Out of Fashion, in the Money

Imagine there were an outlet mall for stocks, a strip 100 miles outside town where past seasons’ hottest securities were hanging on racks marked 35% to 75% off.

Would you still chase after the current season’s overpriced sizzlers, or would you tank up the car and drive a couple of hours out to scrounge for a good deal?

James P. O’Shaughnessy, a financial statistician and soccer dad in suburban Connecticut, has crunched 40 years’ worth of data from a Standard & Poor’s stock market database to develop a compelling case for the bargain rack.

In his new book, “What Works on Wall Street,” he lays out a grim indictment of investors who chase after expensive stocks with glamorous stories, proposing that historical data clearly show that the market rewards patience over impetuousness.

If $10,000 were invested in the 50 highest-priced “story” stocks in 1954 and held for 40 years, he says, it would have grown at a compound rate of 8.4% to $254,601. If the $10,000 had instead been invested in the 50 companies whose stocks were priced lowest in relation to their sales, he says, it would have grown at a compound rate of 15.4% to $3.1 million.

But here’s the kicker: O’Shaughnessy spent three years running dozens of different statistical models against the vast S&P; Compustat stock database--the first researcher ever to have full access to numbers previously used for much more limited purposes. He tried to isolate the factors that characterized the types of stocks the market has most rewarded over the last 40 years and those which it has punished.

The answer, he says, skewered the notion that prices rise and fall in what academics call a “random walk.” Through periods both bullish and bearish, he says, the market has repeatedly heaped the highest annual returns on stocks of the nation’s largest companies with the lowest price-to-sales ratios.

Building on that theory, he says he discovered that he could amplify their 15.4% compounded return by choosing only the 50 that had earnings gains for five consecutive years and displayed the best price performance over the previous year. Using this criteria, he says, the $10,000 invested in 1954 would have grown at a compound rate of 18.2% by 1994 to $8.1 million, with a rate of risk only 9% higher than the S&P; 500.

O’Shaughnessy last week launched a mutual fund to allow investors to buy into his strategy, called Cornerstone Growth ([800] 797-0773). But it’s not hard to create your own portfolio that takes advantage of his research.

Some warnings: O’Shaughnessy insists you must be disciplined and stick to the strategy. No adding an initial public offering here and there. No picking up stray tips at cocktail parties. No getting sidetracked into investing in themes like bandwidth or niche retailing. No trying to outsmart or time the market.

“The best strategies have to fit on the back of a business card,” he says. “If you ask yourself why you bought your last five stocks and hear yourself repeating five separate stories, you’re on the wrong track.”

Eighty percent of the mutual funds in America fail to beat the annual return of the S&P; 500, he says, because their managers fail to stick with one strategy through thick and thin. “This lack of discipline devastates long-term performance,” he warns.

O’Shaughnessy, who ran a quantitative-analysis operation for pension managers before going into the money management business himself, calls his method “strategy indexing.” It has three prongs.

First, eliminate all stocks with market capitalizations of less than $150 million. (He believes that research showing small-cap stocks outperform the market is faulty because the superior returns are owed to successful investments in tiny companies that are too risky for individuals to buy.)

Next, every stock you buy must have a price-to-sales ratio below 1.5. That’s because the average growth stock has a P/S greater than 3, and O’Shaughnessy wanted a number that was less than half that. He thinks sales are a better yardstick than earnings because it is virtually impossible for a company’s accountants to manipulate sales, whereas they can perform sleights of hand with earnings all day long. In addition, he notes that when a company is trading at a low P/S, a slight improvement in margins sends earnings through the roof--a fact that grabs Wall Street’s attention and attracts buyers in droves.

Third, every stock you buy must have consecutive earnings gains for the preceding five years. And out of that universe, you should buy the 40 to 60 whose stock prices have appreciated the most over the previous 12 months--another way of saying that they have the highest relative strength. The high-relative-strength ranking shows that the company is on the upswing from a trough; you are not bottom-fishing all by yourself. And buying fewer stocks may increase the returns in any given year, but it also greatly increases the risk, O’Shaughnessy says. He believes 50 is the optimum number.

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Finally, you must hold the portfolio for a year, then start over again--selling the stocks not on the new list and rebalancing the rest to start again with an even dollar amount of each security.

Where do you find these magic stocks? You knew there had to be a catch, and there is: The current top 50 are listed in a box accompanying this story. Any other time, you’ll have to call S&P; Compustat at (800) 321-6141 and purchase the list for $200. McGraw-Hill has also published “What Works on Wall Street” software, which sells for $49.95. It lets you run a variety of strategies against the Compustat database. For more information, see its World Wide Web site at https://www.compustat.com

Because of the cost of transactions, it doesn’t make sense to try this strategy on your own with a portfolio of less than $50,000. Using an Internet-based deep discounter such as Pacific Brokerage Services (https://www.tradepbs.com), which charges $11 per trade, the cost of the first round of stock purchases would be $550. Add the $200 for the Compustat screen and you’re into it for $750, or 1.5% of the portfolio--about the same expense as O’Shaughnessy’s mutual fund. With a $100,000 portfolio, the expense drops to 0.75%.

The strategy has performed well in 1996 with a month and a half to go. O’Shaughnessy says that if you started a Cornerstone growth portfolio on Jan. 1, it would be up 30.1% through Nov. 7 in stocks with an average market capitalization of $1 billion. The S&P; 500, in contrast, was up 20.1%.

“If you let this strategy do its work, you’ll kick most people’s butt,” he says.

Leaving the strategy alone is indeed the problem. O’Shaughnessy says brokers and investors have a hard time not cherry-picking the list of 50 stocks because of intuitions that particular sectors or stocks will perform poorly over the coming year--an impulse that blows the benefit of the approach. As an example, many stocks in the Jan. 1 list, including CompUSA and Seagate Technologies, were listed as outright sells by brokerage analysts at the time. They have since gained 194% and 43%, respectively.

In the current list, retailers such as Pep Boys, Walgreen and Revco are heavily represented. If history is any guide, that’s the stock market’s way of saying it’s time to go shopping.

Street Strategies explores tactics that the nation’s savviest private and institutional investors use to maximize gains and minimize risk. Jon D. Markman is a Times staff writer. He can be reached at jon.markman@latimes.com