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| The Basics | Earn 18% returns the easy way
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James O'Shaughnessy analyzed decades of data and dozens of strategies to develop the Cornerstone Growth portfolio. The best part? Trade just once a year.
By Harry Domash
Heres a plan for picking stocks that have trounced the market consistently, in terms of returns, during the past 50 years. Even better, you dont have to spend all day glued to your computer. In fact, theres not much to do. You buy your stocks once a year, live your life, and then pick new stocks a year later.
Im talking about the Cornerstone Growth, the most important outcome of James OShaughnessys landmark analysis of stock picking strategies.
Back in the mid-1990s, OShaughnessy researched the returns produced by a variety of stock-selection schemes from 1951 through 1994. OShaughnessy tried picking stocks based on market capitalization, a variety of valuation ratios, dividend yields, earnings growth, profitability ratios and just about anything he could get his hands on. He tried high and low values of each parameter separately, and in combination with each other.
Unexpected outcome
OShaughnessy evaluated each selection strategy by using it to pick 50 stocks at the beginning of each test year and then measuring the return as if the portfolio had been sold one-year later. He published the results in his 1996 book, "What Works on Wall Street."
His results were unexpected. OShaughnessy found that the best-performing strategy was a blend of two seemingly conflicting investing styles: value and momentum.
It finds stocks with low price/sales ratios (P/S), a criterion usually used to pinpoint value-priced stocks, and high relative strength, a hallmark of momentum investing. Those two factors, along with a modest earnings growth requirement, formed the selection strategy he dubbed Cornerstone Growth.
How good was it? Cornerstone Growth returned 18% on average, annually, compared with 13% for the S&P 500 index ($INX), over his 43-year test period. What does that mean in real dollars?
If you start with $1,000, after 20 years compounded at 13%, you would end up with $11,500. Thats a tidy sum, but nothing like the $27,400 you'd have it if your money earned 18% compounded annually.
Now that I have your attention, heres a link to a screen that emulates OShaughnessys strategy. Heres how it works.
Maximum price/sales ratio = 1.5
Price/sales is similar to the P/E, except the recent stock price is divided by 12-months' per-share sales instead of earnings. In his tests, OShaughnessy found that P/S worked better than P/E, probably because earnings often fluctuate wildly from year to year, while sales usually follow consistent trends.
P/S ratios of 3 and above usually define growth stocks, while lower ratios identify value-priced stocks. While some might quibble with those cutoffs, most would agree that P/S ratios of 1.5 and below define value-priced stocks. So much for the name Cornerstone Growth. OShaughnessys formula really picks value stocks.
Year-over-year earnings-per-share growth at least 1%
OShaughnessy requires that the most recent years annual earnings exceed the previous year's, but as far as he was concerned, any amount of growth is enough. He didnt require any specific minimum. In fact, he found that lower-earnings growth stocks produced better returns than growth stocks with higher earnings. So the screen requires only 1% year-over-year earnings growth.
A requirement we omitted
| OShaughnessy limited his testing to stocks with market capitalizations exceeding $150 million, even though he found that smaller stocks performed better. He chose that figure because he wanted to focus on stocks that mutual funds and other professional investors could buy without running into liquidity problems. Obviously, that would not be a problem for most individual investors, so I omitted that requirement from the screen.
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Anyone who does much screening realizes that screens sometimes turn up weird results. I added the following two tests to eliminate stocks that mathematically meet OShaughnessys requirements, but not his intentions.
- Minimum price/sales ratio of 0.1
Occasionally youll find stocks with zero, or even negative P/S ratios. The minimum P/S requirement avoids that anomaly.
- Minimum net profit margin of 0.1
OShaughnessys formula implies stocks with positive earnings, but sometimes money-losing stocks pass the tests. This requirement eliminates those culprits.
12-month relative strength at least 90%
Stocks meeting these simple tests form the pool of potential Cornerstone Growth stocks. To produce the final list, OShaughnessy simply picked the 50 stocks that had moved up the most the previous year; that is, those with the highest 12-month relative strength.
No magic in 50 stocks
The screen turned up 82 stocks when I ran it. To follow OShaughnessys strategy, sort the list with the highest relative-strength stocks on top by clicking the 12-Month Relative Strength header label twice.
Thats great in theory, but how many of us can buy 50 stocks?
It turns out that theres nothing magic about that number. In his book, OShaughnessy said he chose 50 because it was a common portfolio minimum for professional and institutional money managers. But OShaughnessy also described research showing that most of the benefits of diversification come from as few as 16 stocks. If you agree with that premise, simply pick the 16 stocks with the highest relative strength.
By the time you pay commissions, 16 still could be too many if youre buying through a conventional stockbroker. If thats true for you, check out services such as Sharebuilder.com, which are set up to handle such transactions cost efficiently.
You also could accept added risk by buying fewer than 16 stocks, which decreases your diversification. However, I wouldnt go below 10 stocks.
After youve settled on the number of stocks, build your portfolio by buying an equal dollar value of each stock.
Under new ownership
O'Shaughnessy started a fund based on the Cornerstone Growth strategy in 1996. Returns were decent. For instance, the fund returned 31% in 1997, 4% in 1998 and 38% in 1999. But by 2000 the Internet was the place to be, and O'Shaughnessy sold the fund so he could devote his time and efforts to building Netfolio, a Web site for investors desiring to build their own mutual-fund-like portfolios. That turned out to be a bad idea, and Netfolio folded in 2001.
O'Shaughnessy sold the fund to Neil Hennessy, who renamed it Hennessy Cornerstone Growth (HFCGX). Maybe O'Shaughnessy shouldnt have sold. The five-star-rated Hennessy Cornerstone Growth fund sports an impressive five-year annualized return of 16.6%, compared to the S&P 500's 1.3% loss.
Looks like a tweak
Im not sure if Hennessy tweaked the formula, but according to the funds prospectus, his Cornerstone strategy differs slightly from the formula described in O'Shaughnessys book.
O'Shaughnessys original formula used only 12-month relative strength. But Hennessys version also throws the three- and six-month relative strengths into the mix. He requires that passing stocks have positive relative strength over the past three- and six month periods. MSN Money measures relative strength on a 0 to 100 scale, so positive relative strength translates to values greater than 50.
Heres a link to the Cornerstone Growth Screen modified to include those requirements. Use it the same way as the first screen. That is, use the 12-month relative strength to sort the results and pick the top stocks.
Both O'Shaughnessy in his original research and Hennessys fund rebalance annually using end of calendar year data. But theres no reason why you have to wait for years end. You could start the process any time.
As of June 17, 2004, Harry Domash did not own any of the stocks turned up by the two screens described in this column. However, he is sure going to check into changing that situation.
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