- For the conservative investor (who wants to simply mimic the markets 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.
- Value Criteria: OShaughnessy places emphasis on strong sales and a low price-to-sales ratiothe 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. OShaughnessy 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: OShaughnessy 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 stocks price momentum. OShaughnessy 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.
- 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).
- Price-to-sales ratio less than the average for the Market Leaders;
- Earnings per share higher than the previous year.
- 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 companys growth potential. Earnings per share play a critical role in a stocks 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, OShaughnessy 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, OShaughnessy 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.
- Price-to-sales ratio less than 1.5;
- Earnings higher than the previous year;
- Above-average three- and six-month price appreciation.
- A market capitalization between $25 million and $250 million;
- A price-to-sales ratio less than one.
- 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 companys 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 companys cash flow, the lower the ratio will be.
Finally, OShaughnessy 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 companys 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 stocks 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.
- 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.
"Predicting the Markets of Tomorrow": The James O'Shaughnessy Approach
by Cara Scatizzi
But can past trends indicate future trends?
James OShaughnessy believes they can. In his newest book, Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years (Penguin Group, 2006), OShaughnessy 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, OShaughnessy develops a stock selection approach for individual investors that attempts to take maximum advantage of current trends.
This is OShaughnessys fourth foray into the book world. In 1996, OShaughnessy published the immensely popular What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time.
In that book, OShaughnessy 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.
OShaughnessys 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, OShaughnessy 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.
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, OShaughnessy 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, OShaughnessy 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.
OShaughnessys 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 OShaughnessys 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.
OShaughnessy argues that the average investors holding period is 20 years, since most people dont 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, OShaughnessy used rolling 20-year periods to calculate all historical average market returns.
Using these principles, OShaughnessy believes small- and mid-cap stocks should return 7.6% to 9.6% annually during the current 20-year trend. OShaughnessy 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, OShaughnessy still recommends investing in these stocks in order to remain diversified. His stock allocation recommendations are:
The Universe of Stocks
To backtest his stock selection strategies, OShaughnessy 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. OShaughnessy 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. OShaughnessy 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.
OShaughnessy 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).
OShaughnessys 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:
The new Growth Market Leaders screen adds:
Finally, OShaughnessy 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).
Since OShaughnessy believes that small- and mid-cap stocks will be in favor for the next 15 years, he offers two small-cap screening criteria.
According to OShaughnessy, 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. OShaughnessy 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:
OShaughnessy 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).
For the more aggressive investor, OShaughnessy introduces a screen called Tiny Titans, which searches for cheap micro-cap stocks with upward price momentum.
OShaughnessy 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:
Again, OShaughnessy 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).
The last approach tries to lessen the risk of small-cap stocks while still increasing a portfolios 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.
Criteria for the All-Cap Value with a Growth Twist screen are:
Finally, OShaughnessy 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).
OShaughnessy 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 OShaughnessy offers a wide variety of screens. He also references the screens introduced in his previous book, offering investors a multitude of options.
OShaughnessy 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.
An explanation of the original strategies that James OShaughnessy 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 OShaughnessy 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. Youll see the OShaughnessyValue screen listed with the value group and the OShaughnessyGrowth screen listed under the growth and value heading.