O'Shaughnessy founded asset management firm O'Shaughnessy Capital Management, acquired by Bear Stearns in 2001. At Bear, he worked as director of systematic equity, where he was in charge of all quantitative investing for six years, leaving to go independent again at the end of 2007. The Cornerstone Value stock screener implements a strategy he developed in the 1990s using Standard & Poor's Compustat database to back-test the performance of dozens of stock-picking strategies between 1954 and 1996. He tested a large number of simple value strategies (like high dividend yields, low price to earnings ratios, low price to book value ratios and low price to sales) plus a range of growth strategies. After studying the results, O'Shaughnessy came up with his own formula called the "United Cornerstone" strategy.
This approach is a combination of two models: a momentum/earnings growth-focused method called "Cornerstone Growth" and a value-focused method called "Cornerstone Value.". His conclusions were published in the book, What Works on Wall Street”, an in-depth quantitative stock market study and bestseller. O'Shaughnessy found that the value approach was better suited to the large cap universe than the all-stocks universe. The logic behind this is that a troubled large company is more likely to be able to recovery and continue to pay dividends than a smaller company in the same situation. The Cornerstone Value strategy showed that a large-caps stock portfolio with above average stock liquidity and cash flow per share which was ranked for high dividend yields performed best over the long term.
Does the Cornerstone Value Screen Work?
Accordiing to “What Works on Wall Street”, this value strategy outperformed the market producing an annual compound return of 15% from 1954 to 1996, compared to 8.3% for the S&P 500 Index (although his Cornerstone Growth Strategy achieved 18% but with greater volatility).
For more recent data, it is possible to track the subsequent performance of the mutual fund that O’Shaughnessy set up, subsequently sold to Hennessy to become the Hennessy Cornerstone Value Fund (HFCVX). According to CXO Advisory Group, HFCVX has materially underperformed both its benchmark Russell 1000 Value Index and the S&P 500 Index over the decade to 2009.
“The fund underperformed the S&P 500 Index by about 2% per year, compared to the backtested average annual outperformance of about 7%. Its slightly lower standard deviation of annual returns (18.4% versus 19.9% for the Russell 1000 Value Index) seems not to justify the undesirability of the lower return”.
However, the American Association of Individual Investors also present some more recent performance data for this screen, which shows a more compelling 4% ten year return versus 0.7% for the S&P 500 since inception (as at February 2011). To explain the disparity, there may be methodological differences as well as the timing differences involved. For its part, CXO Advisory Group lists the following amongst the possible reasons why the out-of-sample performances of the HFCVX fund fall well short of its backtested past performance:
- "The market changed. For example, the expansion of stock buybacks in lieu of dividends is largely absent from the backtest period and disrupts the dividend-based strategy of HFCVX.
- The market adapted, with more and more investors competing for the abnormal returns from the backtests justifying the cornerstone strategies.
- Deviations by the fund managers from the original backtest specifications materially diminished strategy performance".
How can I run this Screen?
Calculation / Definition
In his "Cornerstone Value" approach, he uses just five criteria to search for large companies with solid cash flows and attractive dividends.
- Market Capitalisation of above average market capitalisation, preferably greater than $1bn.
- Cash flow per share greater than the market average. Cash flow per share = income + depreciation & amortization (before extraordinary items) / diluted average numbers of common shares. O'Shaughnessy focuses on this rather than earnings per share on the basis that it is not accounting profits that enables dividends to be paid.
- Sales over the last twelve months greater than the 1.5 times market average.
- Stock Liquiidity: The number of shares outstanding should be greater than the market average. Liquidity was found to be an important factor for value stock picks.
- Dividend Yield: Finally, the stocks passing all these criteria are sorted by dividend yield and Mr O'Shaughnessy suggested making a portfolio out of the top 50 stocks.
This strategy is a variation of the Dogs of the Dow which selects the top 50 stocks by dividend yield. Interestingly, in the latest version of the book (2005), O’Shaughnessy adjusts the Cornerstone Value strategy to include share buybacks and concludes that this strategy not only outperforms the original Cornerstone Value strategy in both real and risk adjusted terms, but indeed, outperforms all strategies analyzed in risk adjusted terms.
"Between December 1952 and December 2003 the average annual compound return for the Cornerstone Value method was 15.78% with a Sharpe Ratio of .65 while the Cornerstone Value method adjusted for shareholder buyback yielded a return of 17.09% with a Sharpe Ratio of .73".
Watch Out for
Although his approach is purely quantitative, O'Shaughnessy also does emphasize the importance of having the right mindset when putting money to work.
"Generally speaking, when things are going against you, as they inevitably will, you have to stick to the underlying strategy… Only by doing so will you be around for when it comes rebounding back."
From the Source:
The 2005 version of "What works on Wall Street" is available on Amazon. It's also worth referring to the “What Works on Wall Street” website. His more recent book is “Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years” (2006).
- Wikipedia on James O'Shaughnessy
- Forbes Article: O'Shaughnessy's Keep-It-Simple Stock
- Forbes Article: A Portfolio to Beat Buffetts
- Silicon Valley AAII presentation: O’Shaughnessy Screens