Fishing for large-cap winners

Another celeb investor who has courted much success with his stock selection strategy is James O'Shaughnessy. In the concluding part of our series, we test a sub-component of his approach known as 'united cornerstone'. O'Shaughnessy designed this strategy to select quality largecap stocks and it is a combination of growth- and value-focused models.

The growth model is high on risk, while the value model displays low variations or volatility. Here, we back-test the value-focused model of the united cornerstone approach. In this model, he tracks large firms with above-average sales. He found that such stocks are considerably less volatile than the broader market. To filter out such large-cap stocks, he not only used market capitalisation but also other variables such as outstanding shares and trailing 12-month (TTM) sales.

Outstanding shares should be higher than, and TTM sales more than, 1.5 times the market average. He ignored the industry figures and worked on market numbers. For filtering quality large-cap stocks, he used two more variables-cash flow per share and dividend yield. In order to qualify, a stock's cash flow per share should be higher than the market average and it must have a high dividend yield.

James O'Shaughnessy He is the CIO of the O'Shaughnessy Asset Management Company, which, in 2008, managed more than $9 billion worth of assets. He also manages several Canadian mutual funds. O'Shaughnessy has a degree in economics from the University of Minnesota. The Chosen Ones The united cornerstone approach helped pick a portfolio of large-caps, which performed exceedingly well compared with the Nifty.

We tested this approach using the 2008-9 figures for 5,000 listed companies. After filtering, we were left with 69 large-cap firms. We applied the final two criteria of cash flow per share and dividend yield and got 45 companies. Of these, we selected the top 10 firms and checked their price performance between 31 March 2009 and 31 August 2010. An investment of Rs 1 lakh, Rs 10,000 in each stock, on 31 March 2009, would have grown to Rs 3.04 lakh on 31 August 2010. This is an absolute growth of 204 per cent compared with the 78.8 per cent returned by the Nifty.

This means the cornerstone value strategy generated an astonishing absolute return differential of 125.2 per cent. However, to ensure a robust study, we applied the criteria to 2007-8 numbers and listed 57 companies. We selected the top 10 firms and tested their price performance between 31 March 2008 and 31 August 2010. An investment of Rs 1 lakh would have grown to Rs 1.81 lakh on 31 August 2010, generating an absolute growth of 81.7 per cent. During the same period, the Nifty returned a meagre 14.1 per cent. The strategy seems to be working incredibly for large-cap stocks.

We applied the criteria to 2009-10 numbers and 64 companies satisfied the requirements. We selected the top 10 firms and checked their price performance between 31 March 2010 and 31 August 2010. An investment of Rs 1 lakh on 31 March 2010 would have grown to Rs 1.27 lakh on 31 August 2010, an absolute growth of 27 per cent. During the same period, the Nifty returned 2.9 per cent. In the 2009-10 portfolio, the 10 stocks have shown a 45 per cent average increase in profit after tax and 31 per cent increase in operating profit.

Two companies, Colgate-Palmolive and Hero Honda, even paid dividends in excess of 1,000 per cent in 2009-10. The back-testing exercise for the three financial years proves that the value-focused model helps choose a portfolio that can beat the market. This strategy helps filter out large-cap firms that perform very well when the market is down. This is because such stocks do not fall as much as the other stocks during bear phases and tend to outperform the market during the bull phases.

The inclusion of large-caps in a portfolio will compensate for volatility in the market. O'Shaughnessy asserts that the more one trades, the higher the chances of loss. So, choose a strategy and let it play out. Though a proponent of the buy and hold theory, he also asserts that a portfolio should be rebalanced every year. Disciplined implementation of active strategies is the key to performance.