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Master Strategists for 2007: AAII's Top Stock Screens

by Wayne A. Thorp, CFA

Master Strategists For 2007: AAII's Top Stock Screens Splash image

It takes the right moves, clever tactics and perseverance following a grand plan to be a master stock market strategist.

However, the fiercest battle in 2007 was not among the various strategists, but rather against the market itself.

During 2007, over three different three-month periods, the bears clearly took control of the board, with the S&P declining more than 5%. Underlying the bear positions was a deflating real-estate market, which led to a crisis in the sub-prime mortgage industry, as well as increasing unease as to the strength of the U.S. economy. Luckily, the bulls regained control after each market downturn, with a subsequent reversal to somewhat higher levels.

At the time of this writing in mid-December, the S&P 500 has rebounded nearly 7% from its early-December lows. Overall, the S&P 500 is up 6.1% year-to-date through December 7.

However, the fierce competition took its toll: The number of stock screens tracked on AAII.com that have negative returns increased substantially over the prior year, with 17 of the 56 strategies down year-to-date (as of December 7, 2007). This is also a significant increase compared to the mid-year review (in June), when only four screening approaches were down year-to-date. November 2007 was one of the worst months ever for the AAII stock screens, with an average decline of over 6.5%.

How do these stock market strategists rank?

Table 1 presents the year-to-date and annual performance since 1998 of the stocks purchased for the hypothetical portfolios of the various underlying investing methodologies. The 56 screening approaches are grouped based on their style orientation—value, growth, etc.—with additional specialty and sector methodologies broken out separately. The table ranks the screens within each of these groups in descending order by their 2007 year-to-date performance (through December 7).

The 2007 Master Strategists

The top screen for 2007 (based on performance through December 7, 2007) is the O’Shaughnessy Small Cap Growth and Value methodology, which is up 43.9%.

Another one of O’Shaughnessy’s approaches remains at the top of the list for long-term performance, the Tiny Titans growth and value strategy. Although its 2007 performance has been relatively tepid—a 5% increase year-to-date—it has gained 3,044.2% since the start of 1998.

Across all market capitalizations, growth-oriented large(r)-cap stocks reigned supreme in 2007. The NASDAQ 100 index, which consists of the 100 largest NASDAQ stocks based on market capitalization, is up 21.2% through December 7 (on a monthly compounded basis), followed by the S&P MidCap 400 Growth index (up 16.4%), and the S&P 500 Growth index (up 10.7%). Meanwhile, the S&P SmallCap 600 saw itself at the bottom of the various exchanges listed in Table 1 for the first time since 1998.

Furthermore, the S&P SmallCap 600 index underperformed the S&P 500 index for the first time since 1999.

Evaluating Strategy Performance

When examining performance data for any investment approach, it is important to remember that past performance is not a proxy for future returns, especially year-over-year.

Take, for example, the Foolish Small Cap 8 Revised approach. It was the third-best-performing screening strategy of 2006, with a full-year return of 44.6%. So far for 2007, however, the screen is up “only” 8.9%, which puts it in the middle of all AAII stock screens and lagging most broad market indexes.

In addition, higher risk typically goes hand-in-hand with higher returns, and it is therefore important to be mindful of the volatility of any given investment approach. While everyone would love to have the high returns generated by some of these screens, a number of investors would not be able to stomach the wild return gyrations some of these screens have month-to-month.

In Table 1, standard deviation is used to measure the monthly volatility of returns over the full study period. Standard deviation is a measure of total risk, expressed as a monthly change, which indicates the degree of variation in return relative to the average monthly return of an approach over the test period. The higher the standard deviation, the greater the month-to-month volatility of returns and therefore the greater the risk.

The five best long-term performers have monthly standard deviations that are above the median of 6.1% for all the screens in Table 1.

Looking at the other end of the long-term performance spectrum, all but one of the five worst performers have a standard deviation for monthly return that exceeds the median standard deviation for all the screens in Table 1. The sole exception was the Dogs of the Dow screen, with a monthly standard deviation of return of 5.0%. Interestingly, the Murphy Technology sector screen has the lowest long-term performance—a 39.4% loss since the start of 1998—and has the highest standard deviation of monthly return of 14.7%.

Value Master Strategists

The Graham Enterprising Investor approach remains the top strategist among all value-oriented strategies, with a year-to-date gain of 28.1%. This methodology is also the long-term leader of value-oriented screens, having gained 877.1% since the start of 1998.

This screen looks for unpopular dividend-paying companies with low price-earnings and price-to-book ratios that are exhibiting positive earnings and have a reasonable amount of long-term debt relative to net working capital (current assets less current liabilities).

Historically, the Graham Enterprising screen has generated the smallest average number of companies over the test period. For an average month, the methodology has only four passing companies. However, for 2007, the approach was “invested” only for the month of January, when the four stocks that passed the screen at the end of December 2006 had an average gain for the month of 28.1%. Since then, no companies have passed the screen, so it is assumed that it is held in cash, but not earning interest.

Growth & Value Master Strategists

The top 2007 growth and value screen is also this year’s master strategist of all screens, the O’Shaughnessy Small Cap Growth and Value screen. This screen focuses on small-cap companies with low price-to-sales ratios, positive earnings for the trailing 12 months, with above-average relative price performance over the last 13 and 26 weeks. Its 43.9% year-to-date return is its best since it returned 107.5% in 2003. Since 1998, the methodology’s monthly compounded return is 1,185.7%.

The long-term category leader among the growth and value approaches is the O’Shaughnessy Tiny Titans screen, which has risen 3,044.2% since the start of 1998. This screen also has the top long-term performance among all screens.

Growth Master Strategists

For the second year in a row, the top performer among the growth strategies is the Richard Driehaus screen. This momentum-based approach has gained 37.2% year-to-date while focusing on small- and mid-cap companies with strong, sustained earnings growth that have also had strong recent earnings surprises.

Since it is looking for rapidly growing companies, it is probably not surprising that the set of companies currently passing the screen is weighted toward technology and biotech firms.

Once again the original CAN SLIM has the segment-leading cumulative return—1,431.9% since the start of 1998. This approach combines fundamental price-oriented factors to isolate companies with strong price and earnings momentum, and tends to identify small-cap growth stocks.

Behind the 2007 Top Strategy

What characteristics underlie the performance of 2007’s top strategist?

The Monthly Holdings columns in Table 1 offer data on average portfolio holdings over time—the average number of stocks each portfolio held over the last 10 years and the average portfolio turnover percentage from month to month.

On average, 25 companies have passed the O’Shaughnessy Small Cap Growth and Value screen since the start of 1998. This number will hold relatively steady over time because each month this screen limits the final list of companies to the 25 with the highest relative price strength over the last 52 weeks, when possible.

When investing based solely on quantitative screening results, one way to insulate yourself from hidden landmines in the portfolio is by investing in several companies. As the number of companies passing a given methodology declines, it raises the importance of individual company analysis since you have greater exposure to individual stock price movements.

The Turnover Percent column provides an indication of how many stocks exit a given strategy month-to-month. Every month, the screens tracked on AAII.com are rebalanced and only those companies passing the screen for a given month are held over to the next. The lower the percentage turnover, the greater the likelihood a company will continue to pass a screen month after month.

In addition, since our performance figures do not take into account transaction costs such as commissions, you can use the turnover figure to gain a better understanding of how these costs would cut into the reported hypothetical performance.

Since 1998, the O’Shaughnessy Small Cap Growth and Value approach has exhibited monthly turnover of 47.2%. This means that, on average, a little over 47% of the companies that pass the screen one month did not pass the next month. The O’Shaughnessy Tiny Titans methodology, with the highest cumulative return of 3,044.2%, also has a relatively high monthly turnover of 42% (the median monthly turnover for all the approaches tracked on AAII.com is 31.3%).

The O’Shaughnessy Small Cap Growth and Value screen outperformed all other strategies in 2007 with a portfolio of small-cap companies with low price-to-sales ratios, positive earnings for the trailing 12 months, and above-average relative price performance over the last 13 and 26 weeks. The strategy has generated positive returns in all years over the analysis period, although it barely made it in 2002 with a 0.8% gain. The approach’s best year was 2003, when it climbed 107.5%.

The Monthly Variability columns report the greatest monthly percentage gains and losses of each approach as one indication of the volatility it has experienced over the last nine years. The O’Shaughnessy Small Cap Growth and Value approach has experienced a maximum loss of 18.2% during a single month since the start of 1998 (August 1998) and gained as much as 18.5% in one month (October 2003). By way of comparison, the worst month the S&P 500 had over the period was a 14.6% loss and its largest single-month gain was 9.7%. For 2007, the portfolio’s best month was May, when it gained 14.3%, and its biggest loss was 9.4% in November.

The 6.9% monthly standard deviation of the O’Shaughnessy Small Cap Growth and Value methodology places it in the middle of all value strategies and is higher than most of the strategies tracked on AAII.com. In addition, by means of comparison, the monthly standard deviation of the S&P 500 is 4.2%.

In contrast, the NASDAQ 100, which consists of the largest (by market capitalization) domestic and international non-financial companies listed on NASDAQ, has a monthly standard deviation of 9.5%.

The Long-Term Strategist

What characteristics underlie the top long-term strategist’s performance?

The Total Price Gain column in Table 1 indicates the percentage amount each hypothetical test portfolio has appreciated, or declined, between January 1, 1998, and December 7, 2007. Note that this return does not include dividend payments. The performance of large-cap value strategies that tend to generate high dividends, such as the Dogs of the Dow, would not benefit because of this.

The current average dividend yield of the Dogs of the Dow screen is 3.9%; this means shareholders of these stocks would actually have an annual return that is higher by approximately this amount. The top-gaining strategy over the last 10 years is the O’Shaughnessy Tiny Titans screen, which is up 3.044.2%, cumulatively, after gaining 5% year-to-date as of December 7, 2007. This amounts to an average annual return of over 41% for the last 10 years (not shown in the table). Meanwhile, the S&P 500 index is up a total of 55.1% over the entire period.

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.

The Tiny Titans screen is very simple in its construction—it looks for exchange-listed stocks of U.S.-based companies with market caps between $25 million and $250 million, price-to-sales ratios of less than one and strong upward price movement over the last 12 months.

Conclusion

The first step of stock screening is to establish a set of parameters intended to isolate companies that match your investment philosophy.

It is not enough to merely pick those screening methodologies with the highest returns. Instead, it is important to gain an understanding of the forces that influence a portfolio’s performance and how a strategy may perform during current and expected future economic conditions.

Having selected one or more methodologies in which to invest, the next step is to have the discipline to follow these rules instead of allowing your emotions to dictate your investment decisions. However, this does not mean you automatically buy the stocks that pass a given screen. Screening is a multi-step process and the results of a screen should never be considered a “buy” or “recommended list.” It is important to consider various qualitative elements after running your quantitative screens. Such due diligence is needed to evaluate a stock to decide whether it is worthy of your investment dollars.

The AAII Stock Screens are based on relatively simple filters that are our interpretations of the investment approaches advocated by prominent investment professionals or are based on basic investment principles backed by academic research and real-world results. Examining the characteristics of an investment methodology reveals many of the practical problems you may run into when trying to develop your own disciplined investment approach.

Value Strategies   Monthly Monthly
Variability Holdings
Price Gain (%) Std.
Dev.
Largest
Gain
Loss Avg.
No.
Turn-
YTD* 2006 2005 2004 2003 2002 2001 2000 1999 1998 Total* over %
Graham--Enterprising Investor 28.1 72.3 21.3 18.9 25.9 43.5 55.3 24.2 -5.0 -7.3 877.1 7.9 33.1 -18.7 4.4 40.6
Graham--Defensive Investor (Non-Utility) 24.0 26.6 26.2 11.7 32.7 3.1 61.5 12.0 3.6 9.6 521.1 5.9 15.7 -14.6 16.4 21.3
Lakonishok 15.4 14.4 14.0 31.2 39.9 -5.2 -3.5 36.7 14.8 7.3 325.6 5.3 16.6 -13.7 28.5 90.3
Fundamental Rule of Thumb 9.3 31.0 5.0 49.6 83.3 4.7 42.3 28.7 11.7 -9.4 699.4 7.5 33.8 -19.2 50.1 22.1
Weiss Blue Chip Div Yield 9.2 14.2 6.4 13.6 48.9 -14.1 25.6 18.8 3.9 3.3 208.7 5.6 14.3 -14.8 11.5 26.1
Cash Rich Firms 8.4 17.2 -2.5 18.6 64.0 -9.4 20.1 40.5 37.1 -3.8 386.0 6.3 17.6 -20.7 31.4 24.3
Dreman With Est Revisions 7.9 39.8 9.3 35.0 69.2 16.6 -29.9 38.7 6.7 10.7 403.7 6.1 15.2 -25.8 13.1 80.7
P/E Relative 7.0 21.2 17.2 24.7 51.1 11.1 16.1 20.3 -6.0 26.5 428.3 4.4 14.9 -12.4 35.1 76.5
Piotroski 6.8 -15.8 -8.5 82.2 154.6 -15.9 100.2 -0.9 27.1 17.9 853.6 8.1 34.3 -17.2 5.2 28.0
Dogs of the Dow--Low Priced 5 4.6 34.9 -11.8 6.1 17.6 -6.5 7.2 3.2 -2.0 24.6 96.2 6.1 19.4 -15.8 5.0 15.1
Dogs of the Dow 3.7 26.8 -9.8 -1.3 20.4 -9.8 -1.2 4.1 5.7 9.8 51.7 5.0 16.1 -15.5 10.0 6.8
O'Shaughnessy--Value 1.1 24.4 2.2 20.2 47.2 -12.1 10.6 22.3 -3.9 7.2 178.6 5.1 15.5 -14.0 50.1 18.4
Dividend Screen--Non-DRPs -4.8 17.1 7.1 22.8 40.5 28.6 54.7 16.5 -3.6 0.6 363.3 3.7 10.5 -13.6 30.0 29.0
Dividend (High Relative Yield) -4.9 14.5 -1.0 19.1 27.9 0.4 24.1 23.3 -2.1 6.3 162.8 4.1 12.5 -12.0 37.5 20.9
Dreman -11.4 19.3 18.7 24.2 37.7 8.3 26.4 38.0 -3.0 -1.5 287.2 4.5 12.6 -15.4 21.7 30.1
Neff -11.8 13.9 7.7 29.5 85.1 15.0 65.2 37.3 17.4 9.3 767.5 6.8 26.8 -20.2 19.5 34.1
Dividend Screen--DRPs -16.4 20.9 -1.5 17.4 28.3 -1.2 38.9 27.7 -1.1 -4.1 149.5 4.4 15.6 -14.2 29.7 25.3
Price-to-Free-Cash-Flow -16.7 26.6 10.6 30.9 61.7 13.6 63.8 17.8 10.0 2.6 510.0 5.8 25.1 -14.4 30.2 23.4
Growth & Value Strategies   Monthly Monthly
Variability Holdings
Price Gain (%) Std.
Dev.
Largest
Gain
Loss Avg.
No.
Turn-
YTD* 2006 2005 2004 2003 2002 2001 2000 1999 1998 Total* over %
O'Shaughnessy--Small Cap Growth and Value 43.9 36.2 19.1 26.8 107.5 0.8 13.4 13.2 21.1 33.6 1185.7 6.9 18.5 -18.2 24.7 47.2
Oberweis Octagon 36.7 24.0 4.1 42.3 67.8 -17.5 20.2 18.4 33.4 15.6 663.7 8.3 23.3 -23.2 18.7 41.0
Value on the Move--PEG With Est Growth 31.8 18.3 23.1 54.1 87.0 7.9 34.8 22.9 11.0 2.1 1021.9 5.8 15.7 -23.1 47.2 43.9
Value on the Move--PEG With Hist Growth 22.9 9.1 17.2 32.5 50.1 12.1 22.4 19.4 18.0 1.5 512.7 4.4 12.7 -19.1 97.7 36.1
Zweig 20.8 18.6 27.8 49.5 88.8 16.9 57.9 46.2 17.1 54.5 2419.9 7.8 32.7 -24.2 14.9 42.9
Wanger (Revised) 17.1 16.5 14.5 22.5 53.2 -13.1 21.1 -2.8 3.2 -2.4 202.5 6.5 22.8 -19.8 31.4 27.0
O'Shaughnessy--Growth Market Leaders 16.8 9.6 18.9 6.7 26.2 -8.9 5.7 -9.0 16.8 35.3 183.3 5.1 13.6 -15.7 10.3 42.7
Buffett--Hagstrom 15.3 11.3 11.4 27.6 35.2 -8.7 13.9 11.4 31.4 27.5 379.0 4.9 13.2 -15.5 29.9 22.0
O'Shaughnessy--Growth 14.4 17.2 14.4 45.1 90.3 10.1 19.2 11.5 19.5 19.4 783.9 6.7 18.6 -17.9 50.2 37.9
Lynch 12.9 15.6 7.8 59.8 59.0 -7.2 39.3 3.2 8.9 1.3 426.0 4.9 18.9 -17.4 22.0 22.6
Templeton 12.2 5.3 4.7 22.2 46.8 -32.6 22.0 20.3 8.1 16.2 175.8 5.5 14.3 -18.2 24.2 28.0
O'Shaughnessy--All Cap 11.3 24.1 21.9 47.4 28.7 -11.8 63.7 6.3 -15.3 18.2 391.0 5.4 12.9 -15.0 25.4 34.9
Fisher (Philip) 10.7 -1.2 -11.7 -3.9 78.1 -10.7 70.7 -16.7 5.4 2.6 127.1 9.7 27.1 -27.9 22.3 32.8
Stock Market Winners 10.1 -5.5 25.9 9.6 131.5 32.1 41.6 27.6 21.7 -12.0 749.1 6.8 22.0 -23.4 14.4 60.3
Buffettology--EPS Growth 9.3 8.8 11.9 13.2 32.8 -10.9 25.7 5.9 17.7 4.0 190.9 5.4 15.0 -20.4 45.1 11.8
Foolish Small Cap 8 Revised 8.9 44.6 15.3 -3.9 67.8 22.2 29.5 51.5 36.5 12.4 977.3 8.9 28.1 -24.2 7.5 31.0
Buffettology--Sustainable Growth 8.1 8.7 9.5 17.5 37.6 -11.9 29.7 3.3 14.6 7.4 201.9 5.7 16.5 -18.0 32.0 13.7
Price-to-Sales 6.5 16.6 16.9 11.1 69.8 1.3 43.3 23.3 21.1 13.2 571.4 5.6 14.8 -17.8 45.3 40.3
O'Shaughnessy--Tiny Titans 5.0 35.2 7.5 45.8 154.8 51.9 84.1 -6.6 53.8 38.1 3044.2 8.7 37.4 -21.0 25.2 42.0
Rule #1 Investing -1.3 2.5 -6.7 13.5 48.0 -29.4 38.0 15.0 41.4 7.9 170.9 7.7 27.0 -26.8 13.2 27.9
T. Rowe Price -7.9 -11.3 23.1 44.9 39.2 -15.1 8.4 35.2 -4.5 1.8 145.6 6.3 18.3 -18.0 11.3 32.6
Muhlenkamp -15.5 2.0 23.6 31.0 41.2 5.9 43.5 22.2 12.8 -6.6 284.8 5.4 15.1 -17.6 19.6 24.3
Growth Strategies   Monthly Monthly
Variability Holdings
Price Gain (%) Std.
Dev.
Largest
Gain
Loss Avg.
No.
Turn-
YTD* 2006 2005 2004 2003 2002 2001 2000 1999 1998 Total* over %
Driehaus 37.2 41.4 4.3 -10.8 87.8 -42.6 -27.4 -8.3 107.4 nmf 168.5 10.8 51.3 -25.7 14.6 63.7
O'Neil's CAN SLIM Revised 3rd Edition 30.0 -5.4 -1.0 -2.6 74.7 -10.3 33.4 96.3 59.0 7.8 734.4 8.7 52.7 -26.7 10.4 61.9
O'Neil's CAN SLIM 23.1 29.5 24.1 -3.8 79.0 20.5 54.4 38.0 36.6 28.2 1431.9 6.8 23.6 -23.1 9.1 54.8
Return on Equity 8.6 8.7 17.6 23.9 46.9 -3.8 18.1 31.4 1.0 18.8 352.4 5.6 13.0 -22.2 35.3 20.6
Foolish Small Cap 8 -1.6 9.4 22.6 10.1 107.7 -19.4 -8.6 24.2 80.9 17.7 487.9 9.4 38.8 -22.5 22.5 36.1
Inve$tWare Quality Growth -4.7 0.9 14.9 18.0 33.3 -25.0 8.0 18.5 -3.0 14.5 85.4 5.4 18.2 -22.0 26.5 11.5
IBD Stable 70 -7.0 6.9 1.8 29.0 48.4 -11.0 9.5 23.9 3.6 21.9 195.5 4.8 12.0 -18.9 52.7 11.4
Sector/Specialty Strategies   Monthly Monthly
Variability Holdings
Price Gain (%) Std.
Dev.
Largest
Gain
Loss Avg.
No.
Turn-
YTD* 2006 2005 2004 2003 2002 2001 2000 1999 1998 Total* over %
ADRs 29.4 44.7 12.9 14.5 82.3 -4.4 -5.3 9.9 4.0 2.3 367.4 6.1 31.1 -17.7 24.3 41.9
Est Rev Up 5% 24.0 40.3 24.5 25.8 75.0 12.9 -8.1 3.6 107.1 43.3 1419.8 8.6 30.8 -21.7 41.9 92.9
Est Rev Up 16.1 21.8 17.3 25.2 57.3 0.8 -3.5 2.2 38.2 29.9 482.5 5.7 12.2 -18.6 171.5 81.1
Graham--Defensive Investor (Utility) 3.6 29.4 18.5 16.2 16.6 -15.9 5.2 51.4 -8.4 14.6 202.5 4.3 12.0 -11.0 15.5 16.4
Dual Cash Flow -3.7 20.4 10.4 24.7 66.9 -13.9 24.6 5.7 114.3 0.9 553.4 6.8 34.7 -16.2 62.1 31.5
Murphy Technology -13.1 -1.9 34.1 107.9 -33.7 -79.6 26.7 -52.1 139.7 29.7 -39.4 14.7 58.5 -44.9 10.6 23.8
Insider Net Purchases -13.4 4.8 -14.6 33.5 86.8 -20.9 21.8 -38.3 7.5 nmf 23.5 8.1 26.7 -19.0 27.4 28.9
Est Rev Down -15.0 12.9 -0.4 13.4 51.8 -43.8 26.7 -7.1 21.9 -15.0 12.9 7.0 17.6 -23.3 193.4 79.3
Est Rev Down 5% -20.9 26.1 2.5 8.0 70.9 -61.5 28.3 -4.2 27.8 -3.9 9.8 8.6 23.6 -23.2 70.1 89.2
Indexes   Monthly  
Variability
Price Gain (%) Std.
Dev.
Largest
Gain
Loss
YTD* 2006 2005 2004 2003 2002 2001 2000 1999 1998 Total*
All Exchange-Listed Stocks -1.7 17.2 4.5 22.8 81.1 -13.3 21.2 -14.2 35.1 5.9 245.6 6.1 23.9 -20.2    
Dow Jones 30 9.3 16.3 -0.1 2.6 25.3 -16.8 -7.1 -6.2 25.2 16.1 72.3 4.3 11.8 -15.1    
NASDAQ 100 21.2 6.8 1.5 10.4 49.1 -37.6 -32.7 -36.8 102.0 85.5 115.2 9.5 25.0 -27.5    
S&P 500 6.1 13.6 3.0 9.0 26.4 -23.4 -13.0 -10.1 19.5 26.7 55.1 4.2 9.7 -14.6    
 S&P 500 Growth (incl divs) 10.7 11.0 1.1 7.0 27.1 -28.1 -16.1 -19.1 37.4 38.2 56.4 5.2 10.8 -15.8    
 S&P 500 Value (incl divs) 5.3 15.3 8.7 15.0 30.4 -16.6 -8.2 -0.5 4.9 18.9 88.2 3.8 9.6 -13.1    
S&P MidCap 400 10.1 9.0 11.3 15.2 34.0 -15.4 -1.6 16.2 13.3 17.7 165.6 5.1 12.0 -18.7    
 S&P MidCap 400 Growth (incl divs) 16.4 5.8 14.4 15.8 37.6 -19.7 -2.6 15.8 36.1 37.2 279.9 5.9 19.0 -22.2    
 S&P MidCap 400 Value (incl divs) 6.0 13.4 10.8 17.2 33.8 -9.4 1.4 19.5 -2.6 3.7 131.5 4.3 10.9 -15.2    
S&P SmallCap 600 1.9 14.1 6.7 21.4 37.8 -15.3 5.7 11.0 11.5 -2.1 125.1 5.4 13.3 -19.4    
 S&P SmallCap 600 Growth (incl divs) 8.7 10.6 7.3 24.3 38.5 -16.6 3.0 7.6 19.7 -0.1 145.4 5.8 17.0 -21.7    
 S&P SmallCap 600 Value (incl divs) -2.5 19.6 8.5 21.1 39.2 -12.9 9.5 15.8 4.9 -2.6 140.5 4.9 12.8 -16.9    

Winning Tactics: The investment Characteristics of the 2007 Master Strategists

The market in 2007 presented fiercely challenging moves for stock market strategists. The weakening housing market has given way to a sub-prime mortgage crisis, and, coupled with oil prices at historic highs, there are signs that the U.S. economy may be slipping into recession. Further clouding the analysis is next year’s presidential election.

Often during times of market uncertainty, the tactic of investors is to gravitate toward larger companies, and this appears to have been the trend in 2007. For the most part, small-cap issues lagged those of large- and mid-cap companies for the first time in several years. Furthermore, value-oriented approaches underperformed growth-based methodologies.

What tactics are common to the top- and bottom-performing strategies?

Table 2 presents the current characteristics of the top- and bottom-performing strategies for 2007 and cumulatively since 1998.

Many of the bottom-performing strategies are specialty and sector screens. The Estimate Revisions Up 5% screen made the list of long-term top performers while its counterparts—Estimate Revisions Down and Estimate Revisions Down 5%—made the list of weakest cumulative performing screens.

Note that the strong performance for the upward revision screen and weak performance for the downward revision screens came in the months after the revisions, which points to the persistent impact of estimate revisions.

Market Capitalization

The median market capitalization (share price times number of shares outstanding) for the major S&P indexes is currently:

  • S&P 500: $13.5 billion
  • S&P MidCap 400: $2.8 billion
  • S&P SmallCap 600: $735 million

Despite an underwhelming year for small-cap stocks, the top-performing screening approach was the O’Shaughnessy Small Cap Growth and Value methodology. Currently, the stocks passing this screen have a median market capitalization of $392 million. The Driehaus approach is also oriented toward small-cap issues: Its current crop of passing companies has a median market cap of $898.5 million. Meanwhile, the Oberweis Octagon is more of a mid-cap approach, with a median market cap of almost $1.3 billion. Finally, the Value on the Move Estimated PEG ratio ($5.4 billion) and ADR ($19.6 billion) approaches tend to isolate large-cap companies.

Multiples

The price-earnings ratio (price divided by trailing 12-month earnings per share) of the O’Shaughnessy Small Cap Growth and Value screen is 22.6, roughly one-quarter greater than the median value, 18.5, for all the exchange-listed stocks currently in the Stock Investor Pro database, which we use to run and test these screens.

The current portfolio of only one of the five top-performing methodologies—the ADR approach—has a median price-earnings ratio below the typical exchange-listed stock. However, four of the five worst-performing strategies currently have portfolios with a median price-earnings ratio below that of the typical exchange-listed stock.

The O’Shaughnessy Small Cap Growth and Value screen, along with the Oberweis Octagon, have the lowest price-to-sales ratios (price divided by sales per share). Their ratios of 1.2 are one-third lower than the median value for all exchange-listed stocks. The O’Shaughnessy screen specifically limits its passing companies to price-to-sales ratios under 1.5.

Once again, the price multiples—price-earnings, price-to-book, and price-to-sales ratios—of losing strategies tend to be lower than those of the winning strategies for 2007.

The price-earnings to earnings-per-share-growth ratio is called the PEG ratio and attempts to balance the trade-off between price-earnings ratios and earnings per share growth rates. Investors are willing to pay more for current earnings when there are reasonable expectations of growth and higher earnings in the future.

The PEG ratio is computed by dividing the normalized price-earnings ratio (price divided by the consensus earnings per share estimate for the current fiscal year) by the estimated earnings per share growth rate for the next three to five years. Normally, companies with PEG ratios near 1.0 are considered fairly valued. Ratios above 1.5 may indicate overvalued stocks, and ratios below 0.5 potentially indicate attractively priced (undervalued) stocks.

In general, both the top- and bottom-performing methodologies had PEG ratios below the typical exchange-listed stock. As a rule, growth strategies tend to have higher PEG ratios. Among the top- and bottom-performing strategies this year, the O’Shaughnessy Small Cap Growth and Value approach has a middle-of-the-road PEG ratio of 1.2.

Relative Strength

The relative strength figures in the table are calculated against the performance of the S&P 500. Stocks with performance equal to that of the S&P 500 over the last 52 weeks have a relative strength index value of zero. A relative strength value of 26 indicates that the stock outperformed the S&P 500 by 26%. Negative numbers indicate underperformance relative to the index.

Price momentum—measured by either price change or relative strength—was a screening element found in each of the five top-performing methodologies for 2007, perfectly illustrating the dominance of growth and momentum-oriented investing this year.

The stocks currently comprising the O’Shaughnessy Small Cap Growth and Value screen have a median relative strength value of 76%, indicating that the individual stocks currently passing the screen have outperformed the S&P 500 by an impressive 76% over the last year.

All of the top-performing strategies in 2007 are currently selecting stocks that have outperformed the S&P 500 over the last year. Bucking the trend of recent years, all of the 2007 bottom-performing approaches currently consist of stocks with negative relative price strength.

Winning Long-Term Tactics

Over the testing period, several common factors are apparent for those stock strategies enjoying long-term success:

  • Low multiples (price-earnings, price-to-book value, etc.), more on a relative rather than an absolute basis;
  • An emphasis on consistent and reasonable growth in earnings, sales, or dividends;
  • Strong financials;
  • Price momentum; and
  • Upward earnings revisions.
  Price
Change (%)
Market
Cap
($ Mil)
P/E
Ratio
(X)
Price-
to-
Book-
Value
Ratio
(X)
Price-
to-
Sales
Ratio
(X)
P/E
to
EPS
Est
Grth
(X)
Hist
EPS
Grth
(%)
Est
Long-
Term
EPS
Grth
(%)
52-Wk
Rel
Strgth
vs
S&P
YTD Cum'l* (%)
Top Performers: 2007
O'Shaughnessy--Small Cap Growth and Value (Growth & Value) 43.9 1185.7 392.0 22.6 3.5 1.2 1.2 7.3 20.0 76.0
Driehaus (Growth) 37.2 168.5 898.5 22.2 5.0 6.1 1.7 16.6 22.0 4.5
Oberweis Octagon (Growth & Value) 36.7 663.7 1292.1 22.3 2.3 1.2 0.9 12.7 25.0 32.0
Value on the Move--PEG With Est Growth (Growth & Value) 31.8 1021.9 5442.4 18.7 3.3 2.1 0.9 25.3 19.6 26.5
ADRs (Specialty) 29.4 367.4 19640.5 15.5 3.0 1.9 1.5 31.5 12.0 5.0
Bottom Performers: 2007
Price-to-Free-Cash-Flow (Value) -16.7 510.0 1754.1 14.5 1.1 0.6 1.6 15.2 10.0 -35.5
Dividend Screen--DRPs (Value) -16.4 149.5 6802.3 13.0 1.9 1.9 1.5 18.6 9.8 -16.0
Muhlenkamp (Growth & Value) -15.5 284.8 464.9 11.3 1.9 2.4 0.8 24.9 13.2 -37.0
Insider Net Purchases (Specialty) -13.4 23.5 167.5 21.1 2.1 1.3 1.1 20.9 18.3 -5.5
Murphy Technology (Sector) -13.1 -39.4 414.5 7.3 1.6 1.4 0.7 22.1 19.8 -28.0
Top Performers: Total History
O'Shaughnessy--Tiny Titans (Growth & Value) 5.0 3044.2 60.6 18.1 1.7 0.6 1.7 17.4 14.5 82.0
Zweig (Growth & Value) 20.8 2419.9 1626.4 20.2 4.2 1.6 1.3 17.1 16.6 33.0
O'Neil's CAN SLIM (Growth) 23.1 1431.9 308.4 18.3 3.4 2.0 0.9 78.0 19.1 45.0
Est Rev Up 5% (Specialty) 24.0 1419.8 622.1 23.1 2.8 2.4 1.3 15.8 21.7 26.0
O'Shaughnessy--Small Cap Growth and Value (Growth & Value) 43.9 1185.7 392.0 22.6 3.5 1.2 1.2 7.3 20.0 76.0
Bottom Performers: Total History
Murphy Technology (Sector) -13.1 -39.4 414.5 7.3 1.6 1.4 0.7 22.1 19.8 -28.0
Est Rev Down 5% (Specialty) -20.9 9.8 681.5 15.9 1.4 0.8 1.2 19.0 17.2 -40.0
Est Rev Down (Specialty) -15.0 12.9 1282.2 16.1 1.8 1.1 1.2 17.9 14.2 -27.0
Insider Net Purchases (Specialty) -13.4 23.5 167.5 21.1 2.1 1.3 1.1 20.9 18.3 -5.5
Dogs of the Dow (Value) 3.7 51.7 59117.5 17.2 2.6 1.8 1.9 5.9 7.6 -7.0
All Exchange-Listed Stocks -1.7 245.6 441.9 18.5 1.9 1.8 1.4 15.4 14.6 -9.0

Master Moves: The stocks Underlying the Top 2007 Strategy

A winning strategy is the culmination of many individual moves.

After gaining 43.9% through December 7, 2007, the O’Shaughnessy Small Cap Growth and Value approach ended Benjamin Graham’s reign at the top of the strategies tracked at AAII.com. Which individual stocks contributed to the strategy’s overall return?

The stocks passing the Small Cap Growth and Value screen are what James O’Shaughnessy terms “cheap stocks on the mend”—small-cap companies with low price-to-sales ratios, positive short-term earnings growth, and above-average relative price strength.

Unlike recent years, where the top strategy had only a handful of stocks that passed the screen during the year, this year the O’Shaughnessy Small Cap Growth and Value screen had 133 companies pass its filters during the course of 2007. Over the year, the portfolio held an average of 23 stocks in a given month. After running the initial set of filters each month, we then attempt to limit the final number of passing companies to 25 by selecting those with the highest 52-week relative price strength. However, the market conditions were such this year that on four occasions less than 25 companies passed the screen even after fully relaxing the 52-week relative strength requirement.

Table 3 presents the five best- and worst-performing stocks that passed the O’Shaughnessy Small Cap Growth and Value screen in 2007, as well as their performance while they were held in the hypothetical portfolio, the number of months the stock was held this year, and select current financial data.

Spartan Motors was the best-performing O’Shaughnessy Small Cap Growth and Value stock during 2007. The company manufactures specialty and custom vehicle chassis and bodies, including for fire trucks and motor homes, as well as military vehicles. Over the five months it was held in the portfolio, the stock’s monthly compounded return was 131%.

The largest single-month gain was the 34.3% turned in by M&F Worldwide in April. M&F operates four business lines: including financial products and services; licorice products; lending and mortgage solutions; and data collecting and testing, including the venerable Scantron student testing system. On April 5, the company’s stock jumped 23.6% after the company announced that the Department of Justice had granted early termination of the waiting period for its proposed acquisition of the John H. Harland Company. The company did not pass the screen at the end of April because its price-to-sales ratio had risen above the screen’s 1.5 maximum to 1.8. Over the three months that M&F Worldwide was held in the O’Shaughnessy Small Cap Growth and Value portfolio, its monthly compounded return was 87.5%.

PC Mall, Inc., a direct marketer of computer hardware, software, and electronics, had the lowest total return in the portfolio for 2007, falling 37.9% in the only month it was held in the portfolio. This was also the largest single-month decline for all of the stocks held in the O’Shaughnessy Small Cap Growth and Value hypothetical portfolio in 2007. On October 30, PC Mall reported third-quarter earnings and revenues that exceeded the forecast of the single analyst tracking it, yet the stock started a nine-day slide during which it lost over 39%. The stock failed to pass the screen at the end of November due to its weak price performance.

The O’Shaughnessy Small Cap Growth and Value strategy has delivered strong performance over the last 10 years, not just in 2007. In fact, it is one of only a few of the methodologies tracked on AAII.com that has recorded positive returns over the entire testing period dating back to the start of 1998.

Company (Exchange: Ticker) Return
While
in
Port
(%)
Months
in
Port
During
2007
P/E
Ratio
(X)
Price-
to-
Book-
Value
(X)
Dividend
Yield
(%)
P/E to
EPS
Est
Grth
(X)
Hist
EPS
Grth
(%)
Est
Long-
Term
EPS
Grth
(%)
Market
Cap
($ Mil)
  Industry
 
52-Wk
Rel
Strgth
(%)
Spartan Motors, Inc. (M: SPAR) 131.0 5.0 15.5 2.4 1.1 0.5 17.9 25.0 304.0 -12.0 Auto & Truck Manufacturers
M & F Worldwide Corp. (N: MFW) 87.5 3.0 nmf 2.8 0.0 nmf 19.4 na 1168.7 204.0 Food Processing                          
Chart Industries, Inc. (M: GTLS) 43.4 3.0 21.5 2.6 0.0 0.6 37.1 29.8 816.1 78.0 Scientific & Technical Instruments
Hill International Inc. (M: HINT) 41.1 2.0 30.2 5.2 0.0 1.4 na 20.0 363.2 74.0 Business Services
Nexstar Broadcasting Group (M: NXST) 34.2 5.0 nmf nmf 0.0 nmf 55.1 na 241.7 61.0 Broadcasting & Cable TV
AZZ Incorporated (N: AZZ) -25.6 3.0 14.3 2.7 0.0 na 19.7 na 348.3 16.0 Electronic Instruments & Controls
TRC Companies, Inc. (N: TRR) -26.3 1.0 nmf 0.9 0.0 nmf -17.7 na 144.0 -23.0 Waste Management Services
Einstein Noah Restaurant Group (M: BAGL) -27.1 1.0 21.9 nmf 0.0 0.8 65.1 20.0 318.8 136.0 Restaurants                              
MIVA, Inc. (M: MIVA) -30.8 2.0 nmf 1.7 0.0 nmf -168.5 17.5 86.7 -27.0 Computer Services
PC Mall, Inc. (M: MALL) -37.9 1.0 16.2 1.9 0.0 0.6 -5.2 22.5 154.0 10.0 Retail (Catalog & Mail Order)
Exchange-Listed Stocks (Medians) -- -- 18.5 1.9 0.0 1.4 15.4 14.6 441.9 -9.0  
Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


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