It seems that every day, investors are bombarded with advice on "the best" way to make money in the stock market. Stick with large companies with high dividend payouts, and you can be rich like me! some will say. Others will tell you that targeting stocks with the lowest price/earnings ratios is a surefire way to maximize profits. Still others will assure you that the road to riches is paved with small growth stocks with rapidly rising earnings. And these simplistic examples are just a few of the myriad of theories out there, many of which can get far more complex.
In many cases, the "experts" touting these theories are telling you what has worked for them over relatively short periods. But if you've been in the market for any amount of time, you know that what works on Wall Street one day, or even one year, isn't guaranteed to work the next. Wouldn't it be great if we could know which theories have truly stood the test of time?
Well, to a large extent, we do, thanks to James O'Shaughnessy. In his 1996 book What Works on Wall Street, O'Shaughnessy detailed what may be the most in-depth quantitative stock market study in history, in which he used computer programs to back-test how well an array of popular stock-picking approaches worked over the 44-year period from 1951 through 1994. Large market caps, small market caps, high or low price/earnings ratios, strong or weak cash flows -- O'Shaughnessy studied how these and a myriad of other factors (and combinations of factors) affected stock performance over more than four decades. His conclusion about which theory worked best surprised many in the financial world, and formed the basis for one of my "Guru Strategies", computer models that are each based on the philosophy of a different Wall Street great.
O'Shaughnessy has gone on to put his findings to practical use, developing multiple successful mutual funds that he sold to Hennessy Funds in 2000. Today, he heads O'Shaughnessy Asset Management, a Connecticut-based firm that manages more than $13 billion using his strategies. His research has also been of great practical use to me. I've monitored a portfolio of stocks picked using the model I base on his writings since July 2003, and since then it has grown 134.4 percent -- more than two-and-a-half times the S&P 500's 50.2 percent gain. Here's a look at how, using my model, you too can put O'Shaughnessy's groundbreaking findings to work.
Keep it simple
Because his study was one of the most extensive and detailed in the history of stock research, you might expect O'Shaughnessy to have emerged with incredibly complex, never-before-imagined theories on how to pick winning stocks. In reality, his study showed quite the opposite. He writes that investing is one example of the validity of "Ockham's Razor" -- the idea that the simplest theory is most often the best theory.
The strategy that O'Shaughnessy found to have the best overall results was a combination of two simple approaches, calling for a portfolio composed half of large value stocks and half of growth stocks with steadily increasing earnings and strong sales relative to their price. This two-pronged approach did nearly five times as well as the broader market over the period of O'Shaughnessy's study, producing an annual compound return of nearly 17 percent over four decades. What's more, its risk factor was essentially the same as that of the broader market,
Because of his hybrid approach, I actually base two strategies on O'Shaughnessy's writings, one targeting growth stocks and one targeting value stocks. First, let's look at his "Cornerstone Growth" approach, which, with an 18.22 percent annual compound return, produced the highest absolute returns in his study.
The first step in this growth approach is simple: To screen out companies that are too illiquid, a stock must have a market cap of at least $150 million.
The second step involves earnings. If you've encountered any growth strategies in the past, you've probably found that they tend to focus on an earnings growth rate of a particular duration (i.e. the five-year EPS growth rate). O'Shaughnessy's research found, however, that the rate at which a growth stock's earnings grew wasn't as important as the persistence of that growth over time. He wanted a company to show growth in earnings -- regardless of magnitude -- for five years in a row.
As an example of a company that passes these first two O'Shaughnessy-based growth tests, let's take CVS Caremark Corporation (NYSE:CVS), America's largest pharmacy chain. CVS, which manages or fills more than 1 billion prescriptions a year, has a market cap of more than $61 billion, easily passing the first criterion. In addition, over the past five years, its EPS have been $0.88, $1.03, $1.10, $1.45 and, most recently, $1.60, showing the kind of persistent earnings growth that this model likes.
The most important ratio
O'Shaughnessy's growth strategy also contains one of his study's most significant findings. While the price/earnings ratio has long been the most well-known and widely used valuation statistic in stock analysis, O'Shaughnessy found that the relationship between a stock's price and its sales -- not its earnings -- was the most likely predictor of future success and the best way to find growth stocks selling on the cheap.
O'Shaughnessy's growth model targeted stocks with P/S ratios below 1.5, so that's the figure I use in my model. CVS has a P/S ratio of just 0.92, passing this test and indicating that its stock is a good buy at its current price.
The final criterion that O'Shaughnessy used for growth stocks is relative strength, the measure of how well a stock's price has performed compared with all other stocks in the market over the past year. The growth model I base on O'Shaughnessy's book takes all of the firms that pass this strategy's first three tests (market cap, earnings persistence, and P/S ratio) and then gives approval to the 50 with the highest relative strengths.
The combination of these last two factors -- high relative strengths and low P/S ratios -- was a key part of why this growth model produced the best returns in O'Shaughnessy's study, according to O'Shaughnessy himself. By targeting stocks with high relative strengths, you're looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio -- which is actually a value rather than a growth characteristic -- you're ensuring that you're not getting in too late on these popular stocks, after they've become too expensive. "This strategy will never buy a Netscape or Genentech or Polaroid at 165 times earnings," O'Shaughnessy wrote. "It forces you to buy stocks just when the market realizes the companies have been overlooked."
In addition to CVS, here are a couple other growth stocks that my O'Shaughnessy model is high on:
Hess Corporation (NYSE:HES): This energy firm is involved in oil and natural gas production and exploration all around the world, with exploration activities in the U.S., Europe, Africa, and Asia. It has a $22 billion market cap, a 0.74 P/S ratio, and has posted steadily increasing earnings of -$0.93, $1.72, $3.17, $3.98, and, most recently, $5.93 over the past five years.
Reliance Steel & Aluminum (NYSE:RS): One of the largest metals service center firms in the U.S., Reliance makes more than 100,000 metal products that range from stainless steel to aluminum to brass to copper and beyond. Its market cap is $4.2 billion, it has a P/S ratio of 0.59, and it has grown earnings from $0.47 to $0.53 to $2.60 to $3.10 to $4.82 over the past five years.
Focus on value, too
Interestingly, O'Shaughnessy says that all of the most successful strategies he found -- even growth models -- included at least one value characteristic, like the P/S ratio. But he also believed in going a step further in trying to balance the risk inherent in growth stocks. All investors, he says -- including the youngest of the bunch -- should hold some value stocks in their portfolios.
When looking for these less-risky value stocks, O'Shaughnessy targeted "market leaders" -- large, well-known firms with sales well above those of the average company -- because he found that these firms' stocks are considerably less volatile than the broader market. The model I base on his writings targets these large, prominent stocks with three requirements:
- A market cap greater than $1 billion;
- A number of shares outstanding greater than the market mean;
- Trailing 12-month sales at least 1.5 times the market mean
An example of a company that meets these size-related criteria is U.S.-based communications giant AT&T (NYSE:T). With a market cap of $245.4 billion, AT&T isn't just big -- it's one of the biggest companies in the world, easily passing the first criterion. In addition, it has 6.1 billion shares outstanding, which dwarfs the market average of 635 million. And its sales, $104.5 billion over the last 12 months, are more than five-and-a-half times the market average ($18.3 billion). By passing all three of these tests, AT&T shows the kind of size and market presence that this value model sees as signs of stability.
Size and market position aren't enough to make a value stock attractive for O'Shaughnessy, however. Another key factor that was a great predictor of a stock's future, he found, was cash flow, with higher cash flows being better.
The value model I base on O'Shaughnessy's writings thus calls for companies to have cash flows per share greater than the market average. AT&T again fits the bill, with a cash flow of $4.88 per share, more than tripling the market average of $1.57.
Among large market-leaders, another criterion was even more important than cash flow per share, O'Shaughnessy found: dividend yield. While high yields weren't nearly as important when examining smaller stocks (in fact, smaller companies with higher dividends actually underperformed the market in his study), O'Shaughnessy found that high dividend yields were an excellent predictor of success for large, well-known stocks. Large market-leaders with high dividends tended to outperform during bull markets, and didn't fall as far as other stocks during bear markets.
To target these high dividend-payers, my model takes all of the stocks that meet the first four criteria of this strategy and then selects the 50 with the highest dividend yield. In AT&T's case, the firm has a 3.5 percent yield, good enough to make the grade.
In addition to AT&T, here are two other stocks that pass all of my O'Shaughnessy-based value model's tests:
Chevron (NYSE:CVX): This California-based energy giant has a market cap of $188.6 billion and trailing 12-month sales of $207.2 billion, demonstrating the size that O'Shaughnessy likes in value picks. It also has an exceptional cash flow of $12.29 per share and a healthy dividend yield of 2.6 percent.
Pfizer (NYSE:PFE): Based in Connecticut on the U.S.'s east coast, Pfizer produces an array of medications, ranging from allergy drug Benadryl to the antidepressant Zoloft to the cholesterol-lowering Lipitor, to name just a few. The drug firm has a $164 billion market cap, trailing 12-month sales of $48.2 billion, and a very impressive dividend yield of 4.84 percent.
Discipline, discipline, and more discipline
One final, critical note: For all of the groundbreaking statistical data he compiled, O'Shaughnessy says that one of the most important factors in investing doesn't have to do with any specific stock variable. In order to beat the market, he says, it is crucial that you stay disciplined, "consistently, patiently, and slavishly stick[ing] with a strategy, even when it's performing poorly relative to other methods."
The theme of sticking to a proven strategy no matter what is certainly one I've touched on before while discussing other gurus, and I don't want to sound like a broken record. But I think it's extremely important to note that it's not just one or two of these investing legends who advocate such discipline; each and every one of them stresses the importance of not letting your emotions get in the way of making good stock decisions. "We are a bundle of inconsistencies," O'Shaughnessy writes, "and while that may make us interesting, it plays havoc with our ability to invest our money successfully. … Disciplined implementation of active strategies is the key to performance." Coming from the architect of one of the most in-depth stock studies of all-time, that's advice you'd be wise not to ignore no matter what proven strategy you choose to follow.
Published by Globes [online], Israel business news - www.globes.co.il - on November 15, 2007