Markets
The Man Who Broke the Code
Is there a formula that will produce a high stock-market return but at a low risk? Yes.
By James K. Glassman, Contributing Editor
From Kiplinger's Personal Finance magazine, September 2005
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An even better way
This combination of value plus growth is what makes the cornerstone-growth formula work so well, O'Shaughnessy believes. In the updated version of the book, he suggests a few tweaks to the original recipe.
Here is the improved formula: Start with all stocks that have a stock-market value (that is, shares multiplied by share price) greater than $200 million. Eliminate the ones with a P/S ratio of 1.5 or greater. From among the remainder, select the stocks that have increased their earnings over the previous year and increased in price during the past three months and the past six months at a rate that is above the average for all stocks in the Compustat database. (These last two elements, which stress what's called short-term relative strength, are the additions to the original CG formula.)
Now, of the survivors, select the 50 stocks with the highest price appreciation in the past year. Sell the entire portfolio and repeat with new stocks at the beginning of every year. Over the 40 years ended December 31, 2003, this strategy produced an annualized return of 21%, compared with 18% for the original CG strategy and 12% for the stock market as a whole.
Stated in somewhat more dramatic fashion, between 1963 and 2003, an investment of $10,000 would have grown to $936,000 in the market as a whole, $7 million using the original CG strategy and $19 million with the new-and-improved strategy.
Stocks that fit the formula
Hennessy has been using the revised version of the CG strategy ever since he bought Cornerstone Growth in 2000. He sticks to the formula religiously but rebalances -- that is, sells old stocks and buys new ones -- within a window of a few months, rather than on a specific date (no sense letting traders know what you're doing in advance).
The assets of Cornerstone Growth fund include Aetna (AET), a health-insurance provider with a P/S of 1.2 and a P/E of 11; Tesoro (TSO), an oil refiner with a P/S of just 0.3; NVR (NVR), a homebuilder with a P/S of 1.2; Yellow Roadway (YELL), a trucking company with a P/S of 0.4; Toro (TTC), a maker of turf-maintenance equipment with a P/S of 0.9 and earnings growth averaging 27% over the past five years; and Cleveland-Cliffs (CLF), a manufacturer of iron pellets with a P/S of 1.0, a P/E of 5 and a price that's doubled in the 12 months ended July 1. It's a well-balanced portfolio, although that's just a coincidence -- it wasn't designed with that in mind.
In September 2003, Hennessy launched another fund that uses the original cornerstone-growth formula but applies it to only 30 stocks with market caps between $1 billion and $10 billion. This fund, called Hennessy Focus 30 (HFTFX), returned 11% in just three months of existence in 2003, 14% in 2004 and another 14% for the first half of 2005 (compared with a loss of 1% for the S&P in the first half of this year).
Hennessy warned me, however, that Focus 30 is a super-volatile fund. "We call it Nitro 30," he says. "You don't want to buy this if you've had a double-bypass." There's some overlap with Cornerstone Growth, but Focus 30 includes impressive winners, such as Joy Global (JOYG), which makes mining machinery and is up more than 70% for the year ended July 1, and Black & Decker (BDK), up 50%.
I don't expect you to apply the CG strategy at home. Not many of us can afford to own 50 (or even 30) stocks at once. Anyway, access to the Compustat database is out of the price range of all but a few individual investors, and if you had it, you'd still have to crunch the numbers. But if you simplify the formula a bit, you can use the stock screener at Yahoo.com.
Do we know what works?
The great discovery here is that it may indeed be possible to crack the code of consistent stock-market success. The secret is to combine a growth element (in this case, rising earnings and price) and a value element (a low P/S ratio). In the end, I guess that's not much of a secret. The best investments are businesses that are doing well but are also underpriced.
Such bargains, O'Shaughnessy says, are rarely found among big, well-known companies. "When you use strategies like those featured in this book," he writes in the new edition, "they inevitably lead you to stocks in the small- and mid-cap category. I believe this is because the stocks in this category are the least efficiently priced. The sheer number of names in the small- and mid-cap category makes them far more difficult for analysts to adequately cover." So anomalies and mispricings (both high and low) occur.
The beauty of O'Shaughnessy's approach is that no analysis of these small- and mid-cap companies is necessary. All you need to do is use a "systematic, disciplined approach" to find the names. Or let a fund do it for you.
The irony, of course, is that now that the cat is out of the bag, other investors will bid up prices and eliminate the bargains by buying CG stocks, too. But until then ...
Jameks K. Glassman is a fellow at the American Enterprise Institute, host of the Web site TechCentralStation.com, and chairman of Investors Action Alliance, an advocacy group.