O’Shaughnessy sticks to the numbers

(January 20, 2005) With so many mutual funds built and sold on the premise that knowing how the underlying companies are run is key, it’s interesting to meet an investment manager who doesn’t interview company executives at all. If past performance is any indication, the computer-driven, numbers-only approach works.

Jim O’Shaughnessy has been playing with spreadsheets since he was a teenager. He’s an affable guy, but it’s the personality of his computer algorithms investors should concern themselves with.

In selecting stocks for RBC’s lineup of O’Shaughnessy funds he sticks to strict company selection criteria that are primarily driven by a process of computer screening.

The newest fund is the RBC O’Shaughnessy International Equity Fund. Although the international fund is a logical extension of the RBC O’Shaughnessy lineup, it took more than seven years to follow up the manager’s entrance into the Canadian mutual fund market. During that time, RBC’s three existing O’Shaughnessy funds earned five star ratings from Morningstar.

“I think the bank wanted to roll our products out in a measured way,” he says. “I think there was a desire to see our stuff working in real time to get a sense of how it behaves in real time.”

Canada is in fact a bit of a testing ground for the strategy. Following the fund’s launch here, there are plans in place to launch the strategy as a separately managed account for investors in the United States. “We thought rather than launch them concurrently it would make more sense for us to get them up and running here and make sure that there aren’t any problems with the mechanics of it. Thus far we haven’t experienced any.”

The international equity fund invests in 100 holdings with equal weightings in value and growth stocks. On the value side, computer screens pick companies with market capitalization, sales and cash flow that are above average for companies in that country. From the list of 300 to 400 names generated by the model, O’Shaughnessy selects 50 companies that have top dividend yields.

On the growth side, the computer model targets “cheap stocks on the mend” by focusing on liquidity, capitalization and companies with price to sales ratios less than 1.5%. From the list he picks the 50 names with the best one year price appreciation numbers.

Overall, he says the computer screening process works especially well when applied to stocks in European and Far East Asia because markets there tend to be less efficient and present better opportunities.

In launching the fund now, the bank hopes to convince investors about the benefits of diversification and making use of 30% foreign content allowance. Last week, RBC released a study that found only 5% of RRSP holders have reached their 30% foreign content limits and more than one third have no registered foreign holdings at all.

“If you look at North American security markets, we account for 55% of the world’s capitalization — 52% in the United States, 3% in Canada. Right now that means that there is 45% of the world out there that most of us are missing,” he says. “Investors prefer to invest in their own country. It’s called the ‘my back yard effect’.”

In general O’Shaughnessy says equities will be the best performing asset class for investors with five year time horizons. Despite that, he says even those who’ve done well with their investments will likely be disappointed by the outcome. “I believe that their expectations for the kinds of returns they’re getting are still unrealistic. I think for indexes, returns of 7% per year over those five years would be excellent. For strategies like this, add 3-5%, depending on the strategy,” he says.

“It’s a return to rationality. We had the big correction because we had to. Stock prices had become disconnected with reality. I believe equities will be the best performing asset class, but it’s going to be much more realistic.”

For advisors, he says the biggest challenge going forward will be the need to reframe client expectations. “There’s another thing from behavioral finance called anchoring,” he says. “People tend to anchor on a number or a person. Once you personally experience that anchor it becomes your new rule of thumb.” He says investors joining the market in the late 1990s for example believe they should still get 20% returns every year, “because that’s what returns were like back than.”

Similarly, he says people can become attached to their investments once they know and love the company’s management. Combined with the fear they might sell too soon, this can cause investors to stay attached to their holdings, even when the numbers say it’s time to sell. “We just avoid that by being completely uninterested in what a CEO tells us about the company,” he says.

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com