Cornerstones of Value

05/29/2014 9:00 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

My stock screen, based on James O'Shaughnessy's Cornerstone Value strategy, targets "market leaders"—large, well-known firms with sales well above those of the average company, explains John Reese, editor of Validea.

To find these firms, O'Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean.

He also found that large market-leaders with high dividends tended to outperform during bull markets, and didn't fall as far as other stocks during bear markets.

The Cornerstone Value model takes all of stocks that pass these criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield.

The value component is the price/sales ratio, a variable that O'Shaughnessy found was the single best indication of a stock's value and predictor of its future.

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.

And by also making sure that a firm has a low price-to-sales ratio, you're ensuring that you're not getting in too late on these popular stocks, after they've become too expensive.

To apply the relative strength criterion, the Cornerstone Growth model takes all the stocks that pass the three growth criteria I mentioned (market cap, earnings persistence, P/S ratio) and ranks them by relative strength.

Here are two stocks that pass the screen for my O’Shaughnessy-based portfolio:

Drew Industries (DW), is a supplier of components for recreational vehicle and manufactured housing. Its annual EPS before extraordinary items for the last five years passes this test.

The Price/Sales ratio should be below 1.5. This value criterion, coupled with the growth criterion, identify growth stocks that are still cheap to buy.

DW's price/sales ratio of 1.06, based on trailing 12 month sales, passes this criterion. And its relative strength is 74, which is in the top 50, and would pass this last criterion.

Robert Half International (RHI) has seen annual EPS before extraordinary items for the last five years pass this test.

RHI's price/sales ratio of 1.44, based on trailing 12 month sales, passes this criterion. Finally, Robert Half’s relative strength is 71, is in the top 50, and would pass this last criterion.

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