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Beating the S&P 500 index by investing in medium and 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 before fees and expenses, and the outperformance is usually not more than a couple of percentage points. 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 first picks the stocks that have PE ratios below 20, and then buys the ones with the highest one-year price appreciation. Here is what O’Shaughnessy says 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.

In a 52 year back testing, this strategy returned an average annual compound return of 17.9% vs. 13.0% for all stocks. Basically, this strategy beats the S&P 500 index by 4.9 percentage points per year. The downside risk of this strategy is also nearly 10% less than the downside risk of all large cap stocks. Of course, these results are based on average returns and annual performance of the strategy may significantly deviate from these values. Insider Monkey, a source for free insider trading data, obtained the list of stocks with PE ratios below 20 from Google Finance and ranked these stocks based on their 1-year returns. Here are the top 30 stocks that satisfy O’Shaughnessy’s screens:

Company

Symbol

Market Cap

Return (%)

P/E ratio

W&T Offshore, Inc.

WTI

1.62B

156

13.7

Buckeye Technologies

BKI

1.04B

96

9.8

Cimarex Energy Co.

XEC

9.77B

95

17.9

Herbalife Ltd.

HLF

4.78B

82

17.3

Altera Corporation

ALTR

14.13B

77

17.5

The Timken Company

TKR

5.03B

74

18.7

MKS Instruments, Inc.

MKSI

1.70B

69

12.6

Chicago Bridge & Iron Co

CBI

4.00B

69

19.6

El Paso Corporation

EP

12.40B

67

17.7

Marathon Oil

MRO

37.12B

66

14.5

KBR, Inc.

KBR

5.55B

64

17.7

Dillard's, Inc.

DDS

2.32B

63

14.0

InterDigital, Inc.

IDCC

1.97B

60

12.7

SeaDrill Limited

SDRL

13.82B

59

14.2

Discover Financial Serv.

DFS

13.35B

58

10.7

Magna International

MGA

11.63B

57

11.4

CSX Corporation

CSX

29.49B

56

19.7

ConocoPhillips

COP

112.67B

56

10.4

Avago Technologies Ltd

AVGO

7.60B

56

15.5

KLA-Tencor Corporation

KLAC

7.95B

56

15.9

Advance Auto Parts, Inc.

AAP

5.25B

54

16.7

Deere & Company

DE

39.56B

54

18.9

Eastman Chemical Co

EMN

7.02B

53

17.2

Weyerhaeuser Company

WY

13.23B

50

6.2

Valero Energy Corp

VLO

17.34B

50

18.7

World Fuel Services

INT

2.82B

50

17.5

Cognex Corporation

CGNX

1.14B

48

18.1

Chesapeake Energy

CHK

21.95B

48

14.2

Cabot Corporation

CBT

3.04B

47

15.3

Rock-Tenn Company

RKT

2.68B

46

12.3

O’Shaughnessy’s strategy is mostly pointing to energy companies. Fundamentally, this doesn’t seem to be a bad strategy either. Several prominent investors expressed their concerns about Fed’s monetary policy and possible devaluation of U.S. dollar. Jim Rogers, Ray Dalio, and Julian Robertson recommended commodities as a possible hedge. There are also some non-energy stocks in the list. Deere & Co (NYSE:DE) is also benefitting from emerging markets related commodities demand and declines in the value of the US dollar. We believe investors can achieve above market returns on the average by constructing a 30-stock portfolio. However, this strategy doesn’t provide enough diversification, so they should utilize this strategy as part of a multi-strategy investment plan.

Disclosure: I am long CHK.

Source: 30 Stocks Expected to Beat the S&P 500 by 5 Percentage Points