The Cornerstone Investing System

The Cornerstone investing system is a simple investing approach developed by fund manager James O’Shaughnessy. His book What Works on Wall Street, which first publicized the Cornerstone system in 1996, soon became a bestseller and is since then updated several times because of the amazing simplicity of the Cornerstone system, as well as the robust returns it generates.

The Cornerstone system actually consists of two separate strategies: one focuses in growth stocks, another in dividend stocks, and they are unified by a sound capital allocation between the two strategies. Here are the details.

The Growth Strategy

The first half of the Cornerstone investing system is called the growth strategy, which aims to buy stocks with growth potential at a reasonable price. Here are the four parameters of the strategy:

I. Market Capitalization

The first requirement of the growth strategy is that the company must have a market capitalization of at least $ 150 million, because otherwise the company is too illiquid for most investors.

Growth Criterion 1: Market cap must be at least $150 million.

II. Earnings per Share (EPS)

The strategy requires companies to have persistent earnings growth, where the earnings per share before extraordinary items must increase each year for the recent five years.

Growth Criterion 2: Annual EPS must be increasing year after year for the past five consecutive years.

III. Price-Sales Ratio (P/S)

Along with another investing legend Ken Fisher, O’Shaughnessy is also a zealot of the price-sales ratio. He found that the P/S ratio was the single best predictor of a stock’s value in the future, and he targets stocks with price-sales ratios below 1.5 to identify growth stocks that are still cheap to buy.

Growth Criterion 3: The price-sales ratio must be smaller than 1.5

IV. Relative Strength

Relative strength (RS) is a technical criterion that measures the difference between a stock and a benchmark index (e.g. Russell 1000) within a time period (e.g. 12 months). Say, if a stock has a 12-month RS of 90 against the Russell 1000, it means that in the past 12 months, the stock is performing better than the Russell 1000 for 90% of the time.

After you selected all the candidate stocks based on the previous three criteria (market cap, EPS, P/S), you rank them according to their relative strength in 12 months, 6 months and 3 months respectively. You are only allowed to invest in the stocks which are present in the top 50 in all three lists. The benchmarks used here are the Russell 1000 (for large cap stocks) and the Ibbotson Small Stocks Index (for small cap stocks).

Growth Criterion 4: RS in 12 months, 6 months and 3 months must be in the top 50 of all candidates that satisfy the previous three criteria.

The Value Strategy

The other half of the cornerstone investing system is the value strategy, which in contrast to the growth strategy, targets large companies with nice cash flows and solid dividends. This strategy does not include utility stocks because of their high yields. The benchmark used in this strategy (e.g. market averages of financial data) is the Russell 1000 Value index.

I. Market Capitalization

The value strategy looks for large, well-known companies with market capitalizations greater than $ 1 billion, as O’Shaughnessy found that they can provide steady dividends more often.

Value Criterion 1: Market cap must be at least 1 billion.

II. Cash Flow per Share (CFPS)

O’Shaughnessy seeks companies whose cash flow per share exceeds the average cash flow per share of the market, because strong cash flows are typically what the institutional long-term investors look for.

Value Criterion 2: CFPS must be greater than the market average.

III. Shares Outstanding

O’Shaughnessy seeks companies with a large number of outstanding shares, because these are the better known and liquid stocks.

Value Criterion 3: Shares outstanding must be greater than market average.

IV. Trailing 12-Month Sales

High trailing 12-month sales is a hallmark of earning consistency. As a general rule, a company’s trailing 12-month sales should be 1.5 times or greater than the average market value.

Value Criterion 4: Trailing 12-month sales must be at least 1.5 times of the market average.

V. Shareholder’s Yield

Shareholder’s yield is a term defined by O’Shaughnessy as the dividend yield plus the net decrease of shares (in percentage) in a given period. For example, if the dividend paid for the previous year was 1%, and in the same period the company repurchased 5% of the outstanding stocks, then the shareholder’s yield would be 6%. Conversely, if the company issued new shares instead, then it has to be deducted from the dividend yield.

After you selected all the candidate stocks based on the previous four criteria (market cap, cash flow, outstanding stocks, sales), you rank them according to their shareholder’s yield and only invest in the top 50 stocks.

Value Criterion 5: Shareholder’s yield must be in the top 50 of all candidates that satisfy the previous four criteria.

Allocation and Rebalancing

After some research into portfolio allocation, O’Shaughnessy finds an ideal allocation of capital to be the following:

• 50%: Value strategy in large cap stocks (benchmark: Russell 1000 Value).
• 35%: Growth strategy in small cap stocks (benchmark: Ibbotson Small Stocks).
• 15%: Growth strategy in large cap stocks (benchmark: Russell 1000).

O’Shaughnessy also practices a periodic rebalancing of portfolio, i.e. selling existing stocks that no longer meets your criteria, and reinvest in new opportunities at a fixed interval of time. Originally, O’Shaughnessy recommends rebalancing your portfolio every year after your purchase because of US tax reason (long-term capital gain tax). However, later research found that, if tax is ignored, it is actually better to rebalance at a shorter time intervals (e.g. quarterly or even monthly), especially for the growth strategy with small cap stocks.

Discipline

Regardless which strategy, allocation or rebalancing period you choose, O’Shaughnessy made it clear that the most important thing is to have the discipline to stick to your method, even when it is underperforming relative to other strategies every once in a while. As he wrote:

“Sounds simple and sensible [to get rich with these simple rules], yet many investors have a nearly impossible time following this simple advice… I passionately believe that investors who manage to short-circuit their underlying emotions by following a simple equity asset allocation plan with consistent discipline will vastly outperform those who are unable to do so, whatever the overall market environment. By letting the data of 108 years inform us — rather than listening to what a talking head is saying right now on the TV or internet — we can see the simple truth that using simple, straightforward and time-tested investment strategies leads to the best overall results in virtually all market environments.”

Conclusion

Here is a summary of the Cornerstone investing system:

The Growth Strategy:

1. Market Cap > 150 million.
2. Earnings per Share: Increasing for 5 years.
3. Price-Sales Ratio < 1.5.
4. Relative Strength: Top 50 of Candidates.

The Value Strategy:

1. Utility stocks not included.
2. Market Cap > 1 billion.
3. Cash Flow per Share > Market Average.
4. Shares Outstanding > Market Average.
5. Trailing 12-month Sales > 1.5 x Market Average.
6. Shareholder’s Yield: Top 50 of Candidates.

Allocation and Rebalancing:

• 50% of value with large cap stocks.
• 35% of growth with small cap stocks.
• 15% of growth with large cap stocks.
• Rebalance the portfolio at least once a year.