O'Shaughnessy's Tried & True One-Two Punch

Investors are continually deluged with advice on the "best" way to make money in the stock market. Buy stocks with low price/earnings ratios and low debt, some say. Focus on dividend-paying stocks, others advise. Stick with past winners, still others will tell you, because they're likely to keep winning.

Who's right? Well, each person pushing a particular approach says their method is best -- and all too often, they do so without providing long-term data backing up their claims. Instead, they point to recent short-term successes as "proof". But using such short-term data can end up leading to long-term failure.

Thanks to James O'Shaughnessy, however, we have a pretty good idea of what does work over the long run. In his 1996 book What Works on Wall Street, O'Shaughnessy detailed what may be the most in-depth quantitative stock market study in history, in which he used computer programs to back-test how well an array of popular stock-picking approaches worked from 1951 through 1994. Large caps, small caps, high or low price/earnings ratios, strong or weak cash flows -- O'Shaughnessy studied how these and a myriad of other factors affected stock performance over more than four decades. His conclusion formed the basis for one of my "Guru Strategy" computer models, each of which is based on the approach of a different Wall Street great.

Since July 2003, I've monitored a portfolio of stocks picked using this model. It's grown by an average of 6.7% per year amid a rough stretch for the broader market -- the S&P 500 has gained just 0.4% annualized in that time. Here's how you can make O'Shaughnessy's market-beating approach work for you.

Less is More
Given the depth of his study, one might expect O'Shaughnessy to have developed some incredibly complex, never-before-imagined theories on how to pick winning stocks. In reality, however, the strategy O'Shaughnessy found to have the best overall results was fairly straightforward. It was actually a combination of two simple approaches, calling for a portfolio composed half of large value stocks and half of growth stocks. This two-pronged approach did nearly five times as well as the broader market over O'Shaughnessy's study, producing an annual compound return of nearly 17% over four decades.

First, let's look at his "Cornerstone Growth" approach, which, with an 18.22% annual compound return, produced the highest absolute returns in his study. It focused on stocks with market caps of at least $150 million, screening out illiquid stocks.

O'Shaughnessy found that the rate a growth stock's earnings grew wasn't as important as the persistence of growth over time. He thus wanted a company to show a growth in earnings -- regardless of magnitude -- for five years in a row.

O'Shaughnessy's growth strategy also contains one of his study's most significant findings. While the P/E ratio has long been the most widely used valuation statistic in stock analysis, O'Shaughnessy found that the relationship between a stock's price and its sales -- not its earnings -- was the most likely predictor of future success and the best way to find growth stocks selling on the cheap. He thus targeted growth stocks with price/sales ratios below 1.5.

The final criterion: relative strength. The growth model I base on O'Shaughnessy's book takes all of the firms that pass this strategy's first three tests (market cap, earnings persistence, and P/S ratio) and gives approval to the 50 with the highest relative strengths. The model thus helps you buy stocks the market is embracing (as shown by the high RS), but which haven't become overpriced (that's where the low P/S ratio comes in).

Value Plays
When it came to value stocks, O'Shaughnessy targeted "market leaders" -- large, well-known firms with sales well above those of the average company -- because he found that these firms' stocks tend to be considerably less volatile than the broader market. My O'Shaughnessy value model does this by targeting firms with market caps greater than $1 billion; a number of shares outstanding greater than the market average; and trailing 12-month sales at least 1.5 times the market mean.

O'Shaughnessy also found that a great predictor of a stock's future was cash flow. The value model I base on his writings calls for companies to have cash flows per share greater than the market average.

The final factor in this value approach: dividend yield. The O'Shaughnessy-based model takes all of the stocks that meet the first four criteria of this strategy and selects the 50 with the highest dividend yield.

It's All About Discipline
One final, critical note: For all of the groundbreaking statistical data he compiled, O'Shaughnessy says that one of the most important factors in investing doesn't have to do with any specific stock variable. In order to beat the market, he says, it is crucial that you stay disciplined, "consistently, patently, and slavishly stick[ing] with a strategy, even when it's performing poorly relative to other methods."

What's his method high on right now? Here are a few stocks that meet my O'Shaughnessy-based model's standards:

Johnson & Johnson (JNJ): Healthcare giant has the size and market leadership my O'Shaughnessy-based value model likes ($168 billion market cap and more than $61 billion in annual sales). It also has a strong cash flow ($5.65 per share) and dividend yield (3.21%).

W.W. Granger, Inc. (GWW): Illinois-based company ($6.6 billion market cap), which provides an array of facilities maintenance equipment, has increased EPS in each year of the past five-year period. It also has a strong 1.02 P/S ratio and a solid relative strength of 77. All of that makes it a favorite of my O'Shaughnessy-based growth model.

China Mobile Ltd. (CHL): Chinese cellular service giant ($205 billion market cap, more than $60 billion in annual sales) has an excellent cash flow of $6.74 per share and strong yield of 3.54%, earning it high marks from my O'Shaughnessy-based value model.

At the time of publication, John Reese and his private clients at Validea Capital Management were long STRA and TWGP.

John P. Reese is founder and CEO of Validea.com, an investment research firm, and Validea Capital Management, an asset management firm serving affluent investors and companies. He is also co-author of two investing books, including The Guru Investor: How to Beat the Market Using History's Best Investment Strategies