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    "Predicting the Markets of Tomorrow": The James O'Shaughnessy Approach

    by Cara Scatizzi

    Over the years, many investors have learned—some the hard way—that history tends to repeat itself. The more astute learn from the past and avoid repeating the same mistakes.

    But can past trends indicate future trends?

    James O’Shaughnessy believes they can. 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 develops a stock selection approach for individual investors that attempts to take maximum advantage of current trends.

    This is O’Shaughnessy’s fourth foray into the book world. In 1996, O’Shaughnessy published the immensely popular “What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time

    In that book, O’Shaughnessy declared that investors fail to beat the market because of their inability to follow a disciplined investing approach and because they are prone to making emotional decisions. To combat those problems, his prior book proposed two stock screening strategies, one focused on finding growth stocks and the other on value stocks.

    O’Shaughnessy’s newest publication does not contradict his previous thinking. However, his new book focuses on finding stocks among the various market capitalizations of firms that are most likely to do well based on current market trends.

    Examining Long-Term Trends

    For this new book, O’Shaughnessy examined data as far back as the late 1790s and found that equity markets tend to move in cycles or trends of about 20 years.

    According to this pattern, the U.S. 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 and large-cap value stocks.

    The previous 20-year cycle favored large-cap growth stocks, while small- and mid-cap stocks and large-cap value stocks were, on average, underperforming the market.

    The remainder of the book focuses on stock strategies that take advantage of the current 20-year trend.

    O’Shaughnessy’s Philosophy

    Many investors believe that, on average, the market will return about 10% per year over the long term. While this number has been proven to be accurate over the long term, O’Shaughnessy gives a few reasons as to why the figure can be misleading.

    Importantly, the 10% average annual return does not take the effects of inflation into account. Inflation can eat away at returns but many investors fail to consider this when calculating portfolio performance.

    In his examination of stock market history, O’Shaughnessy calculates the long-term inflation-adjusted average return to be about 7% per year. He finds this number to be “an almost ironclad average” yearly return over the long term. He also believes that the market will always revert to this mean, meaning that if the market has returned an average of greater than 7% per year over several years, it will spend the next years regressing back toward the average, often overshooting this mark and falling below it.

    O’Shaughnessy’s research shows that in the past few years, small- and mid-cap stocks have been rebounding from the largest performance gap from large-cap stocks in history. In the last 20-year phase, large-cap stocks had returns above their long-term average while small- and mid-cap stocks had returns that fell well below their long-term averages. Applying this information to O’Shaughnessy’s ideas about reversion to the mean implies that small- and mid-cap stocks are due for higher than average returns while large-cap stocks should produce lower than average returns.

    O’Shaughnessy argues that the average investor’s holding period is 20 years, since most people don’t have the means to save for retirement until their prosperous middle years, which usually starts about 20 years prior to retirement.

    In contrast, the long-term non-inflation-adjusted average return of 10% that many investors are relying on has typically been calculated over a 78-year period. Since most investors are not investing for 78 years, they are susceptible to the shorter-term ups and downs of the market, which tend to be much more volatile over 15- to 20-year periods. Because of this, O’Shaughnessy used rolling 20-year periods to calculate all historical average market returns.

    Using these principles, O’Shaughnessy believes small- and mid-cap stocks should return 7.6% to 9.6% annually during the current 20-year trend. O’Shaughnessy also believes that large-cap value stocks will return 6.0% to 9.1% annually, while large-cap growth stocks will return only 2.0% to 4.0% annually over the same period.

    Although he believes that the current trend does not favor large-cap growth stocks, O’Shaughnessy still recommends investing in these stocks in order to remain diversified. His stock allocation recommendations are:

    • For the conservative investor (who wants to simply mimic the market’s diversification): 25% in small- and mid-cap stocks, and the remaining 75% in large-cap stocks.
    • For the more aggressive investor: 35% in small- and mid-cap stocks, 50% in large-cap value stocks and 15% in large-cap growth stocks.

    The Universe of Stocks

    To backtest his stock selection strategies, O’Shaughnessy used the S&P Compustat database, which has 52 years of fundamental data on U.S. stocks including American depositary receipts (ADRs), which are dollar-denominated certificates issued by U.S. banks representing a number of shares of a foreign stock traded on a U.S. stock exchange. O’Shaughnessy is quick to point out that these 52 years of data cover every market environment except a great depression.

    Each of the screens introduced in the book combines elements of value and growth strategies. O’Shaughnessy recommends purchasing 25 stocks for a small- and mid-cap portfolio and 10 for a large-cap portfolio. Because small- and mid-cap stocks are more volatile, additional stocks are needed to help diversify away some of the risks.

    Large-Cap Stocks

    O’Shaughnessy thinks large-cap value stocks will outperform large-cap growth stocks over the next 15 years. However, he looks for viable investments by combining growth and value constraints. Because he believes investors should put money in both value and growth stocks, he created a single new screen, called Growth Market Leaders, that resembles both the Cornerstone Value and Cornerstone Growth screens he introduced in “What Works on Wall Street” (visit the Stock Screens section of AAII.com for more information on these stock screening strategies).

    • Value Criteria: O’Shaughnessy places emphasis on strong sales and a low price-to-sales ratio—the current stock price divided by the sales per share for the last four fiscal quarters (trailing 12 months). Unlike earnings, sales are less subject to management assumptions, therefore 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. In “What Works on Wall Street,” he found that the price-to-sales ratio was a very effective screen for stocks of all market-cap sizes and that low ratios consistently produced higher returns.
    • Financial Strength: O’Shaughnessy looks for stocks with a higher cash flow per share than the average stock in the S&P Compustat database. This ratio is calculated by adding depreciation and amortization to income before extraordinary items, then dividing by the fully diluted average number of common shares outstanding. Cash flow measures the actual inflows and outflows of cash by taking out non-cash items. This is a harder number to manipulate and can be a more truthful measure of financial strength.
    • Growth Criteria: Earnings per share growth is a criterion that helps identify momentum stocks and is a common factor in growth-oriented stock screens. Price strength (price change over a specified period) also plays a large role in a stock’s price momentum. O’Shaughnessy picks the top 10 stocks with the greatest 12-month price appreciation for his final portfolio. 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, he warns that it is a highly volatile approach. Stocks with high price appreciation may be at or close to their peaks, meaning they may have smaller upside and larger downside potential.

    O’Shaughnessy’s Growth Market Leaders approach starts with the Market Leaders universe, a group of stocks he first introduced in “What Works on Wall Street.” Market Leader stocks are non-utility stocks with greater than average:

    • Market capitalization;
    • Number of shares outstanding;
    • Cash flow per share for the past 12 months; and
    • Sales for the last 12 months (1.5 times greater).

    The new Growth Market Leaders screen adds:

    • Price-to-sales ratio less than the average for the Market Leaders;
    • Earnings per share higher than the previous year.

    Finally, O’Shaughnessy selects the 10 stocks with the greatest 12-month price appreciation (or the smallest price decline if less than 10 stocks have positive price movements).

    Small-Cap Stocks

    Since O’Shaughnessy believes that small- and mid-cap stocks will be in favor for the next 15 years, he offers two small-cap screening criteria.

    • Value Criteria: A price-to-sales element, as discussed earlier in the large-cap section, finds cheap stocks and provides a meaningful value for comparison and analysis.
    • Growth Criteria: Earnings per share growth is a popular way to measure a company’s growth potential. Earnings per share 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. Multiple price appreciation factors also help find companies that are growing earnings and whose stock prices are rising. Besides finding stocks with a high 12-month price appreciation, O’Shaughnessy adds additional criteria that look for stocks with greater than average three- and six-month price appreciation, capturing a true momentum stock. Due to limited data, O’Shaughnessy added the three- and six-month price appreciation criteria to his backtesting starting in 1963, while the other criteria were tested over the entire 52-year period.

    According to O’Shaughnessy, his new Small-Cap Growth and Value screen focuses on “cheap stocks on the mend.” The first criterion is an inflation-adjusted market capitalization between $200 million and $2 billion. O’Shaughnessy uses an average annual inflation rate of 3%, meaning that going forward he would increase the market capitalization criterion by 3% each year.

    The additional criteria are:

    • Price-to-sales ratio less than 1.5;
    • Earnings higher than the previous year;
    • Above-average three- and six-month price appreciation.

    O’Shaughnessy then picks the 25 stocks with the greatest 12-month price appreciation (or the smallest price decline if less than 25 stocks have positive price movements).

    Micro-Cap Stocks

    For the more aggressive investor, O’Shaughnessy introduces a screen called Tiny Titans, which searches for cheap micro-cap stocks with upward price momentum.

    O’Shaughnessy believes there are many advantages to investing in micro-cap stocks. Few analysts cover these small stocks and this lack of coverage leaves much room for upside potential when good stocks are largely unnoticed. Additionally, micro-cap stocks have a low correlation with other market capitalization strategies, including the S&P 500, which is comprised mainly of mid- and large-cap stocks. This means that the performance of the S&P 500 has a smaller impact on the performance of micro-cap stocks. For example, when the overall market (as measured by the S&P 500) is in a slump, a portfolio of micro-cap stocks is more likely to perform better.

    These tiny stocks, however, are highly volatile and best suited for investors who can handle the dramatic swings that a portfolio of these stocks will produce.

    The Tiny Titans screen looks for stocks with:

    • A market capitalization between $25 million and $250 million;
    • A price-to-sales ratio less than one.

    Again, O’Shaughnessy selects the 25 stocks with the greatest 12-month price appreciation (or the smallest price decline if less than 25 stocks have positive price movements).

    All-Cap Alternative

    The last approach tries to lessen the risk of small-cap stocks while still increasing a portfolio’s overall diversification.

    The All-Cap Value With a Growth Twist screen is a combination of both the Growth Market Leaders and Small Cap Growth and Value screens, and adds a growth component to a mostly value-oriented screen.

    • Value Criteria: Again, restricting the price-to-sales ratio eliminates stocks that are priced too high relative to company sales. Additionally, a low price-to-cash flow element (calculated by dividing the current stock price by income before extraordinary items plus depreciation and amortization) also narrows the search to “cheaply” priced stocks. This ratio measures how much investors pay for a stock per dollar of a company’s cash flows. It is similar to the more familiar price-earnings ratio in that a low ratio indicates a cheaper stock. The lower the stock price compared to a company’s cash flow, the lower the ratio will be.

      Finally, O’Shaughnessy found that a high dividend yield (calculated by dividing the indicated dividend by the current stock price) was a useful criterion only for large-cap stocks. Companies that are new (which tend to be smaller companies) or are undergoing rapid growth will find better uses for excess cash, such as investing in the company’s growth. Once a company matures, it may begin to pay dividends with excess cash. A high dividend yield indicates a low price compared to the stock’s indicated dividend, meaning investors pay less per dollar of dividend.

    • Growth Criterion: The only growth element in this All-Cap screen is 12-month price strength which, like the small-cap screens, finds the 25 stocks with the highest 12-month price strength.

    Criteria for the All-Cap Value with a Growth Twist screen are:

    • An inflation-adjusted market capitalization greater than $200 million;
    • The 30% of stocks with the lowest price-to-sales ratio;
    • The 30% of stocks with the lowest price-to-cash flow ratio;
    • The 30% of stocks with the highest dividend yield.

    Finally, O’Shaughnessy selects the 25 stocks with the greatest 12-month price appreciation (or the smallest price decline if less than 25 stocks have positive price movements).

    Portfolio Monitoring

    O’Shaughnessy does not give specific sell and rebalancing rules. However, when backtesting his screens, he rebalanced annually, selling stocks that no longer met the original criteria and adding new stocks that did. All stocks were bought in equal dollar amounts.

    Putting It All Together

    In his new book, James O’Shaughnessy offers a wide variety of screens. He also references the screens introduced in his previous book, offering investors a multitude of options.

    O’Shaughnessy 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.

       “Predicting the Markets of Tomorrow”: The James O’Shaughnessy     Approach
    Philosophy and Style

    The stock market moves in 20-year phases in which certain asset classes are in favor. However, investors should always hold stocks from each asset class in order to be properly diversified and to maximize returns and minimize risk. To get an accurate view of investment performance, investors must find the “real,” or inflation-adjusted, rate of return. Predicting future returns based on past performance is only useful if the investment holding period is considered.

    Criteria for Initial Consideration

    Growth Market Leaders(market-leading, large-cap, growth stocks)

    • Exclude foreign stocks
    • Exclude utility stocks
    • Market capitalization that is greater than the average stock
    • Average number of shares outstanding greater than the average stock
    • Cash flow per share for the last 12 months greater than the average stock
    • Sales for the last 12 months 1.5 times greater than the average stock
    • Price-to-sales ratio less than the average for the Market Leaders
    • Earnings for the prior 12 months greater than the previous 12-month period
    • Choose the top 10 stocks with the greatest 12-month price appreciation

    Small-Cap Growth and Value(cheaply priced small-cap stocks with upward price momentum)

    • Three- and six-month price appreciation above average
    • Exclude foreign stocks
    • Market capitalization between $200 million and $2 billion (inflation-adjusted)
    • Price-to-sales ratio less than 1.5
    • Earnings for the prior 12 months greater than the previous 12-month period
    • Choose the top 25 stocks with the greatest 12-month price appreciation

    Tiny Titans(cheaply priced micro-cap stocks with upward price appreciation)

    • Exclude foreign stocks
    • Market capitalization between $25 million and $250 million
    • Price-to-sales ratio less than one
    • Choose the top 25 stocks with the greatest 12-month price appreciation

    All-Cap Value With a Growth Twist(reduces overall variability in a portfolio)

    • Market capitalization greater than $200 million (inflation-adjusted)
    • The 30% of stocks with the lowest price-to-sales ratio
    • The 30% of stocks with the lowest price-to-cash-flow ratio
    • The 30% of stocks with the highest dividend yield
    • Choose the top 25 stocks with the greatest 12-month price appreciation

    Stock Monitoring and When to Sell

    Stock Asset Allocation

    To mimic the diversification of the market, investors should put 25% of assets in small- and mid-cap stocks and the remaining 75% in large-cap stocks. More aggressive investors should place 35% of assets into small- and mid-cap stocks, 50% in large-cap value stocks and the remaining 15% in large-cap growth stocks.

    Portfolio Size

    O’Shaughnessy recommends having at least 25 stocks in a small- or mid-cap portfolio and at least 10 in a large-cap portfolio in order to mitigate risk. In O’Shaughnessy test portfolios, all stocks are bought in equal dollar amounts.

    Rebalancing and When to Sell

    In O’Shaughnessy test portfolios, all portfolios are rebalanced annually, and stocks no longer meeting the original criteria are dropped from the portfolio while new stocks are added.

       AAII.com

    An explanation of the original strategies that James O’Shaughnessy wrote about in “What Works on Wall Street” can be found by going to the AAII Journal area and selecting November 1997 from the Past Journal Issues box on the right side of the page. Click on the Stock Analysis Workshop article titled: “Diversifying Among Investing Styles: The James O’Shaughnessy Approach,” by Maria Crawford Scott.

    To locate the stock screens that AAII tracks based on the Cornerstone Value and Cornerstone Growth approaches outlined in “What Works on Wall Street,” go to AAII Stock Screens, select All Screens and scroll down. You’ll see the O’Shaughnessy—Value screen listed with the value group and the O’Shaughnessy—Growth screen listed under the growth and value heading.

→ Cara Scatizzi