Predicting the Market’s Future With O’Shaughnessy

Investors have tried and will continue to try a multitude of strategies to predict the future of the stock market using fundamental analysis, charting and technical analysis. Sometimes dealing with a frustrating market can make you think that drawing tickers from a hat is the best way to pick stocks. While there is no surefire way to choose winning stocks, James O’Shaughnessy believes that looking at the past is the best way to predict where the market is headed in the future.

In his newest book, “Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years” (Penguin Group, 2006), O’Shaughnessy argues that investors can predict where the markets are going by simply looking at historical long-term trends. Through an examination of stock market history, O’Shaughnessy developed a stock selection approach for individual investors that attempts to take full advantage of current market trends.

O’Shaughnessy examined data going back to the late 1790s and found that equity markets tend to move in trends lasting about 20 years. Based on this pattern, O’Shaughnessy feels the U.S. market is currently in the midst of a 20-year trend that began in early 2000, during which greater returns will be earned by small- and mid-cap stocks as well as large-cap value stocks.

Overview

O’Shaughnessy introduced four new screens in his book: Growth Market Leaders, a large-cap screen that combines growth and value criteria; Small-Cap Growth and Value, which looks for cheap stocks on the mend; Tiny Titans, an aggressive screen that searches for cheap micro-cap stocks with upward price momentum; and All-Cap Value With a Growth Twist, a combination of the Growth Market Leaders and Small-Cap Growth and Value screens. 

In the August 2006 AAII Journal, the four screens were introduced and explained in detail (“Predicting the Markets of Tomorrow: The James O’Shaughnessy Approach”). That article focused on the four screens by explaining the criteria for each as O’Shaughnessy used them in his testing.

We built each of O’Shaughnessy’s four new screens to use with AAII’s fundamental stock screening program Stock Investor Pro. The screens were backtested over an eight-and-a-half-year period from January 1998 to July of 2006. The screens were run using month-end data and tracked assuming that all stocks were bought in equal dollar amounts and held the entire month, when the screen was re-run.

While we backtested all four screens, this article focuses on only the Small-Cap Growth and Value screen. An in-depth look at this screen as used in Stock Investor Pro is accompanied here by a list of current passing companies, screen characteristics and the screen’s performance data. Table 3 lists the screening criteria used in Stock Investor Pro for all four screens. See the AAII Stock Screens area at AAII.com for more details on the three other screens.

Applying the Small-Cap Screen

O’Shaughnessy believes that small- and mid-cap stocks will be in favor for about the next 15 years. The Small-Cap Growth and Value screen, as derived from its name, focuses on small-cap stocks with both growth and value criteria and those that have upward price momentum. According to O’Shaughnessy, the screen finds “cheap stocks on the mend.”

Using Stock Investor Pro, we first limit the possible stocks to only U.S. stocks traded on the New York Stock Exchange, American Stock Exchange or NASDAQ. We exclude over-the-counter stocks due to their less stringent filing rules. This narrows our universe to 5,196 possible stocks from 8,638 (using data as of August 11, 2006).

Market Capitalization

The next criterion for this screen eliminates large- andmicro-cap stocks, as O’Shaughnessy is focusing on small-cap stocks only. He defines a small-cap stock as having a current market capitalization between $200 million and $2 billion. We used the long-term average inflation rate of 3% per year to adjust the market capitalization limits each year. Using O’Shaughnessy’s current market-cap values of $200 million to $2 billion, we worked backward to find a market-cap range of between $160 million to $1.6 billion for January of 1998. We continued to increase the numbers by 3% each year, ending in 2006 with a range of $200 million to $2 billion market cap.

Adjusting for inflation is important for more than simply calculating portfolio returns. By adjusting the market capitalizations when backtesting and going forward, you are better able to maintain a database of your desired cap-size stocks regardless of inflation’s effect on asset size. Applying these size limitations to the database cuts our universe from 5,196 to 2,196 stocks. In the Stock Investor Pro database, 3,999 stocks have market capitalizations above $200 million, while 7,188 stocks have market capitalizations less than $2 billion.

The market caps for companies currently passing the complete screen (Table 1) range from just over the lower limit—CPI Corp. with $207.9 million—to just below the upper limit—Alon USA Energy, Inc. at $1,999.2 billion. The median market capitalization for the passing stocks (Table 2) leans toward the lower end of the small-cap spectrum at $493.6 million and is slightly larger than the median market capitalization of all exchange-listed stocks ($418.2 million).

Price-to-Sales Ratio

An important value element in the screen, the price-to-sales ratio serves as a defense against overpriced stocks. The price-to-sales ratio is calculated by dividing the current stock price by the sales per share for the last four fiscal quarters (trailing 12 months).

Unlike earnings, sales are less subject to management assumptions, making them more difficult to manipulate, and are often less volatile. All viable companies have sales, so the majority of companies will have a meaningful price-to-sales ratio. O’Shaughnessy believes that a low price-to-sales ratio is a way to identify “cheap” stocks.

The Small-Cap screen eliminates any stock with a price-to-sales ratio greater than 1.5, meaning its stock price is no larger than 1.5 times its sales per share. Applying this criterion eliminates over 50% of the remaining companies, leaving the universe at 915 stocks. Overall, 3,491 stocks met the price-to-sales criteria.

The stocks that currently pass based on this criterion have price-to-sales ratios ranging from 0.2 to 1.5, while the median ratio is 0.9. The median price-to-sales ratio for all exchange-listed stocks is much higher at 1.8.

Earnings per Share Growth

Earnings per share (EPS) are defined as revenues minus cost of sales, operating expenses and taxes. EPS growth over a given period of time is a popular way to measure a company’s growth potential and can play a critical role in a stock’s price, mainly due to market expectations. Low or negative earnings are often signs of young companies; however, these start-ups attempt to grow earnings quickly and can be profitable investments.

The Small-Cap Growth and Value screen searches for companies with current earnings that are simply higher than the previous year. Using Stock Investor Pro, we can quantify this by looking for EPS growth over the trailing 12-month period (the most recent four quarters) that is greater than zero. Adding this criterion shrinks the possible companies from 915 to 506 (4,545 companies meet this criterion alone).

Eleven of the 26 stocks that currently pass the complete screen have EPS growth of 100% or greater; the median is 91.8%. This is the highest median EPS growth rate of O’Shaughnessy’s four screens and greater than the median of exchange-listed stocks (11.4%). A reasonable explanation is that most new companies are in the small- to mid-cap size range and, as mentioned before, these young companies tend to grow earnings fairly quickly.

The highest EPS growth rate, 884.0%, comes from Ampco-Pittsburgh Corp. A closer look reveals that this company, incorporated in 1929 and by no means a start-up, battled with small and negative earnings during 2004. The company blamed litigation fees and payouts for various lawsuits—including those alleging personal injury from exposure to asbestos-containing components used in certain products the company produced—as reasons for the negative earnings in 2004.

Additionally, in the fourth quarter of 2005 the company received a boost of $0.37 per share due to a one-time insurance claim—one drawback of not using earnings from continuing operations, which exclude these extraordinary, or “one-time” items.

The earnings for the last three quarters of 2004 (two of which reported a loss) and the first quarter of 2005 are the basis of comparison for calculating this growth rate. Currently, Ampco-Pittsburgh’s earnings per share for the four most recent fiscal quarters are $1.96. When you compare this number to a loss of $0.27 per share for the four previous quarters, the huge growth rate is not surprising. Although this does not mean Ampco-Pittsburgh would make a bad investment, it shows the importance of additional research to fully understand the basis of the underlying data.

Relative Strength

O’Shaughnessy’s initial testing called for stocks with a greater than average three- and six-month price appreciation. Due to limited price data, O’Shaughnessy added the three- and six-month price appreciation criteria to his backtesting starting in 1963, while his other criteria were tested over the entire 52-year period.

He found that stocks with the highest price changes over the past year tend to produce the highest returns the following year. Although this can be a very effective filter, it is also a highly volatile approach. Stocks with high price appreciation may be at or close to their peak, meaning they may have smaller upside and larger downside potentials.

For use in Stock Investor Pro, we look for 13- and 26-week relative strength numbers greater than the universal average. Relative strength measures how well a stock has performed versus a benchmark (the S&P 500 index in Stock Investor Pro) over a certain timeframe. A negative number indicates underperformance, while a positive number denotes a stock has outperformed the benchmark. Adding these criteria shrinks the universe from 506 stocks first to 224, and then to 169. Overall, 5,142 stocks meet the 13-week relative strength criterion and 4,786 stocks meet the 26-week relative strength criterion.

Lastly, O’Shaughnessy believes that proper diversification is a key factor in maintaining a profitable portfolio. He recommends at least 25 stocks in a micro-, small- or mid-cap portfolio and at least 10 in a large-cap portfolio. Smaller-cap stocks tend to be more volatile, so additional stocks are needed to mitigate some of the risks.

From the 169 passing companies, we pick the 25 stocks with the greatest 12-month price appreciation for the final portfolio. This is attained by adjusting the 52-week relative strength each month until only 25 companies pass.

As expected, the stocks passing the Small-Cap Growth and Value screen have higher 13-, 26-, and 52-week relative strength figures than the typical exchange-listed stock. Interestingly enough, the exchange-listed stock median relative strength numbers for all three timeframes are negative, meaning underperformance of the market over 13-, 26- and 52- week periods. The stocks passing the Small-Cap screen have outperformed the S&P 500 by 13%, 44% and 94% over these three time periods.

Monthly Portfolio Observations

Table 2 summarizes various portfolio statistics for all four screens. O’Shaughnessy recommends choosing 25 stocks for the Small-Cap Growth and Value portfolio; however, this number was sometimes as high as 27 and as low as 24 during the course of backtesting, due to securities with identical 52-week price appreciation (which explains why the current passing companies list in Table 1 contains 26 names). This screen also produced a relatively high monthly turnover rate of 46.5%.

Performance

Figure 1. Performance of the New O'Shaughnessy Screens CLICK ON IMAGE TO SEE FULL SIZE.

O’Shaughnessy’s Small-Cap screen has outperformed both the S&P 500 and S&P SmallCap 600 indexes since 1998, logging a cumulative return of 633.0% (Figure 1). In 2002, the market sank. However, the Small-Cap Growth and Value screen managed a small 0.8% gain for the year, while the S&P 500 lost 23.4% and the S&P SmallCap 600 lost 15.3%. The screen’s best year was 2003, a good year for most small-cap stocks: The Small-Cap screen returned an impressive 107.5%. Even in the rocky market we’ve seen recently, this strategy seems to find profitable investments. As of July 31, 2006, the strategy was up 11.7% year-to-date.

Conclusion

Over the years, O’Shaughnessy has created a variety of screens to offer investors a multitude of options. He encourages investors to choose the strategies that match their risk-tolerance and investment philosophies. As an advocate of diversification, he recommends combining many strategies to create a portfolio of small-, mid-, and large-cap growth and value stocks. By combining approaches, investors can reap the benefits of the upswings in one asset class while minimizing the effects of a slow or down market in another.