5 Tried-and-True Quant Picks

03/14/2012 10:15 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

There are only a handful of Old School quantitative analysis gurus out there, and below we feature one strategy that has continued to prove its skills, decade after decade, writes John Reese of Validea Hot List.

To say that James O'Shaughnessy has written the book on quantitative investing strategies might be an exaggeration—but not much of one. Over the years, O'Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone.

He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor's Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.

O'Shaughnessy has revamped his strategies over the years, most recently in his new, updated version of What Works on Wall Street. I've chosen not to tinker with my O'Shaughnessy-based models, however, given the exceptional performance they've had over the long term. The models discussed here are thus based on O'Shaughnessy's 1996 version.

So, let's start with the value stock strategy. O'Shaughnessy's Cornerstone Value approach targeted "market leaders"—large, well-known firms with sales well above those of the average company—because he found that these firms' stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch—should hold some value stocks.

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.

Size and market position weren't enough to make a value stock attractive for O'Shaughnessy, however. Another key factor that was a great predictor of a stock's future, he found, was cash flow. My O'Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average.

O'Shaughnessy found that, when it came to market leaders, another criterion was even more important than cash flow: dividend yield. He found that high dividend yields were an excellent predictor of success for large, well-known stocks (though not for smaller stocks). 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 the stocks that pass the four aforementioned criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval.

The Cornerstone Growth approach, meanwhile, isn't strictly a growth approach. That's because one of the interesting things O'Shaughnessy found in his back-testing was that all of the successful strategies he studied—even growth approaches—included at least one value-based criterion.

The value component of his Cornerstone Growth strategy was the price-to-sales ratio, a variable that O'Shaughnessy found—much to the surprise of Wall Street—was the single best indication of a stock's value, and predictor of its future.

The Cornerstone Growth model allows for smaller stocks, using a market cap minimum of $150 million, and requires stocks to have price-to-sales ratios below 1.5. 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. A key part of why the growth stock model works so well, according to O'Shaughnessy, is the combination of high relative strengths and low P/S ratios.

By targeting stocks with high relative strengths, you're looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio, you're ensuring that you're not getting in too late on these popular stocks, after they've become too expensive.

"This strategy will never buy a Netscape or Genentech or Polaroid at 165 times earnings," O'Shaughnessy wrote, referring to some of history's well-known momentum-driven, overpriced stocks. "It forces you to buy stocks just when the market realizes the companies have been overlooked."

The O'Shaughnessy-based portfolio will pick stocks using both the growth and value methods I described above. It picks whatever the best-rated stocks are at the time, regardless of growth/value distinction, meaning the portion of the portfolio made up of growth and value stocks can vary over time.

For a long time, the portfolio has been leaning strongly to the growth side. But it's begun to shift back toward a neutral stance in 2012, with six of its holdings chosen using the growth method and four picked with the value model.

Here are five picks now:

Growth: Ross Stores (ROST)
Growth: The TJX Companies (TJX)
Growth: CoinStar (CSTR)
Value: AstraZeneca (AZN)
Value: BP (BP)

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