Lower-risk, market-beating value stocks

Jim O’Shaughnessy thinks not (as does, it should be noted, most of the active fund industry, albeit for different reasons). Since the 1990s, the famed investor has argued that we can do better than monkeys throwing darts at a list of stocks. Based on his analysis of decades of data, O’Shaughnessy points to good evidence that the US market consistently rewards certain attributes, such as stocks with low price-to-sales ratios, while punishing others, such as stocks with high price-to-sales ratios.

By applying these observations to stock selection in a consistent and disciplined fashion, O’Shaughnessy explains, investors can beat the market over time.

“Far from following a random walk, the evidence continues to reveal a purposeful stride,” he states in his seminal work, What Works on Wall Street, first published in 1997. “Investors can do much better than the market if they consistently use time-tested strategies that are based on sensible, rational methods for selecting stocks.”

Last week’s stock screen, based on Joel Greenblatt’s Magic Formula, hunted for stocks with a blend of both value and growth factors. In What Works on Wall Street, O’Shaughnessy separates these styles into two stockpicking methodologies, the first of which – his Cornerstone Value screen – we have run this week. Its complementary screen, Cornerstone Growth, returns in seven days.

For the three years immediately prior to the pandemic, the performance of our UK-focused Cornerstone Value screen was mediocre. More recently, it has returned to form and revealed the virtue of stubbornly sticking to the methodology – as marked by a widening gap between the screen and its benchmark. After 11 years, the total return stands at 167 per cent, compared with 97 per cent from the FTSE 350. While this falls to 139 per cent once a 1 per cent annual dealing charge is factored in, the value picks have now comfortably beaten the market for two years in a row.

Last year, stocks selected by the screen posted a total return of 19 per cent, on average, compared with 16.3 per cent from the benchmark. The extent to which this reflects a growing appetite for value stocks is hard to say. But it does suggest O’Shaughnessy’s methodology is worth sticking with, even if we have had to take several shortcuts to make the screen work for the UK market.

O’Shaughnessy takes a quantitative approach to fundamental analysis, meaning his thoughts on stockpicking are based on “empirical relationships between the data and the desired outcome”, rather than subjective judgements about markets.

In What Works on Wall Street, he shows that stocks that screen well on single value factors – such as the lowest price/earnings, price/sales, price/book or price/cash flow ratios – consistently beat the average stock market return. What's more, they also beat strategies that focus on the most impressive individual measures of growth (such as stocks with the leading return on equity or earnings growth).

However, this also reproduces an inherent problem in value investing: stomach-churning levels of volatility. On average and over time, O’Shaughnessy observed, cheap stocks lead to a higher return on investment, but they also involve sporadic episodes of large underperformance compared with the broader market. “This makes it difficult, if not impossible, for investors to stick with the strategy in real time, and more important, with real money,” he concluded.

To address this, O’Shaughnessy applies several tests to identify what he calls “market-leading” names, defined as “non-utility stocks with greater than average market capitalisation, shares outstanding, cash flows, and sales of 50 per cent greater than the average stock”.

Only then does the screen look at stock valuation, by ranking the market leaders by dividend yield, as a proxy for cheap, cash-generating stocks.

While we have always sought to be faithful to these tests, the idiosyncrasies of London’s equity market mean our UK Cornerstone Value screen differs in several respects. For a start, because we are drawing from a much smaller pool of stocks than the S&P 500, our screen has historically restricted itself to the top 25 picks, rather than O’Shaughnessy’s recommended 50. Without this adjustment, the filter would leave us with too small a selection. This year, for example, just 37 stocks (or 6 per cent of the FTSE All-Share) ticked all of our tweaked 'market leader' tests.

That’s after defying another O’Shaughnessy edict and including utility stocks such as Centrica (CNA) and BT (BT.A) – which were last year’s two best-performing Cornerstone Value picks – and energy supplier SSE (SSE), which makes the top 25 for the second year in a row. To get to that point, our size test simply looks for companies with a £500mn minimum market capitalisation. Applying that lower bound to the All-Share’s current constituents filters out 13 per cent of all stocks, rather than the half that would be excluded using the original $1bn (£740mn) barrier, meaning there are more stocks to choose from. But it is not entirely in the spirit of O'Shaughnessy's large-cap focus.

In a later edition of What Works on Wall Street, O’Shaughnessy also sought to improve on the original strategy by including “shareholder yield”, which adds returns from buybacks to dividends. The limits of our dataset, and the fact that buybacks are a less common feature of shareholder returns on the London Stock Exchange than they are in the US, means the UK picks focus on dividends.

The criteria for the tweaked/Anglicised version of the screen are as follows:

• Market capitalisation of at least £500mn.
• Greater-than-average number of shares outstanding.
• Higher-than-average cash flow per share.
• Turnover of more than 1.5 times average.

This year’s 25 stocks can be found in the accompanying table along with some fundamentals. As usual, a more detailed excel table is available to download.