 and much more interested in girls and going to parties and everything else. My first swing at it was I wanted to say “Okay, what are the facts? What are the facts with that conversation that my dad and my uncle John had had that I felt was really wrong. Let’s find the facts.” I did some research and that meant going to the library. No internet, no iPhone to look it up on. I went down and asked the librarian you know “I’m interested in doing some research on the stock market. What would you recommend?” And she said “Well, we maintain the S&P book of the 500 stocks that are in the S&P 500. Maybe you want to start there?” She got that for me and I looked at it and I started going through it and I’m like “I can’t go through 500 stocks. This is crazy.” You know, this is back when spreadsheets were paper right. I brought one down with me and it was you know this wide.
Jim O’Shaughnessy: I thought “You know what, there’s only 30 stocks in the Dow Jones industrial average. Why don’t I do those?” You know those are going to be the biggest best known blue chips in the country anyway, so let me try that. I started going through and doing by hand things like earnings, price earnings, you know things like that. Price to book, dividend yield. I think the original work was maybe 12 years. Again, as an 18 year old, you think 12 years, you know that’s forever. Even in that 12 year period this would have been ending in 78. Of course now I know there was that huge bias built into value because of the bear market between 1972 and 74 and then value came back and slayed from 75 through 80. Didn’t know that at the time obviously.
Jim O’Shaughnessy: One of the things that I did was I listed them by PE and then I bought the ten highest and lowest PE. A blood bath for the ten highest PE, absolute nirvana for the lowest PE. Then dividend yield same deal. Highest dividend yield fantastic. Then I kind of put it on hold. Fast forward, graduate, get married, have Patrick when I was 24 years old, and doing research on the market because that was my passion. Now we have computers and everything else. It’s not 92 I think, and I’d done a huge amount of research and in fact started to write my first book which was called Invest Like the Best. That was because I was a consultant to big pension plans you know basically cloning the manager quantitatively. Then putting that what we call normal portfolio, i.e. a portfolio that had the same factor characteristics as the manager, to see if that manager’s buying and selling made any difference or not.
Jim O’Shaughnessy: That was my Aha, eureka I found it moment because the clones killed the managers. Killed them.
Tobias Carlisle: Why was that?
Jim O’Shaughnessy: It was because we didn’t override. We didn’t buy and sell based on what was happening in the market at the moment and the managers did right. You know managers reacted emotionally, they listened to stories, they a charismatic CEO. Name the story right, whereas the neural portfolio was just whatever factors were the five biggest factors of that manager’s portfolio I used as a screen.
Tobias Carlisle: What factors were you looking at at that time? Was it value momentum or what were they?
Jim O’Shaughnessy: All of them. All of them. I was looking at simple momentum. Six month, 12 month. I was looking at all of the factors that we still use to this very day. I was looking price earnings, price of book, price to cash flow, price to sales ration, even the Enterprise Value. You know, all the ones that we use.
Tobias Carlisle: You would reverse engineer their portfolios to find out what the factors were and then you would implement those with a system picking the stocks, then that outperformed the managers because the managers were exercising their own discretion to [crosstalk 00:14:53]
Jim O’Shaughnessy: Bingo.
Tobias Carlisle: Wow.
Jim O’Shaughnessy: Bingo. In fact, that’s what got me my first book contract because I wanted to show people “Hey, you have a favorite manager Peter Lynch, Ken Headner, whoever your favorite manager is, I’ll show you how to clone them. Your clone is going to do much better than manager because your clone doesn’t have emotions.” McGraw Hill was like “Yeah, we like that.” In fact, the book came with a disc for you to be able to do it on your computer. Doing that work for the pension plan is what kind of made me become the full time quant. The first paper I ever wrote about the market was essentially behavioral finances before it had a name. Horrible named paper, it’s up on a line somewhere.
Tobias Carlisle: What did you call it?
Jim O’Shaughnessy: I think it was something along the lines of Using Quantitative Models as an Aid to Systematic Errors Made by Human Beings. It was horrible.
Tobias Carlisle: That’s not that bad.
Jim O’Shaughnessy: Horrible. I’ll send you a copy.
Tobias Carlisle: It’s not going to sell, but it’s probably a good name.
Jim O’Shaughnessy: I got much better at titles. I started doing a ton of research and back then, it was all psychology. Most of it was in psychology. There was a great book about psychotherapy. It was a called House of Cards by a guy by the name of Robyn Dawes. It was called Psychotherapy Built on Myth. He had a whole chapter on comparing the results of clinical assessments, i.e. a doctor or psychologist, making an assessment of you or the patient and quantitative empirically derived assessments. What everyone thought was going to be a floor that they human expert would soar above was a ceiling they couldn’t even touch. What it really came down to as we all know now right, is that the deal was… it wasn’t that the models were smarter or even better.
Jim O’Shaughnessy: It’s because they were based on the human being’s factors and what they look like. It was because they were used consistently all the time. They accepted an error factor right. When we make an investment in an OFAM right, we make that investment fully understanding that the probabilities that maybe three out of every ten stocks that we buy are going to lose money. That’s what the empirical evidence over, in many instances, 80 years show us right. Okay, those are good odds.
Tobias Carlisle: Those are very good odds. Let me just back up a little bit because I wanted to ask you, when I was looking at your Wikipedian entry again, it said that you started your career as a VC, you’re a venture capitalist.
Jim O’Shaughnessy: Right, well kind of. We had a family company that was a real estate company, it was called Northern Properties. It owned a bunch of real estate… not a bunch. You know, some apartment buildings and a couple of commercial spaces really. It was kind of small potatoes honestly. My dad asked me to look at it after I was going on and on about how Reagan’s original tax cuts were going to decimate real estate and we should sell all of our real estate. He was like, you know as he should be, what I was 24 or 25-
Tobias Carlisle: You have the 12 year back test.
Jim O’Shaughnessy: Right, exactly. I convinced him, you know these real estate guys they don’t believe it’s real. It’s interesting because it gets to human behavior again right. They were so used to the way real estate used to be run and then interestingly became to be run again when they overcame all of the things that Reagan did away with in his tax cuts, but at that time you were losing a ton of the tax advantages of real estate. Even when I went to sell all the properties, which I did, I would say because I felt I owed them a good faith negotiation, I would literally say to these men who were you know in their 60s “Hey, you know I know I’m just a kid and everything, but if you guys really look at Reagan’s new tax law it’s not good for real estate.” They’re like “Ah, you’re a kid. We’ve been here for so long, you’re wrong we’re right.” I’m like “Okay.”
Jim O’Shaughnessy: Anyway, we sold all that real estate and then I suggested that we invest that in start up style companies, like the tech of today. For example, we invested in a sign making company which was a big deal back then because a company that could make a sign rapidly right, in those days if you wanted a sign you had to wait months. This new company that we invested in could make a sign using computers, you know you could have it that day. Then we invested in a clothing manufactured. A whole variety of kind of different one off investments, but I would not really call it venture capital.
Tobias Carlisle: A colleague of yours observes you’ve got this instinctive intuitive… you’ve already done a back test as a kid. Somehow tracking down that data and doing a back test by hand. He sees that you’ve got this to sort of quantitative research methods. He says “You should try this in pension consulting.” That’s when you set up O’Shaughnessy Capital Management.
Jim O’Shaughnessy: That’s exactly right yeah. My friend was the general council for a company called Control Data which no longer exists. It was a result of the conglomerate mania of the late 60s and early 70s where companies just kept buying other companies right, and combining. Control Data had been the result of a bunch of combinations. His name was Dan Penny, he’s still around, a great very smart guy. We were at lunch and he was like “Tell me about what you’re doing with this stock market stuff.” I told him and he’s like “If you form a company, Control Data will hire you because we would love to have some clarity around-” because they had a bunch of different managers that were legacy managers from the companies that they had acquired right.
Jim O’Shaughnessy: Again, you’ve got to put yourself back in kind of the 80s and not many people were using kind of computer analysis and specifically quant and factory analysis. That was what kind of got me into the… okay, let’s take do an x ray of the factor profile of these managers. We’ll give the high level to the committee right, so this manager is a small cap manager and they like growth right. The biggest factors are all growth oriented and they’re PEs are much higher which is normal of growth, et cetera. We’re using those factors to create this normal portfolio.
Jim O’Shaughnessy: What was really interesting was in many circumstances, the manager could get by with basically just saying we buy good stocks. Back in the 80s people were like “Oh, cool. Good.”
Tobias Carlisle: That makes sense, it’s better than the bad ones.
Jim O’Shaughnessy: Exactly right.
Tobias Carlisle: We buy the ones that go up.
Jim O’Shaughnessy: Right. That was Will Rogers right?
Tobias Carlisle: Don’t buy the ones that don’t go up.
Jim O’Shaughnessy: Yeah, don’t buy the ones that don’t go up. Or if they don’t go up don’t buy them.
Tobias Carlisle: That’s it.
Jim O’Shaughnessy: The original momentum investor right Will Rogers.
Jim O’Shaughnessy: A lot of these committees right, which had fiduciary responsibilities around these portfolios, honestly they didn’t know whether the manager was a growth or a value or a big cap or a small cap or whatever. That was all information that we shared. As I had mentioned earlier, that was my eureka moment. When I had been at that for more than a year and we had quarterly meetings, which again back even then I was saying “This is madness. You know this is noise, we’re going to talk about noise here.” They were like “Well, no no no no, you know we got to know what’s going on in these last three months. It’s really important.” And I went “No, actually it’s not. It’s misleading.” I lost that fight. I got a little bit better at that one.
Jim O’Shaughnessy: Anyway, my aha moment was watching for the ninth time all of the cloned portfolios, not just one or two, all of the cloned portfolios be they small cap, large cap, value, or growth killing the manager that they were cloned from. I was like “It’s all because they don’t act emotionally. It’s all because they don’t second guess. It’s all because they just use the rules.” I decided “Okay, I’m going into active management and there you are.”
Tobias Carlisle: That becomes Invest Like the Best which comes out in 1994. You discuss how you can look through… you clone the strategy outperform the manager potentially. Then you set up a family of mutual funds Cornerstone.
Jim O’Shaughnessy: That’s right. In the first version of What Works On Wall street you know interestingly enough, I had very high hopes for What Works On Wall street because obviously at this time when it’s coming out, there was academic work. French pharma, you know the drill. LSB all the folks there, Clift who’s my neighbor here in Greenwich, lots of papers. Very little for the general practitioner. Even then the general practitioner wasn’t so good, unless he was a really big nerd, wasn’t so good about following all of the academic research. I was a really big nerd and followed all that stuff. I thought “Wouldn’t it be great if we could just go as far back as we can and definitively say does buying low P stocks work? If it works, by how much? How often? What are the draw downs?” Et cetera. When what works came out it inexplicably became a best seller. You know the book-
Tobias Carlisle: Very well.
Jim O’Shaughnessy: -it’s charts and graphs right? O’Shaughnessy Capital literally saw four to five hundred million dollars of assets come over the transom. All of the calls were incoming. I have a guy who started with me in 97 who’s my president here today, Chris Loveless, he made the very funny joke that a guy who used to be with me was in charge of private clients because we used to take high net worth individuals directly. We take them now through advisors. Anyway, he used to joke that Dan was the highest paid phone rep operator in history. Literally all the calls came in, the money came over the transom, because it was new. We decided let’s launch mutual funds. I had dubbed the two strategies on the growth and value side cornerstone growth and cornerstone value, thus the names in the mutual funds.
Tobias Carlisle: What works on Wall street now is an investment classic in it’s fourth edition. I think everybody knows what it is. Everybody will use it as I use it too as a reference. You know what are the best performing strategies. I’ve mentioned this to you before, but there’s a novel at the start of that book about behavioral investment which is one of the best I’ve ever read on the subject.
Jim O’Shaughnessy: Oh, well thank you.
Tobias Carlisle: I’m very glad I wrote Quantitative Value after… before I read that because I may not have done it.
Jim O’Shaughnessy: Which is a great book. You know, I love that.
Tobias Carlisle: Listen, I may not have done it if I’d read that because it’s very very good. I don’t know that we’re charting that much new territory as we were doing it. At some stage through there you joined Bear Stearns. O’Shaughnessy Capital Management becomes the systematic quantitative arm of Bear Stearns.
Jim O’Shaughnessy: You know that’s an interesting story because I actually wrote a piece about it. It’s at my Tumbler which is called What Works On Wall street-
Tobias Carlisle: Is that which stakes were made, but not by me?
Jim O’Shaughnessy: Yeah, that’s the one.
Tobias Carlisle: Yes by me, I’m sorry.
Jim O’Shaughnessy: Yes, by me. Yeah that’s the difference of my title. I myself am a classic example of people memetically copying other people because they’re so overwhelmed by the activities of others that they can’t help themselves. This is the perfect example. In 1999 I wrote a piece in April of 1999 called The Internet Contrarian. In that piece I said “This is the biggest bubble any of us have ever seen in our careers. 85% of these companies are going to go bankrupt. Even the companies that are going to go on to be the winners, and I specifically cover Amazon and AOL at the time, even they are probably 90% over valued right now. What do I do a few months later? Of course I start an internet online advisor called Netfolio.
Jim O’Shaughnessy: Netfolio was essentially kind of the first robo advisor right, except it was an asset manager as opposed to an advisor. I made a deal with Bear Stearns to be the back office. The internet bubble blew up and the folks at Bear said “You know, we love the tech, we’re not really terribly interested in that though. What we are very interested in is you and your team because you’re trackers goods are really great and why don’t you just come over to Bear Stearns and be our quant arm within asset management?”
Jim O’Shaughnessy: At that time, I’d never worked for another company, I’d always had my own company. Bear was kind of like the only of the big investment firms that I could work for because they had a… I have to choose my terms very carefully here. They had a very entrepreneurial spirit. In other words, they tried as best they could for a big investment bank to empower people with good ideas to not wrap them up in red tape, et cetera. You know really kind of a shame when Bear was lost, because it really was kind of the last of that kind of company on Wall street.
Jim O’Shaughnessy: Anyway, yeah moved over to Bear, became their systematic equity, they didn’t like the term quantitative, and rapidly became the largest long only manager within Bear Stearns asset management. At my height when I was leaving we controlled about 74% of Bear Stearns asset management long only equities. Now, there were hedge funds within Bear. It was really an amalgamation of boutiques. There were a couple of other long equity managers that were traditional fundamentalists. There was a value team and there was a emergent market team et cetera.
Jim O’Shaughnessy: Yeah, we had a nice run at Bear Stearns. Great company, lots of really great people.
Tobias Carlisle: After Netfolio, because you journal as you go, do you still journal? Do you still record what you do?
Jim O’Shaughnessy: I do. Not so much on the investment side as on the speculative side. Because we have a process which I will not override right. You know I’m not going to write I ran market leaders value again and I’m buying cheap stocks with high shareholder yield again, I’m going to hold them until they are no longer in the model again. I really can’t do much there. One of the things that I have journaled about and have… let me take a step back. I am such a quant that it is in my DNA. Unless it’s a private company or a new venture, I literally can’t pull the trigger on a public market investment without there being a ton of empirical evidence on why I’m doing that.
Jim O’Shaughnessy: While I was still at Bear in 2006 I started getting incredibly negative on real estate and on CDOs in particular, collateralized debt obligations. I was walking around telling anyone who would listen to me if you can short your house, short your house. Don’t buy these things you know. They’re bad. I didn’t have any quantitative things that I could point to right. I wrote in the journal I think it’s going to be really really bad for real estate and here’s why, because they’re making the rookie error of saying… recency bias right. Real estate never goes down. Well, yes it does if you go back and… Bob Sholer up at Yale who’s just about a 45 minute drive from where I am right now, he has all that data and he shows quite clearly real estate can and does go down.
Jim O’Shaughnessy: Anyway, didn’t have a quant model so I didn’t do anything. You know what happened. I started thinking about it, and I started thinking wouldn’t it be great to come up with some kind of quantitative indicator. To take a step even further, I’m sorry for… but you kind of have to cover this to cover that right. I’ve always thought, and here’s where my journals are very helpful, because I went back through them a couple of weeks ago and I’ve thought this since 1988 was the first time that I wrote the following sentence.
Jim O’Shaughnessy: The stock market is a complex adaptive system with feedback. The reason that it works so well is because people have heterogeneous interpretations of things right. Toby might buy my Apple stock from me because he’s going to get married or he has a child or whatever, and he wants to fund that child’s future education. Jim is 58 and has a grandchild, he might want to sell that so that he can help pay for the grandchild’s education right. Neither one of us is wrong right. I’m right because of why I’m selling it, for the reason I’m selling it. You’re right for the reason you’re buying it right.
Jim O’Shaughnessy: That’s why markets generally clear and why markets are great aggregators of information right, the wisdom of crowds type thing. However, I also had a corollary theory that was attached to that which was rarely, maybe call it 10% of the time, things that I at the time and still call information cascades happen. What’s an information cascade?
Jim O’Shaughnessy: An information cascade is where all of the information is going in one direction only and very importantly, all of the investors interpretations of that data are the same. Objectives are no longer heterogeneous, they’re homogeneous. We’re all thinking the same thing. Which led me to this deep dive study that I’ve done on memetic behavior right. By the way it’s fascinating. You’re head spins because it’s really been around, the name is different right. Memetic behavior, but Plato talked about it right. The simple version of it is we do things by copying other human beings. Pretty simple.
Jim O’Shaughnessy: Then we don’t know that right, we don’t know we’re copying them, and we invent rational reasons for our behavior after the fact. Especially in these situations where we have an information cascade, everybody is interpreting that information the same way, interpretations become homogeneous right, and the memetic drive, making the guy who wrote the most bearish article on the internet started an internet company right. I’m the perfect idiot example here.
Jim O’Shaughnessy: It overwhelms us. It overwhelms us to such a degree, and you know we could a whole pod cast just on memetic behavior and the transference through memes right of behaviors both good and bad, and how they infect the mind right. I think it was Dawkins who came up with the term gene, he also came up with the term meme and called it you know a virus of the mind. Actually there’s a book, a good book, of that title Viruses of the Mind about memetic behaviors and transference and everything like that.
Jim O’Shaughnessy: The reason I have to get into all this stuff is A: I want to understand why is this happening right. B: can I quantify it? Is there a way to quantify this? Then see is there a quantitative signal that I can develop that says information cascades happening, event happened, run for the hills. In other words, it happens at watershed turning points.
Tobias Carlisle: Can you apply that to the 2007 real estate crash? How does the meme manifest in that particular point in time?
Jim O’Shaughnessy: Let’s be careful, I can’t empirically yet prove my thesis. I haven’t been able to fully test my hypothesis. Dirty little secret, about half of what I do on Twitter is in service to a lot of the research that I’m doing. I also want it to be fun. We have through the brilliant program that Patrick started, the O’Shaughnessy research partners. We have some of the brightest machine learning guys in the world on our partnership team. I was on the phone about a month ago with one of our lead guys, and I love engineers because they immediately just start solving the problem right. They’re like “Oh, well we could do this, we could do this” you know.
Jim O’Shaughnessy: Anyway, we don’t yet have any empirical proof that I could offer to you. My theory is that during the CDO and real estate crisis that yes, we had information cascades had happened. People’s interpretation of what was going on became homogeneous except for very few which were written about in the great book The Big Short by Michael Lewis and made a movie. How they made a movie, an enjoyable movie at that, about that I mean that’s genius right there.
Jim O’Shaughnessy: Anyway, yes that’s what happened. What happened was everybody was behaving memetically. I sat in on several pitches for hedge funds that were you know going along short CDOs. They were mostly going long, mostly with huge leverage. You know if you learn anything in stock market 101, it’s that if you want a prescription that always works if you want to fail is you use 40 times leverage on illiquid instruments. It’s not if you’re going to die, it’s when you’re going to die. You’re always dead.
Jim O’Shaughnessy: Yeah, that’s what was going on then. It’s what was going on during the dot com frenzy. You know we’ve got Jamie now works for us, the financial history guy, and I know you know Jamie well. You know he’s very good at showing that it went on all the way back to the Babylonians right. Anything new and exciting ignites the human imagination as I understand why it should right.
Tobias Carlisle: In the ordinary course, in the ordinary stock market it’s heterogeneous. We have different reasons for buying and selling. Then in these booms and probably or so in the bust we become homogenous in we’re all pursuing the same thing. We see the dot com is going to be huge, so we all want to be buying dot com stocks and then eventually it busts so we all want to be out or short of the dot com that applies again in real estate and then possible in crypto. In the recent run up it becomes sort of overwhelming. You might be able to use something like Twitter or a web search to either count the number of times that crypto or something like that appears.
Tobias Carlisle: I know that Ben at Epsilon theory he creates these, and I think they’re quantitative mind maps of news events that are occurring at any given time.
Jim O’Shaughnessy: Yeah, I love Ben and his whole team. By the way, I should hasten to say I disagree with their conclusions probably more than I agree with them. This is a classic example of a practice of mine that I think everyone should get in the habit of. That is when there’s very very smart people writing very very smart things, you got to read them. You might not agree with their final conclusions, that doesn’t matter. What you have to do in my opinion to ground yourself and continually test the calibration of your mental models is you’ve got to read intentionally people who you disagree with or you know you’re going to disagree with right.
Jim O’Shaughnessy: Because the chances are really good that I could be wrong right. The problem is is that we begin to think of our beliefs as facts. They’re not facts, they’re beliefs. Challenging a human being’s beliefs, boy you want to see anger, you want to see just pure hatred, start really poking at somebody about their most deeply held beliefs. It’s not a pretty picture. What you’re going to see is you know everything from argument ad horminum you know “O’Shaughnessy you’re a jack ass, you’re an idiot, you know you don’t know what you’re talking about.”
Tobias Carlisle: You don’t get it.
Jim O’Shaughnessy: Right, you don’t get it.
Tobias Carlisle: You don’t understand.
Jim O’Shaughnessy: You don’t understand. It’s so funny because I intentionally go out of my way to… I know I probably don’t get it. You know there’s a lot of things I don’t get. That’s why you have to try to read as broadly as you can in my opinion to continually test because really things that we think of right as even quantitative rules that have 80 years of empirical evidence, they’re still probabilistic right. They can change right. Have our bedrock ways of managing money changed? No. Have the underlying strategies evolved? Absolutely. In fact, if you looked at a say let’s take market leaders value right, which used to be called corner stone value back in the 90s. Has it changed? Pretty much entirely. Same theme right, by cheap market leading companies of good quality that have high use to be dividend yield now it’s shareholder yield which is by back plus dividend yield.
Jim O’Shaughnessy: It morphed through evolution into what I think is a vastly superior strategy. I think if you and I are talking ten years from now, it’s going to have morphed again. I love one of the things that people say about quants you know the throw away line is “Whoa, what do you guys golf all day” or you know, whatever. No. The research team here is forever doing research and sometimes it’s really un-sexy research. For example we have very negative views on price to book as it is currently used. That isn’t because we decided we don’t like price to book, that was because we’re doing continual research and we’re saying “There seems to be some problems here.”
Tobias Carlisle: Let’s talk about that a little bit. The first edition of What Works on Wall street you favored price to sales. The argument there was pretty compelling. It’s the very top line in the income statement, it’s hard to game and everything below that is a little bit more diluted. Ultimately the problem with it is that there are some companies are going to yield more out of the sales. They’re going to have a higher margin, they’re going to be a better business, so you end up moving down the income statement a little bit. There are problems with price to book which I think O’Shaughnessy Asset Management has done the best job of sort of illuminating with a price to book… negative equity companies and so forth.
Tobias Carlisle: A few years ago now you brought out an article, I’m not sure how old it is. It could be 10 years old where you suggested that a better approach was some sort of combination of metrics because then you’re not so tied to whichever one. You make the point that… it’s to the date that we wrote quantitative value the best performed strategy and that was Ebid on Enterprise Value. There’s no reason why that should be. It could easily be free cash flow to enterprise yield for the next… and the way that you avoid that is you have some sort of blend of all of these different metrics because the objective is to uncover something that is genuinely undervalued and not something that merely matches the price ratio.
Tobias Carlisle: How do you get comfort with the particular blend or the combination that you use?
Jim O’Shaughnessy: Sure. We tend to be very Occam’s Razor around here. We try to not be terribly fancy in things. You’re not going to see a lot of work out of here on over engineered strategies or lots of switching between over weighting one particular factor versus another. The value composite that we do in fact use, the factors are equally weighted and we did that because we concluded through research that you know we’d be data mining. If we’re going to be honest about this yeah of course. With the evidence available in the past, yeah we can overweight this and voila, it’s a better way to do it. It’s also heavily data mined.
Jim O’Shaughnessy: In quant research it’s really interesting to me to see how far it’s advanced. I think it’s great. There is this continuum right, and so there’s the one side that I happen to be on, which is the really conservative side. Which is for the most part, it should make economic sense. It should be somewhat intuitive. It should you know if you ask an intelligent human being… I often use food trucks as my example you know. Would you buy that food truck with a hundred thousand of revenue for 10 million dollars? No. Thus that’s price to sales right, price to revenues. Price to earnings also makes sense, although earnings can be an R endlessly manipulated.
Jim O’Shaughnessy: Price to book another one. Perfect for the industrial era, not so perfect for the era where symbols are more valuable than real things. By the way, Travis Fairchild who I did a podcast with him and he wrote the paper, did that piece on price to book. We have a piece coming out, will probably be out I don’t know when this is going to air, but-
Tobias Carlisle: Early June. Early June.
Jim O’Shaughnessy: Early June, okay so it will probably either have just come out or have been out for a bit. If you think that Travis’ piece on price to book was devastating, wait until you see what we’re coming out with that Jesse Livermore did. My hat is off to this gentleman. This guy is one of the most brilliant market researchers I’ve ever come across. We’re talking kaboom. You’ll see that when it comes out, but the point is we tend to be very conservative. We don’t over engineer things so we knew that we could try to do a weighting scheme on the factors.
Jim O’Shaughnessy: The conclusion was yeah, but honest minded data mining i.e. you’re mining it even though you don’t think you are right. That’s why we do all of these boot strap’s that’s why we split up the universes, that’s why we test it on our sample, we do it because you know… Doug Adams I think, the author of Hitchhikers Guide, I love him. He wrote some books about other things that are just brilliant. He died way too soon. I think one of his quotes was “You can’t fool proof anything because you are underestimating the ingenuity of your average fool.”
Jim O’Shaughnessy: That’s why we have all these other tests right, because we could be mining something innocently. These other tests will show us if that’s the case.
Tobias Carlisle: I’m sorry, keep going.
Jim O’Shaughnessy: No no, go ahead.
Tobias Carlisle: My question was just going to be even so after you create whatever analysis you bring, in a value universe for example. It’s been a very rough five years for value, it hasn’t performed particularly well. The fact is presumably why to [inaudible 00:51:03] particularly well through that period of time either, how do you know then whether you’ve got a price to book type scenario on your hands or whether this is a normal cyclical… normal cycle in the market and value will have it’s day in the sun again.
Jim O’Shaughnessy: That’s a great question because it gets to what I was alluding to earlier which is the very non-sexy research that we do here too. That research is taking apart these factors right down to the studs. We want to see, okay, how many different ways are they defined, you’d be surprised. If you were looking at a something as straight forward as you would think would be straight forward right as a PE ratio. Type in the stock of your choice and make it a big one too. One that everyone knows. Do Google or Amazon or Apple. Type it into Bloomberg, look at the PE there, then go over to Reuters type it in there look at the PE there, then look at what the company says it’s PE is and then look at it on free websites. Often times you’re going to get four different numbers because they’re calculating it differently.
Jim O’Shaughnessy: One of the things that we do which is really un-sexy, we can’t write unless something is glaringly obvious like the price to book. We’re not going to write a white paper about it because we find that yeah it’s okay. We take these factors down to the studs, we look at the definitions, we talk about “Does that make sense? Does this make sense the way they’re defining Ebid to Enterprise Value? Is this the right way to calculate Enterprise Value? Et cetera.
Jim O’Shaughnessy: After we do all of that research, that is the kind of research that leas us to, well in this instance price to book. We don’t use price to book anymore. We don’t use it because we have serious misgivings about it. We could use it if we took Travis’ corrections into play, but we have something else coming down the pike in this paper that I’ve talked to you about from Jesse Livermore. That’s going to be better.
Jim O’Shaughnessy: Anyway, so if the factor itself right, after we’ve taken it down to the studs, done the research, done all the homework, is there anything that is smelly or is being manipulated here, all these things. If it withstands this sustained you know assault of research, then we say “Yeah, okay. PE is still fine. Price of sales is still fine. Ebid to Enterprise Value still fine. Then it becomes a question, as you alluded to, well you know value isn’t working particularly well for the last five years.
Jim O’Shaughnessy: The other thing you have to remember and you of all people know this very well, value is not a monolithic thing right. There are deep value guys who don’t look at all like us. There are guys like us who are value, yes, but also quality, also high shareholder yield. Buy back, I know it’s the enemy of the certain group of people right now. Again, it’s the hydra right, you cut one head off and two grow back.
Tobias Carlisle: There are many bad arguments against buy backs.
Jim O’Shaughnessy: Oh my god. It’s a herculean task because they just keep throwing them at you, and they’re so stupid for the most part. Well, that’s what happens and I better take that back, because that will be the quote.
Tobias Carlisle: It won’t I guarantee it.
Jim O’Shaughnessy: Okay. They’re not paying attention to the empirical evidence right. I have something up on the screen right now. Research that we did and we looked at you know how do companies allocating capital, how do they do historically? Well, deluders, people who issue shares, do horribly. They do about four percent annually worse than the average stock in the universe. Debt issuers, horribly right. Again, if we were just two guys in a pub talking about this we’d reach these conclusions right?
Jim O’Shaughnessy: Expansion, empire builders, horrible. Minus 4.5%. Well why is that? Well what are empire builders? They’re ego driven CEOs… you know, I’m going to show them that I’m the best. You’re not. Regular acquisitions they reduce value. What is the one that absolutely over long periods of time adds value? Buy backs. At 2.5% annually, and we have the data going back to the 20s.
Tobias Carlisle: This is your, I forget the word that you used, but it’s… you’re not talking about every buy back because buy backs for the most part do tend to be valued as strong. You’re talking about the particular buy backs, the concentrated buy backs, I’m just blanking on the word.
Jim O’Shaughnessy: Yeah, high conviction.
Tobias Carlisle: High conviction, thank you.
Jim O’Shaughnessy: Again, it’s funny because everything is nuanced. One of the other things that we try to do around here and I think if you listen to Patrick, if you listen to me, if you listen to anyone on the portfolio management team, Chris Meredith, Travis, et cetera, what you’re going to find is we try to explain things as simply as we can but not simpler right. Yes you’re correct, we believe that high conviction buy backs done when the company is in say the bottom third of value. In other words, the cheapest third of which universe, that never the less has strong financials that’s the quality piece. Those buy backs are perfect right.
Jim O’Shaughnessy: Buy backs done for other reasons or when a company is expensive or for you know trying to monkey with earnings per share so that options… you know, all of those other reasons, most of the reasons people say buy backs are horrible. They don’t do nearly as well right. I do have to take issue with you’re saying most buy backs are valued destroyed. That is not true.
Tobias Carlisle: That’s not the case.
Jim O’Shaughnessy: That is not the case. When you look at buy backs, even including those bad actors right who are buying back at high valuations and doing that, they still do better, add value, over long periods of time. They don’t add significant value, but in aggregate they are not value destroying and that’s another thing. Again, all we have is 80 years of proof and these people have their opinions that they’re asserting as facts right.
Tobias Carlisle: That’s interesting, my impression was that the bulk of buy backs occurred closer to market tops and then buy backs tended to dry up as markets bottomed.
Jim O’Shaughnessy: I don’t have the paper right in front of me so I’m not going to make a statement that might be wrong, but we have a lot of papers on buy backs and what we have found is that the majority of buy backs happen from 1987 through whenever we published this paper for instance, happened when the company was in that bottom third of valuation. The majority were being made-
Tobias Carlisle: Not good.
Jim O’Shaughnessy: -sensibly right. Harry Singleton at Teledyne is kind of the poster child for this. Maybe we can put a pin in that and we’ll look at the paper, but my recollection is that it’s not true that the majority of the buy backs are done at market peaks, however, as I’m thinking about this, I think we do show that on a dollar volume basis that actually might be right. Again, I’d have to go and look at the research. The argument that we’re making is pretty simple and that is cheap, high quality, buying back, good. With high conviction.
Tobias Carlisle: Little bit of a side step, but you have several patents-
Jim O’Shaughnessy: I do.
Tobias Carlisle: -including one for a strategic index that I think if you enforce might bring down the entire financial system.
Jim O’Shaughnessy: Que doctor Evil. Really. Excellent.
Tobias Carlisle: How many patents do you have?
Jim O’Shaughnessy: You know, honestly I think I have five if memory serves me. They’re around here somewhere.
Tobias Carlisle: You’re strategic index patent, what does that one do exactly?
Jim O’Shaughnessy: That one, that is so funny. I think they… and this is from memory. This was issued in 2000, and it was a strategic investment strategy using the world wide web. Basically all of the robo advisors, it’s everything.
Tobias Carlisle: It’s everything.
Jim O’Shaughnessy: The kitchen sink. My feeling on that is it’s silly okay, so yeah, I was going for every advantage that I could have back when I was doing Netfolio and I thought why not, let’s get a patent on this. We got it. I think that to fight that war you’d have to have you know Goldman Sachs money. You’d have to have 500 million dollars that you’re willing to throw because that’s going to be a battle that is never ending.
Jim O’Shaughnessy: Secondly, it’s a troll like behavior. Life is too short. Honestly, yes I’m very happy that I have that patent that it’s fun to talk about. I mean, is it enforceable? I don’t know. I don’t even want to find out because you know it would require me to dedicate the rest of my… I’m 58 right, so I probably would see my big win when I was 90. Patrick would probably be very happy if we won. Life is too short.
Jim O’Shaughnessy: Patents were a thing for a little while right. Patenting business use strategies, I did it, so I can’t really argue against it, but honestly I know that Merrill had a very famous case where they went after people for a cash management system. I think they ultimately won, but it was a Pyrrhic victory. By that time things had evolved so that that particular very narrowly written patent was really valueless.
Jim O’Shaughnessy: Yeah, we do have that patent and I guess we get bragging rights in that we were there early. Life is way too short to be a troll. It’s always been my guiding principle that let’s move things forward, all of us right. People used to say to me “Why did you write What Works on Wall street? Why didn’t you keep that secret?” Well, I know enough about human nature that I could give you the exact formula right now, I could just email it over to you. Well, maybe not you, but I could email it to-
Tobias Carlisle: You can send it to me Jim.
Jim O’Shaughnessy: Right. The minute it stops working you’re going to say “Well, this O’Shaughnessy is a fool. This doesn’t work anymore.” You’ve got to scream this stuff from the mountaintops, you’ve got to repeat it ad nauseum and you might get a few people to be willing to stick it out with you. Again, it’s not the way that we evolved right. I was talking to a new hire here and we were talking a little bit about… he was like “Why are you so into behavior?” I’m like “Well, because that’s the whole thing, that’s it right.” As long as human beings price securities, we’ve got something to arbitrage. I said to him “By the way, all of us sitting in this room are the descendants of who? The people who ran away.” Not the people who were like “Huh, that bush over there is moving, I wonder what that is? I’m going to go check that out.” No no, they all died.
Tobias Carlisle: Pick up that snake like object.
Jim O’Shaughnessy: Exactly. We are the descendants of the ones who went “Run Forrest, run.” Right, risk aversion. We are the descendants of the people who were the most cautious, the most afraid, the most I’m going to protect me and mine, right. All of that, and it makes sense right. It makes a lot of sense. It made sense for people who were optimized for living on a savanna and being hunter gatherers. It doesn’t make so much sense for people who go to whole foods and pay for it in Bitcoin right.
Jim O’Shaughnessy: Here we are and here we find ourselves. Evolution works, but it works very very slowly. I think it’s going to continue on it’s merry way. I have two grandchildren I’m delighted to say. My grandson Pierce is five and my granddaughter Mave is three. They’re Patrick’s children and his wife Lauren. It’s going to be the same in their lifetime too. I think it’s going to take a long, long time for human nature to change. It’s going to require just mountains of not only evidence but money.
Jim O’Shaughnessy: I got asked on Twitter the other night, he said “I’m 22 years old, do you think that the hedge funds like they’re run today will continue or do you think that AI will just completely put them out of business?” I was like “No, I think they’ll continue.” I said “Parenthetically as I always do, I could be wrong, but what that would require is somebody coming up with the AI and then making a trillion dollars and saying see.” Then people might go “Yeah, I see.”
Jim O’Shaughnessy: Again, knowing what we know about economies and everything and the medallion fund right is only open to employees there now right because scale right. You can’t scale these things, so yeah will AI make people like us better? Hopefully. We’re looking at it. Jury is out. A lot of that can’t scale, but it scale and make the company enormously rich but it can’t scale to the point where you know you’re worth a trillion dollars.
Jim O’Shaughnessy: Like everything, it will have a failure rate. It’s that failure rate that people will latch on to. Somebody else was like, you know they were talking to me and they’re like… they had been doing research on me and they were like “I found these really negative articles about you.” I’m like “Okay, so?” He’s like “Well, how do you deal with that?” I’m like “Look, you know one of the most unintentionally great movies about Wall street was Wall street by Oliver Stone who wanted to vilify Wall street and you’re now making everyone love Wall street. He’s got this line which is true you know, if you want a friend get a dog. That doesn’t mean that I want people to be intentionally mean, I don’t think they should be, but I understand.
Jim O’Shaughnessy: Again, we’re back to human nature. What happens is for somebody who manages money the way we do quantitatively, empirically et cetera, we’re always going to have that period where we under perform. Anyone really could have a period where they under perform. It’s always during the periods when you’re under performing that all the knives come out. They’ve just been waiting. When you’re doing really really well, eerie silence. Nothing bad. Even you might have some people saying “Whoa, he’s a genius.” I use that as a contra indicator. Anytime someone tells me how smart I am, I start going “Oh my god, this is the end.”
Tobias Carlisle: It’s over.
Jim O’Shaughnessy: It’s over. Then of course… so I say you go through the… it’s like a sine wave you know. Hero genius, idiot goat. Hero genius, idiot goat. When you’re an idiot goat, and not greatest of all time. I mean goat in Baa, that type of goat, that’s where all the knives come out. If you can’t deal with that, then you shouldn’t be in this business.
Tobias Carlisle: Well, that’s a great sentiment to end it on Jim. I really do appreciate the time that you’ve given me because I know you’re an extremely busy man. If people want to follow you, the best to follow you I think is probably Twitter and what’s your Twitter handle?
Jim O’Shaughnessy: Just JP O’Shaughnessy.
Tobias Carlisle: You’re the reigning gif king, how do you pronounce that is it gif or jif?
Jim O’Shaughnessy: Okay, so I had David Purel who you might know. He’s a young guy, he’s doing a writing course, et cetera. I was with him at the shin dig that my new employee and colleague Jamie put on in Washington. I said well all of my kids who are all millennials say it’s jif and David, who is also a millennial, was like “No it’s not” he goes “I was with the founder of Giffy and he said it’s gif. Not jif.” You know, who knows. Life is short and I think one of the things in addition to gaining some pretty interesting, useful, memetic information, I can entertain people and that’s great. I think Mark Twain said laughter is the only effective weapon that human beings have. In other words, if you get people laughing at something, it’s over.
Tobias Carlisle: Well thanks very much Jim. I really do appreciate the time. Jim O’Shaughnessy.
Jim O’Shaughnessy: My pleasure Toby.
Tobias Carlisle: Thank you.
Jim O’Shaughnessy: Thanks, bye bye.
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