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Is it possible to crack the code? Is there a formula that will produce a consistently high stock-market return but at relatively low risk? Yes. For years, I was skeptical. But in 1996, I became fascinated by What Works on Wall Street, a book written by an obscure money manager in Greenwich, Conn., named James P. O'Shaughnessy. Using the massive Compustat database maintained by Standard & Poor's, O'Shaughnessy had tried dozens of strategies to find out which produced the best results from 1952 (when Compustat began collecting statistics) to 1994.
What really works?
O'Shaughnessy made some remarkable discoveries, the most surprising being the power of the price-to-sales (P/S) ratio -- that is, the number of dollars it takes to buy a dollar's worth of a company's annual revenues. The P/S ratio measures the money that comes into the till, a crude figure that rarely gets respect from analysts. O'Shaughnessy's work downplays the importance of the vaunted price-earnings ratio, which measures a business's profits or earnings.
O'Shaughnessy found that if you had invested in the 50 stocks with the lowest P/S ratios during each of the 43 years he studied, your average return would have beaten the market as a whole by an average of 4.3 percentage points per year -- a large margin. Investing in the lowest P/E stocks beat the market by only a tenth of a percentage point per year. "P/S, I love you!" was my conclusion after reading the book.
I suspect that P/S works so well for three reasons. First, most investors ignore it. Second, it measures something that unscrupulous companies rarely manipulate. And third, a company with great sales and relatively low profits (thus, in most cases, a low price) is a company that may be on the brink of taking off. But forget the reasons. The research clearly shows that P/S is a revealing indicator.
A more detailed (but still fairly simple) strategy, which O'Shaughnessy called cornerstone growth (which I'll abbreviate as CG), did even better than the low-P/S formula, whipping the market by seven percentage points per year over the period of those 43 years.
O'Shaughnessy started a mutual fund based on the CG strategy, then sold it a few years later to Neil Hennessy, a money manager in Novato, Cal., who specializes in funds that follow formulas. Hennessy Cornerstone Growth (symbol HFCGX) celebrated its fifth anniversary under his leadership on July 1, and its performance has been brilliant -- an annualized return of 11.7%, versus a 2.4% loss for the benchmark Standard & Poor's 500-stock index. The fund has whipped the S&P decisively in each of the four most recent calendar years at risk levels only a little higher than the market.
A new edition
I'll get back to the mutual fund in a second, but, first, the news: O'Shaughnessy, who now works for Bear Stearns, has just come out with a revised version of his What Works on Wall Street, this time updating the Compustat data through 2003.
The book confirms O'Shaughnessy's original finding about P/S and reinforces his earlier conclusions. One is that last year's profits are worthless in determining whether a stock is a good investment. Another, says O'Shaughnessy, is that "you can do ten times as well as the S&P 500 by concentrating on large, well-known stocks with high dividend yield." Stay away from last year's biggest losers on the one hand and from high-P/E stocks on the other; the latter perform poorly over time and have loads of volatility. The best returns come from the smallest stocks -- micro caps, with market values under $25 million -- but these "are too small for virtually any investor to buy" and are extremely risky.
The new data also reinforce the notion that the best strategy is one that combines value and growth elements. In other words, many stocks that are cheap deserve to be. If you can find a cheap stock whose profits and share price are moving up, then you've got something.
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