Using O’Shaughnessy’s Growth II Screening Model
This week, we present the strategy used by James O’Shaughnessy, influential investor and president of the investment advisory firm O’Shaughnessy Asset Management LLC. Read on for how we identify stocks possessing the key characteristics O’Shaughnessy utilizes for this strategy and 25 current stock ideas passing the AAII O’Shaughnessy Growth II screen. As of June 28, 2024, the O’Shaughnessy Growth II screen has an average annual gain since inception in 1998 of 16.2%, versus 6.4% for the S&P 500 index over the same period.
The Universe
O’Shaughnessy establishes two base groups of stocks from which to pick investments and that serve as performance and risk benchmarks: all stocks, and those with a large market capitalization (shares outstanding times market price). The all-stocks universe is determined by selecting stocks with a market cap of $150 million or greater. Rather than use all exchange-listed stocks, O’Shaughnessy focuses only on stocks that a professional money manager could buy without too much difficulty due to liquidity. In his book “What Works on Wall Street” (Fourth Edition, McGraw-Hill, 2011), O’Shaughnessy chose to hold the market-cap cutoff static at $150 million, so we decided to follow suit when constructing screens based on O’Shaughnessy’s strategies.
Limiting the analysis to stocks with a market cap above $150 million cuts out 25% of the stocks currently traded on U.S. exchanges.
The large-cap universe is determined by selecting stocks with a market cap greater than the average for the overall universe. Typically, a lower percentage of companies pass this filter because very large firms push up the average market cap. Testing reveals that the large-cap group has similar return and risk performance to that of the S&P 500. The market-cap average was $1,597 million when AAII ran its first screen using this strategy on September 30, 1997. As of July 2, 2024, the average market cap of exchange-listed stocks had increased to $12.7 billion.
Growth Strategies
Growth strategies try to find companies that will continue to produce above-average earnings growth. O’Shaughnessy tested a number of basic growth strategies including high rates of one- and five-year earnings growth, high profit margins, high return on equity (ROE) and high relative price strength. Most of these simple growth strategies proved to be risky. Although growth stocks go through spurts when they produce high returns, especially during bull markets, they also go through bearish periods. And over the long term, the returns do not adequately compensate for the high risk. The exceptions, however, were relative price strength and persistent earnings growth.
Earnings growth: O’Shaughnessy found that purchasing firms with the largest increases in earnings growth, whether over one year or five years, is a losing proposition. Investors, he says, tend to pay too much for these stocks. On the other hand, stocks that show persistent earnings growth — annual increases over a five-year period — appear to do well when combined with other screens.
Relative price strength (one-year price changes): Stocks with the highest relative price strength (the highest price changes over the prior year) produce the highest returns the following year. O’Shaughnessy found this screen to be one of the most effective filters for stocks of all sizes, although he warns that it is a very volatile approach that can severely test investor discipline. Why does a momentum indicator work? O’Shaughnessy speculates that the market is simply “putting its money where its mouth is.” Conversely, O’Shaughnessy suggests that investors should avoid the biggest one-year losers since they will most likely continue to lose.
Growth strategies show more consistent performance with smaller stocks, although O’Shaughnessy prefers not to exclude large firms from consideration. Although the magnitude of growth appears to be of little use in identifying high-returning stocks, screening for persistent earnings growth and high relative price strength provides better options.
Implementing the Growth II Strategy
With the exception of relative price strength, the growth strategies tested by O’Shaughnessy were not very promising. O’Shaughnessy’s single-factor test screened for companies with extreme values — factors such as highest earnings growth, highest margins and highest return on equity. By reducing these extreme growth requirements and establishing moderate value requirements, O’Shaughnessy was able to construct a portfolio that had the desired combination of strong price growth and reasonable risk.
However, the criteria making up his growth screen changed between the first and revised editions of “What Works on Wall Street” without any explanation of the shift. The original growth screen emphasized earnings consistency and relative price strength, while the revised screen (Growth II) emphasizes relative price strength.
O’Shaughnessy’s growth stock screen is based on the all-stocks universe because smaller stocks have greater growth potential than their large-cap counterparts. Originally, his growth strategy focused on earnings consistency, rather than high earnings growth levels. A screen for five years of consecutive earnings growth was specified and proved to be very restrictive. The revised edition requires that current annual earnings only be higher than the previous year. The revised growth screen looks for a positive change in earnings per share for the latest four quarters compared to the previous four quarters. About half of the stocks pass this criterion, compared to less than 10% of all stocks for the earnings consistency screen.
O’Shaughnessy balances the growth requirement by establishing a maximum price-to-sales (P/S) ratio ceiling of 1.50. The price-to-sales ratio is the current price divided by the sales per share for the most recent 12 months. It is a measure of stock valuation relative to sales. A high ratio might imply an overvalued situation; a low ratio might indicate an undervalued stock. When used independently as a value screen, more restrictive ceilings of 0.75 or 1.00 are common. The price-to-sales ratio ceiling is loosened for the screen to allow more growth-oriented companies to pass yet filter those companies with extreme valuations.
O’Shaughnessy then screens for the 50 companies with the highest relative price strength over the last year. Relative price strength is a price momentum indicator; it confirms investor expectations and interest by comparing the performance of a stock relative to the market.
Top 25 Stocks Passing the O’Shaughnessy Growth II Screen
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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