value stock selection strategy
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
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.
keep you in suspense, I’m referring to William J. O’Shaughnessy’s
Cornerstone Growth Strategy.
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
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.
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
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
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.
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.
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.
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.
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
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.
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.
specify 150 for the number of stocks to display and run the search.
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
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.
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.