Growth or Value? O'Shaughnessy Method Generates Big Returns Using Both

Includes: MWIV, ROST, SNY, T, TJX
by: John P. Reese

To say that James O'Shaughnessy has written the book on quantitative investing strategies might be an exaggeration -- but not much of one. Over the years, O'Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor's Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.

In addition to finding out how certain strategies had performed in terms of returns over the long term, O'Shaughnessy's study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns -- what he called his "United Cornerstone" strategy.

The United Cornerstone approach is actually a combination of two separate models that O'Shaughnessy tested, one growth-focused and one value-focused. This two-pronged method forms the basis for my O'Shaughnessy-inspired Guru Strategy portfolio, which, after nearly doubling the S&P 500 in 2010, is now averaging annualized returns of 9.9% since its July 2003 inception. The S&P has returned just 3.7% annualized over that same period.

Currently, you can get access to this market-beating model through the Guru Analysis & Guru Stock Screener App in Seeking Alpha's Investing App Store.

Double-Barreled Attack

My O'Shaughnessy-inspired value strategy looks for stocks with market caps of at least $1 billion and trailing 12-month sales that are at least one-and-a-half times the market mean. O'Shaughnessy found that these large, well-known firms' stocks are considerably less volatile than the broader market. This approach also looks for stocks with cash flows per share greater than the market mean, and with more shares outstanding than the market average.

The value model I base on O'Shaughnessy's writings takes the stocks that meet all four of those tests -- market cap, sales, shares outstanding, and cash flow -- and then ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval.

The O'Shaughnessy-based growth approach, meanwhile, is not, in fact, strictly a growth approach. That's because one of the interesting things O'Shaughnessy found in his back-testing was that all of the successful strategies he studied -- even growth approaches -- included at least one value-based criterion. The value component of his Cornerstone Growth strategy was the price/sales ratio, a variable that O'Shaughnessy found -- much to the surprise of Wall Street -- was the single best indication of a stock's value, and predictor of its future.

My O'Shaughnessy-inspired growth model uses a market cap minimum of $150 million, and requires stocks to have price/sales ratios below 1.5. To avoid outright dogs, the strategy also looks at a company's last five years of earnings, requiring that its earnings per share have increased each year since the first year of that period.

The final criterion of this approach is relative strength, the measure of how a stock has performed compared to all other stocks over the past year. A key part of why the growth stock model works so well, according to O'Shaughnessy, is the combination of high relative strengths and low P/S ratios. By targeting stocks with high relative strengths, you're looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio, you're ensuring that you're not getting in too late on these popular stocks, after they've become too expensive. My model takes all the firms that pass the O'Shaughnessy-based market cap, earnings persistence, and price/sales ratio tests and ranks them by relative strength. The top 50 get final approval.

My O'Shaughnessy-based portfolio includes 10 stocks picked using the growth and value approaches. Depending on market conditions, it can thus contain an even number of growth and value picks, or tilt to one side or the other. Currently, it's leaning heavily to the growth side, with 8 of its 10 holdings being selected by the growth strategy.

Here's a look at a handful of the portfolio's current holdings:

  • The TJX Companies Inc. (NYSE:TJX): This Massachusetts-based bargain retailer is the owner of such popular chains as T.J. Maxx, Marshalls, and Home Goods. The $20-billion-market-cap firm gets approval from my O'Shaughnessy-based growth approach, thanks to its having upped EPS in each year of the past half-decade, and its P/S ratio of 0.92 and relative strength of 64.
  • MWI Veterinary Supply, Inc. (NASDAQ:MWIV): Based in Idaho, MWI ($850 million market cap) is involved in the animal health arena, supplying veterinarians in the U.S. and U.K. with pharmaceuticals, vaccines, diagnostics, capital equipment, and pet food and nutritional products. It's a favorite of my O'Shaughnessy-based growth model, thanks to its combination of a high relative strength (83) and low P/S ratio (0.63), and the fact that it has upped EPS in each year of the past half-decade.
  • Ross Stores (NASDAQ:ROST): TJX isn't the only off-price retailer in the O'Shaughnessy-based portfolio. In fact, it currently holds four discount retailers, including California-based Ross. The $8.4-billion-market-cap firm has upped EPS in each year of the past half-decade, has a P/S ratio of 1.1, and has a relative strength of 79, all reasons the O'Shaughnessy-based growth model gives it high marks.
  • Sanofi-Aventis SA (NYSE:SNY): Based in Paris, this pharma giant ($91 billion market cap) is one of the two value picks that are in my O'Shaughnessy portfolio right now. A few reasons: its size ($43.5 billion in trailing 12-month sales vs. the market mean of $18.2 billion); its $4.07 in cash flow per share (vs. the market mean of $1.22); and its stellar 4.3% dividend yield.
  • AT&T Inc. (NYSE:T): This Dallas-based telecom giant ($167 billion market cap) is the other value play in the portfolio right now. Its $124 billion in trailing 12-month sales dwarf the market mean, plus it is generating $6.57 in cash flow per share. And, topping it off, AT&T is paying a 6.1% dividend yield.

Disclosure: I am long TJX, MWIV, ROST, SNY, T.