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Recent articles by Harry Domash: • A top blogger's market-beating strategy, 4/9/2006 • Spot the next hot sector before it lifts off, 3/26/2006 • Telecom relics rolling in cash, 3/12/2006 More... |
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| Simple strategy delivers 18% a year | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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It sounds too good to be true. But I have tested the Cornerstone Growth method for two years, and the returns have been remarkable. Here's how to do it. By Harry Domash Almost two years ago, in June 2004, I described a stock-selection strategy that had averaged an 18%-or-so annual return for more than 50 years. The strategy, called Cornerstone Growth (Read "Earn 18% returns the easy way," is deceptively simple to implement. You pick 50 stocks, hold them for one year and then repeat the process. In my article, I opined that you didnt really need 50 stocks -- you could get away with only 16 stocks, and possibly as few as 10. I included a screen in the article for finding qualifying stocks. I also compiled a portfolio of 10 stocks to see how a short list would fare. Last week, I dug out the portfolio and tabulated its performance. My portfolio of 10 stocks returned 50%, on average, in the year or so (53 weeks) from June 21, 2004, to June 30, 2005. By comparison, the S&P 500 ($INX) gained 4% during the same period.
I calculated those returns as of June 2005 to correspond to author James P. O'Shaughnessy's strategy of holding the stocks for 12 months. But there doesn't seem to be anything magic about the one-year time frame. If you had held the stocks through April 17, 2006, the day I wrote this column, your returns would have soared to 118%, on average. A simple strategy: Use what works The Cornerstone Growth strategy came out of OShaughnessys exhaustive study of what works and what doesnt, which he described in his 1996 best seller, "What Works on Wall Street. Related news and commentary on MSN Money
For the book, OShaughnessy tracked the returns produced by selecting stocks based on high or low values of valuation ratios such as price/earnings, profitability gauges such as return on equity (ROE), dividend yields, earnings growth -- you name it. OShaughnessy evaluated dozens of factors, by themselves and in combination with each other. For each year from 1951 through 1994, OShaughnessy used each selection strategy to pick 50 stocks at the beginning of the year, then measured the portfolios return 12 months later. The best-performing strategy, which OShaughnessy dubbed Cornerstone Growth, uses only three parameters: price/sales ratio, earnings growth and relative strength. OShaughnessy first identifies a universe of stocks with price-to-sales ratios (P/S) of 1.5 or less, adding the hurdle that they also had to record at least some earnings growth over the prior year. From that list, OShaughnessy picks the 50 stocks with the highest relative strength for his Cornerstone Growth portfolio. Thats it! Its that simple. Many value investors use low P/S ratios to identify value-priced stocks. So the name is misleading. Cornerstone Growth is really a value strategy. According to OShaughnessy, Cornerstone Growth returned 18% on average, annually, compared to 13% for the S&P 500, over his 43-year test period. Putting those percentages in dollars, if you had started with $1,000, after 20 years youd end up with $27,000 if you saw an 18% average annual return. That's compared to $11,500 at 13%. Unlike many strategies that fail once theyve been publicized, Cornerstone Growth hasnt lost its mojo. The Hennessey Cornerstone Growth (HFCGX) mutual fund, which uses OShaughnessys selection formula, has averaged an 18% annual return since its November 1996 inception. Heres my screen for finding Cornerstone Growth stocks. Buy them cheap The price/sales (P/S) ratio is similar to the price-earnings (P/E) ratio, 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. Theres no hard-and-fast definition as to the dividing line between value and growth, but most would agree that stocks with P/S of 1.5 and below are values. Screening parameter: Price/Sales Ratio <= 1.5 Any earnings growth will do OShaughnessy required that the most-recent years annual earnings exceed the previous year. But he didnt set a minimum growth rate. In fact, he found that lower-earnings-growth stocks produced better returns than high-growth stocks. So my screen requires only 1% year-over-year earnings growth. Screening parameter: EPS Growth Year vs Year >=1 Say no to anomalies If you do much screening, you know that screens sometimes turn up unexpected results. I added the following two tests to eliminate stocks that mathematically meet OShaughnessys requirements, but not his intentions. Sometimes screens turn up stocks with zero, or even negative P/S ratios. I require a minimum 0.1 P/S to rule out such stocks. Screening parameter: Price/Sales Ratio >= 0.1 OShaughnessys formula implies stocks with positive earnings. But the way the math works, money-losing stocks can pass the tests. I require a positive trailing 12-months net-profit margin, which rules out unprofitable firms. Screening parameter: Net Profit Margin >= 0.1 Stocks meeting these simple tests form the universe of Cornerstone Growth stock candidates. Only the strongest survive Relative strength measures how a stock has performed compared to the overall market over a specified period. To build his Cornerstone Growth portfolio, OShaughnessy picked the 50 stocks with the highest 12-month relative strength, meaning that they had moved up the most during the previous year. If you want a portfolio of 50 stocks, require a minimum 12-month relative strength of 90. That should give you a list of 80 to 100 stocks to choose from. Then, sort the list based on relative strength by clicking on the 12-Month Relative Strength heading on the screeners stock list. You may have to click the header twice to organize the list with the highest-relative-strength stocks at the top. The top 50 stocks are the Cornerstone Growth stocks. Implement the strategy by buying an equal dollar amount of each stock. Screening parameter: 12-Month Relative Strength >= 90 You dont need 50 stocks There is nothing magic about 50 stocks. In his book, OShaughnessy said he chose 50 because it was a common portfolio minimum for professional and institutional money managers. But he also mentioned 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 could still 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 this type of investing cost-efficiently. In my June 2004 column, I suggested that you might be able to cut the list down to as few as 10 stocks, and it was a 10-stock portfolio that I used to check the returns. However, if you do plan to go that low, increase the minimum-relative-strength requirement in your screen to 98, which will list around 20 to 25 stocks. Then, maximize the portfolios diversification by eliminating multiple stocks in the same industry. Start by sorting the list based on industry. Then, within each industry, eliminate the duplicate stocks with the lowest relative strength. My screen listed 23 stocks when I ran it last week. Eliminating industry duplicates cut the list down to 17 stocks. Heres the original 23-stock list with the industry duplicates crossed out. Since all energy stocks tend to move together, I considered Oil & Gas Services and Oil & Gas Refining & Marketing as being in the same industry. I arbitrarily picked one stock to delete if two stocks in the same industry had the same relative strength.
Next, I cut the list to 12 by deleting all stocks below 99 relative strength, which is the portfolio Im going to test over the next 12 months. If you want only 10 stocks, youll have to arbitrarily pick two of the three 99-relative-strength stocks to delete.
Although OShaughnessy formed his portfolios at the beginning of each year, you can start anytime. At the time of publication, Harry Domash did not own or control shares of companies mentioned in this column. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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