Style Diversification Using the James O'Shaughnessy Approach

    by Wayne A. Thorp

    For decades, stock investors have been debating the merits of growth versus value investing. While growth investors risk being burned by the latest hot stock, value investors may end up buying undervalued stocks that only get cheaper.

    James O’Shaughnessy set out to answer this argument “once and for all” by testing a series of growth and value screens on a sufficiently large stock database that covered a meaningful period of time. His goal was to determine which screens within each style group produced the best returns.

    The results of O’Shaughnessy’s analysis were first published in the 1996 book “What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time” (McGraw-Hill).

    He followed this up with a revised edition the next year, which provided a more detailed breakdown of the performance of the strategies and, most importantly, made wholesale changes to one of his strategies.

    What O’Shaughnessy found is that both the growth and value strategies can be successful, but they each are successful with different kinds of stocks. To put it simply, the value strategy tended to work best on large-capitalization stocks, while the growth-focused approach was useful for a stock universe emphasizing small stocks.

    In addition, O’Shaughnessy found that the two methodologies actually complemented each other—the value strategy offered less volatility, while the growth approach offered greater potential for capital appreciation.

    Cornerstone Growth & Value Screens

    Based on the second edition of “What Works on Wall Street,” AAII developed two screens, one a “growth” screen and one a “value” screen.

    The Cornerstone Value approach seeks stocks with:

    • Above-average market capitalization and shares outstanding;
    • Above-average cash flow per share;
    • Above-average revenues; and
    • High dividend yields.

    In contrast, the Cornerstone Growth methodology isolates companies with:

    • Positive earnings growth;
    • “Low” price-to-sales ratios; and
    • High relative price strength.

    Stock Investor Pro, AAII’s fundamental stock screening and research database, includes these O’Shaughnessy screens. Stock Investor Pro actually includes three screens—the two outlined above (labeled O’Shaughnessy Growth II and O’Shaughnessy Value in Stock Investor Pro) that follow the book’s second edition screens, and a third screen that is based on the original growth screen in the first edition of “What Works On Wall Street” (labeled O’Shaughnessy Growth in Stock Investor Pro). O’Shaughnessy completely changed his growth criteria between the first and second editions. However, the AAII Stock Screens area of tracks only the growth and value screens from the second edition, and they are simply labeled O’Shaughnessy—Growth and O’Shaughnessy—Value.

    Screens’ Performance

    On a monthly basis, lists the companies passing the two O’Shaughnessy Cornerstone screens and tracks the performance of these stocks in hypothetical portfolios.

    Figure 1.
    Performance of
    O'Shaughnessy Cornerstone

    For the passing companies each month, we list only the top 50 stocks for each screen—the 50 passing companies with the highest dividend yield for the Cornerstone Value screen and the 50 passing companies with the highest relative price strength for the Cornerstone Growth screen.

    Figure 1 illustrates that both the Cornerstone screens have outperformed the overall market since the beginning of 1998. Furthermore, the Cornerstone Growth screen has generated positive returns each year over the period. Between January 1998 and the end of July 2007, the Cornerstone Value screen returned 182.5% while the growth screen generated an 823.8% return. By comparison, the S&P 500 has gained an even 50% since 1998.

    Profile of Passing Companies

    Table 1 presents the characteristics of the companies passing both Cornerstone screens as of August 10, 2007. The Cornerstone Growth screen emphasizes relative price strength and, typically, such stocks have higher valuations. This holds true, for the most part, with the current set of passing growth companies. The median price-earnings ratio is 21.0 as compared to a median of 12.2 for the companies currently passing the Cornerstone Value screen.

    However, with its requirement that passing stocks have a price-to-sales ratio of less than 1.5, the current Cornerstone Growth companies have a significantly lower median price-to-sales ratio of 0.73 than that of the current Cornerstone Value stocks (1.76).

    Whereas the Cornerstone Growth screen focuses on price momentum, the Cornerstone Value screen isolates companies with high dividend yields. The current Cornerstone Value stocks have a median dividend yield of 4.7%. In contrast, the current Cornerstone Growth companies have a much lower median dividend yield of 0.0%.

    While the Cornerstone Growth screen does require positive earnings growth over the last four fiscal quarters, the companies passing the screen have roughly the same long-term earnings growth (18.5%) as those companies passing the Cornerstone Value screen (18.2%).

    The Cornerstone Growth screen eliminates only the smallest companies—those with a market cap below $150 million. In contrast, the Cornerstone Value screen looks for companies with above-average market cap as well as sales over the last 12 months that are 150% above the average company.

    These requirements lead to passing companies from the value screen that are significantly larger than those from the growth screen. As Table 1 shows, the median market cap for the Cornerstone Growth companies is $1.45 billion, while the median for the current Cornerstone Value companies is $35.6 billion.

    Finally, the Cornerstone Growth companies have had extraordinary performance over the last year, outperforming the S&P 500 by 90% on a median basis. In comparison, the companies passing the Cornerstone Value screen have underperformed the S&P 500 by 6.5%.

    Table 1. O'Shaughnessy Cornerstone Growth and Value Portfolios' Characteristics
    Portfolio Characteristics (Median) Cornerstone
    Price-earnings ratio (X) 21 12.2 18.8
    Price-to-book-value ratio (X) 3.13 2.09 2.07
    Price-to-sales ratio (X) 0.73 1.76 1.84
    Dividend yield (%) 0 4.7 0
    EPS 5-yr. historical growth rate (%) 18.5 18.2 15.6
    EPS 3-5 yr. estimated growth rate (%) 16.4 8.5 14.5
    Market cap. ($ million) 1,445.10 35,571.50 471.1
    Relative strength vs. S&P (%) 90 –6.5 –3
    Monthly Observations
    Average no. of passing stocks 50 50  
    Highest no. of passing stocks 61 53  
    Lowest no. of passing stocks 43 48  
    Monthly turnover (%) 37.8 18.6  

    Passing Companies

    Table 2 lists the top 15 companies for both Cornerstone screens as of August 10, 2007. For performance measurement purposes, as well as for listing on the AAII Web site, we use the top 50 companies passing each screen.

    The companies passing the Cornerstone Growth screen are ranked by 52-week relative strength while the Cornerstone Value companies are ranked by dividend yield.

    Every one of the 15 Cornerstone Value companies has a dividend yield greater than any of the Cornerstone Growth companies. Telecom Corp. of New Zealand has the highest dividend yield for all the value companies at 13.7%, based on an indicated dividend of $3.53. Cooper Tire & Rubber, with a yield of 1.8%, has the highest dividend yield among the Cornerstone Growth companies.

    For value-based strategies, O’Shaughnessy suggests buying firms with large market capitalizations while, for growth-based strategies, he suggests including larger-capitalization stocks along with smaller firms.

    Looking at the Cornerstone Value firms, Fidelity National Financial has the smallest market capitalization at $4.6 billion while Bank of America is at $215.6 billion. ITC DeltaCom, a communications services firm on the growth list, has the smallest overall market cap at $164.2 million.

    Finally, looking at relative price strength over the last 52 weeks, the 15 Cornerstone Growth companies all rank in the 96th percentile or higher. Calpine Corporation, an electric utility, is in the 100th percentile, having outperformed the S&P 500 by an astounding 639% over the last year. During that period, Calpine’s stock price gained 744%, going from roughly $0.37 per share to $3.08 per share.

    The best performer among the Cornerstone Value companies is Southern Copper Corp., which is in the 95th percentile. Over the past year, this mining company has outperformed the S&P 500 by 95%. Meanwhile, financial holding company National City Corp. has the worst overall relative strength, ranking in the 21st percentile. Over the period, the company underperformed the S&P 500 by 32%.



    O’Shaughnessy argues that it is possible for individual investors to beat the market, as long as they remain disciplined, with their emotions in check. Stock screening is an excellent way to instill discipline on your investment approach—it forces you to examine only stocks that match your criteria.

    The Cornerstone Growth and Value screens identify high-momentum and high-yield stocks, respectively. Since it is probably not prudent to invest wholly in only one strategy or another, O’Shaughnessy suggests diversifying between the two.

    No matter which methodology you follow, you need to view the companies passing any screen as a starting point. The stocks passing this or any other quantitative screen do not represent a “buy” or “recommended” list. Overall, it is important to perform additional due diligence to verify the financial strength of passing companies and identify stocks that match your investing tolerances and constraints before committing your investment dollars.

       What It Takes: O’Shaughnessy’s Cornerstone Growth and Value Criteria
    Value Criteria:

    • Exclude companies in the utilities sector;
    • The market capitalization for the last fiscal quarter (Q1) is greater than or equal to the average market capitalization for the entire stock universe;
    • The average number of shares outstanding from the last fiscal quarter (Q1) is greater than the average number of shares outstanding for the entire stock universe;
    • Cash flow per share for the last 12 months is greater than the average cash flow per share for the last 12 months for the entire stock universe;
    • Total sales for the last 12 months is greater than 1.5 times the average total sales for the last 12 months for the entire stock universe; and
    • The dividend yield is such that only 50 companies are included in the final results.

    Growth Criteria:

    • The market capitalization for the last fiscal quarter (Q1) is greater than $150 million;
    • The price-to-sales ratio is less than 1.5;
    • The growth rate in earnings per share over the last 12 months is positive; and
    • The percent change in stock price over the last 52 weeks is such that only 50 companies are included in the final results.

    Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.

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