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Cornerstone Growth 

a value stock selection strategy

Are you unsure whether the market is heading up or down? I’m going to tell you about a stock picking strategy that, historically, at least, seems to produce remarkably steady long-term returns, in both strong and weak markets.

For instance, even though the market, at least as measured by the S&P 500 Index, has lost 3 percent, on average, annually, over the past five years, stocks picked according to this strategy moved up 14 percent, on average, annually, over the same period.

I won’t keep you in suspense, I’m referring to William J. O’Shaughnessy’s Cornerstone Growth Strategy.

You Name It -- He Tested It! 
In the mid-1990s, O’Shaughnessy performed an exhaustive study of stock picking strategies, checking just about everything that could be tested. He evaluated systems based on valuation gauges such as price/earnings and price/book ratios. He tried fundamental characteristics such as profit margins and earnings growth. He tried picking stocks using high and then low values of each factor, separately, and in combination with each other.

O’Shaughnessy’s study covered the years 1951 through 1994. He evaluated each combination of selection parameters by using them to select 50 stocks at the beginning of each test year, and then tabulated the return realized by selling the portfolio one-year later.

O’Shaughnessy published the results in his 1996 book, “What Works on Wall Street.” Surprisingly, the best results came from the blend of two seemingly conflicting investing styles. It combines low price/sales ratios, which usually identify value-priced stocks, with high relative strength, a factor typically employed by momentum investors to identify fast moving stocks.

If you’re not familiar with the terminology, price/sales ratio is similar to price/earnings ratio (P/E) except the recent stock price is divided by sales per share instead of earnings per share. Relative strength measures how a stock has performed over the past year compared to the overall market.

Price/sales ratios below 3 typically define value-priced stocks, and those above are growth stocks, at least from a valuation standpoint. So, O’Shaughnessy’s 1.5 maximum P/S limits the field to deep value stocks, that is, stocks most investors are shunning, most likely because they’ve reported disappointing recent results.

While the low price/sales ratio limits the selection to out-of-favor stocks, the high relative strength requirement pinpoints stocks that have started to move up, indicating that at least some investors see a recovery at hand. As insurance, O’Shaughnessy also requires positive earnings growth over the past 12-months.

The value strategy, which O’Shaughnessy inexplicably named Cornerstone Growth, returned more than 18 percent annually, on average, over the 43-years tested, compared to 13 percent for the S&P 500.

O’Shaughnessy founded a mutual fund, since taken over by Neil Hennessy, and now called the Hennessy Cornerstone Growth fund, which uses the same strategy. The fund has returned 15 percent annually, on average, since its inception on November 1, 1996, and, as I mentioned earlier, 14 percent annually over the past five years.

Do It Yourself  
You can invest in Cornerstone Growth stocks by simply buying the fund, but if you can buy enough stocks, the strategy is easy to implement on your own. You simply screen for stocks with price/sales ratios below 1.5, and any amount of positive earnings growth over the last 12-months.

Once you have the list of stocks meeting the price/sales and earnings growth requirements, simply list them according to their 12-month relative strength, with the best performers on top.

If you want to follow O’Shaughnessy’s formula exactly as described in his book, buy the top 50 stocks on the list. However, O’Shaughnessy picked 50 because that was a typical minimum portfolio size for institutional money managers, the target audience for his research. In his book, O’Shaughnessy implied that you could do almost as well, in terms of diversification, with a portfolio of only 16 stocks. Once you have your list, buy equal dollar values of each stock, hold the portfolio for one-year, and then repeat the process. 

You can find Cornerstone Growth stocks using most free Web screening tools. I’ll describe how to search for Cornerstone Growth stocks using Business Week's Advanced Screener, which is one of the easiest to use.  

Business Week Advanced Screener 
Access the screener from Business Week's homepage (www.businessweek.com) by selecting Investing, then Stocks, then Stock Screeners (under Investing Tools), finally, click on Advanced Stock Search.

Note: as of 1/17/07, Business Week's screeners were no longer available. You can run similar screens using MSN Money's Deluxe Screener (moneycentral.msn.com) or Reuters Investor's PowerScreener Lite (www.investor.reuters.com). MSN's screener requires downloading special software and Reuters' screener requires registration, but both are free.

Specify a price/sales ratio range of 0.1 to 1.5. The 0.1 minimum rules out unusual stocks with zero or negative P/S.

Then, enter 1 (1%) for the minimum value for the EPS Growth 1-year parameter (Since O’Shaughnessy didn’t specify an earnings growth minimum, I arbitrarily selected 1 percent). Then, select "High as Possible" for "One- Year Relative Performance. Business Week’s relative performance parameter, which is the stock’s percentage gain for the year, isn’t the same as relative strength, but in this instance, it works just as well.

Finally, specify 150 for the number of stocks to display and run the search. 

The screener lists the stocks meeting the search requirements sorted according to relative performance, with the best performers on top, which is what we need. The top 16 stocks listed are the Cornerstone Growth picks. Buy equal dollar amounts of each stock and hold the portfolio for 12-months. 

As They Say, Past Doesn't Predict. . .
While O’Shaughnessy’s strategy has produced impressive historical results, there is no guarantee that it will continue its winning ways. In fact, the last time I checked, the Hennessy’s Cornerstone Growth mutual fund was down almost 9 percent so far this year. 

Considering commissions, buying 16 stocks in small quantities may not be cost effective through a conventional broker. If that’s the case for you, check out services such as Sharebuilder.com, which are set up to handle such transactions cost efficiently.
published 8/22/04

 

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