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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 P/E ratios below 20, and then buys the ones with the highest one-year price appreciation. O’Shaughnessy writes 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. 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 30 stocks that satisfy O’Shaughnessy’s screens:

Stock

Ticker

P/E Ratio

52-Week Return

Atlas Pipeline Partners, LP

(NYSE:APL)

9.72

239.27

RPC, Inc.

(NYSE:RES)

17.84

222.06

Westlake Chemical Corp

(NYSE:WLK)

12.67

155.5

W&T Offshore, Inc.

(NYSE:WTI)

19.23

153.4

Holly Corporation

(HOC)

15.02

140.74

CF Industries Holdings, Inc.

(NYSE:CF)

16.63

120.88

Six Flags Entertainment Corp

(NYSE:SIX)

3.51

112.64

Frontier Oil Corporation

(NYSE:FTO)

14.16

111.54

Altera Corporation

(NASDAQ:ALTR)

17.53

97.52

Dillard's, Inc.

(NYSE:DDS)

16.38

97.26

Chicago Bridge & Iron Co

(NYSE:CBI)

17.39

88.49

CBS Corporation

(NYSE:CBS)

19.77

88.42

Moody's Corporation

(NYSE:MCO)

16.81

85.78

National-Oilwell Varco, Inc.

(NYSE:NOV)

18.21

81.83

The Timken Company

(NYSE:TKR)

14.04

75.39

Celanese Corporation

(NYSE:CE)

14.26

73.73

Humana Inc.

(NYSE:HUM)

11.74

73.7

Discover Financial Services

(NYSE:DFS)

10.33

73.5

National Semiconductor

(NSM)

19.34

72.01

Aaron's, Inc.

(NYSE:AAN)

18.2

71.95

KBR, Inc.

(NYSE:KBR)

14.75

71.1

Helmerich & Payne, Inc.

(NYSE:HP)

19.29

70.4

Terra Nitrogen Company, LP

(NYSE:TNH)

12.48

69.89

Joy Global Inc.

(JOYG)

18.59

69.65

Eastman Chemical Company

(NYSE:EMN)

15.13

69.3

Marathon Oil Corporation

(NYSE:MRO)

12.08

68.68

Caterpillar Inc.

(NYSE:CAT)

18.02

68.55

Corn Products International

(CPO)

15.58

68.4

NewMarket Corporation

(NYSE:NEU)

12.96

66.4

Amtrust Financial Services

(NASDAQ:AFSI)

9.15

66.07

Atlas Pipeline Partners tops our list. The stock returned nearly 240% during the past 52-weeks. It also has a 4.5% dividend yield. Leon Cooperman’s Omega Advisors has a very large investment in this stock, owning more than 10% of outstanding shares. Glenn Fuhrman’s MSD Capital and Remy Trafelet’s Trafelet Capital also have large investments in the stock.

CF Industries is another stock with triple digit returns. The stock has a P/E ratio of 16.6 and has been a hedge fund favorite for a very long time. Phill Gross’ Adage Capital, David Tepper’s Appaloosa, and John Burbank’s Passport Capital are still bullish about CF despite its huge increase.

Six Flags also returned more than 100% during the past year and there is still significant interest in this stock by hedge funds and insiders. Large shareholders, directors, and officers of the company have been buying continuously since last year. Rehan Jaffer’s H Partners Management had $480 Million in this $2 billion stock. Matthew Halbower’s Pentwater Capital and Rishi Bajaj’s Altai Capital also had more than $100 million invested in SIX at the end of March. There are nearly a dozen other hedge funds with moderate investments in SIX.

We believe investors can achieve above market returns on the average by constructing a 30-stock portfolio. Buying all of these 30 stocks should provide some diversification as well.

Source: O'Shaughnessy Strategy: 30 Stocks Expected to Beat the S&P 500 by Five Percentage Points