O'Shaughnessy says his reasonable runaways strategy will pull in over 18% annually and he has the statistics to prove it.  What kind of crack is he smoking?

James O'Shaughnessy perused an ocean of data covering 45 years of Wall Street's history. He was the first person to be granted access to Standard & Poor’s vast database of historical stock performance, and he focused huge computing power on a simple question: of the most popular investment strategies, which have worked best over the long haul? He has come up with a pretty interesting plan for your money. Here are the rules for his "'Reasonable Runaways" strategy, as outlined in his book, How to Retire Rich:

• Buy stocks with a price to sale ratio (or P/E) of less than one.
• Make sure all these stocks have a market cap of over 150 million.
• Buy the 25-50 stocks that the biggest percentage price increases last year.
• Re-balance the portfolio each year to conform to these standards.
  

Using these strategies, one would have returned over 18% compounded during the last 45 years. The problem is that Jimmy did not use appropriate statistical methods to "mine" this data.

Forty-five data points is not enough to reach any significant conclusion. He frequently shows numbers like 14.59%, with a standard deviation of 23.24% -- apparently not realizing that this means the real answer is likely anywhere between -8.65% and +37.83%. In other words, it's consistent with a 0% return, or a completely random return. O'Shaughnessy continually draws conclusions based on differences of a few percent or less, a fraction of the standard deviation, between competing strategies, even though doing so is statistically meaningless.

Jim set up a set of mutual funds a few years back, promising to use his strategies in the funds. Of O'Shaughnessy's four original funds, only one beat either the Standard & Poor's 500-stock index or its average comparable fund, as measured by Morningstar. And that one, Cornerstone Growth, prevailed by a sole percentage point.

O'Shaughnessy is now breaking away from the mutual fund business, starting a new company called Netfolio, possibly doomed as well, judging from the look of his hompage.

Hennessy Funds uses these ideas with some success in their Cornerstone Growth fund.  However, they've modified the formulas significantly, focusing more on relative strength over last year's growth percentage, and don't mention O'Shaughnessy on their website at all as far as I can tell.

The strategy as modified by Hennessy seems to have potential. However, with only a 7 year track record, it is too soon to tell if they have a winner on their hands. I would venture to guess that like most other simplistic investment strategies, this one will prove to be about as profitable as Dogs of the Dow -- that is, not very.