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Beating the S&P 500 index by investing in large cap stocks has been a formidable challenge for most mutual fund managers. Most mutual funds underperform the S&P 500 index after fees and expenses. Only some mutual funds beat the S&P 500 index. The outperformance is usually not more than a couple of percentage points. Fund manager James O'Shaughnessy combined a variation of value and momentum investing strategies in his book What Works on Wall Street. One of the screens he devised is picking the stocks that have P/E ratios below 20, and then buying the ones with the highest one-year price appreciation. O’Shaughnessy says the following about why this strategy works:

I believe that adding relative strength to a value portfolio dramatically increases performance because it picks stocks just after investors have recognized that they are bargains and are buying them once again. All the value factors that make them good buys are still in place, but the addition of relative strength helps pinpoint when investors believe the stocks have been oversold.

Backtesting this strategy for 52 years returned an average annual compound return of 14.9% vs. 11.7% for the large cap universe. Basically, this strategy beats the S&P 500 index by 3 percentage points per year. The downside risk of this strategy is also nearly 15% less. Of course, these results are based on average returns. The annual performance of the strategy may significantly deviate from these values.

In case you want to test this theory out, we obtained the list of stocks with P/E ratios below 20 from Google Finance and ranked these stocks based on their 1-year returns. Here are the top 40 stocks that satisfy O’Shaughnessy’s screens:

Company name

Symbol

Market Cap

P/E ratio

52w Return (%)

National-Oilwell Varco, Inc.

(NYSE:NOV)

33.27B

19.9

68.7

Magna International Inc. (USA)

(NYSE:MGA)

12.02B

11.8

67.3

Cummins Inc.

(NYSE:CMI)

20.04B

19.2

63.0

Altera Corporation

(NASDAQ:ALTR)

13.11B

16.4

57.0

Polo Ralph Lauren Corporation

(NYSE:RL)

11.44B

19.3

48.9

Deere & Company

(NYSE:DE)

38.07B

18.2

47.5

Weyerhaeuser Company

(NYSE:WY)

13.24B

6.2

46.3

EI du Pont de Nemours & Company

(NYSE:DD)

49.51B

16.3

43.4

CSX Corporation

(NYSE:CSX)

29.14B

19.3

43.1

Time Warner Cable Inc.

(NYSE:TWC)

23.76B

19.0

39.5

Discover Financial Services

(NYSE:DFS)

12.35B

18.6

38.4

Companhia de Bebidas das Americas

(ABV)

83.63B

18.4

36.8

Eaton Corporation

(NYSE:ETN)

17.96B

19.4

34.9

Chevron Corporation

(NYSE:CVX)

211.91B

11.1

34.5

Dover Corporation

(NYSE:DOV)

11.99B

17.2

34.1

Comcast Corporation

(NASDAQ:CMCSA)

67.05B

18.8

34.0

Coach, Inc.

(NYSE:COH)

15.20B

18.6

34.0

Ameriprise Financial, Inc.

(NYSE:AMP)

14.77B

14.4

33.3

Parker-Hannifin Corporation

(NYSE:PH)

14.56B

17.3

33.3

Texas Instruments Incorporated

(NASDAQ:TXN)

39.45B

12.8

32.9

PPG Industries, Inc.

(NYSE:PPG)

14.22B

19.0

32.3

Compania de Minas Buenaventura

(NYSE:BVN)

11.86B

16.8

29.1

AmerisourceBergen Corp.

(NYSE:ABC)

10.52B

16.9

29.1

Hess Corp.

(NYSE:HES)

27.54B

12.6

27.0

Danaher Corporation

(NYSE:DHR)

33.70B

19.4

26.8

UnitedHealth Group Inc.

(NYSE:UNH)

47.09B

10.5

26.7

Cliffs Natural Resources Inc

(NYSE:CLF)

12.31B

12.1

26.4

Teck Resources Limited

(NYSE:TCK)

31.37B

15.9

25.8

The Western Union Company

(NYSE:WU)

13.85B

15.7

25.7

Union Pacific Corporation

(NYSE:UNP)

46.75B

17.2

24.5

Siemens AG (ADR)

(SI)

118.54B

19.0

24.1

Canadian National Railway (USA)

(NYSE:CNI)

33.75B

16.1

22.9

Johnson Controls, Inc.

(NYSE:JCI)

27.34B

18.2

22.7

Freeport-McMoRan Copper & Gold

(NYSE:FCX)

49.08B

11.4

22.4

Reynolds American, Inc.

(NYSE:RAI)

19.99B

15.1

22.0

Analog Devices, Inc.

(NASDAQ:ADI)

11.42B

14.5

21.8

Tyco Electronics Ltd.

(NYSE:TEL)

15.15B

13.4

21.0

Philip Morris International Inc.

(NYSE:PM)

113.72B

16.1

20.8

Barrick Gold Corporation (USA)

(NYSE:ABX)

50.64B

16.0

20.7

Archer Daniels Midland Company

(NYSE:ADM)

22.92B

11.9

20.5

Some of these stocks are very popular among hedge funds. T. Boone Pickens is extremely bullish about the top stock in this list, National Oilwell (NOV). Jim Simons’ Renaissance has ALTR in its portfolio. Steven Mandel’s Lone Pine has Ralph Lauren (RL) in its portfolio. David Tepper’s Appaloosa and Roberto Mignone’s Bridger are bullish about United Health (UNH). John Burbank’s Passport Capital and Phil Falcone’s Harbinger like Cliff Natural Resources (CLF).

Source: 40 Large Cap Stocks Expected to Beat the S&P 500 by 3 Percentage Points