Screener - O'Shaughnessy: Growth Screen II

Predicting the Markets of Tomorrow: A Contrarian Investment Strategy by James O’Shaughnessy

Investing in the stock market is notoriously difficult to predict, yet many investors strive to anticipate where the market is headed. In his book Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years, renowned investor James O’Shaughnessy challenges conventional wisdom by suggesting that long-term market trends can be forecasted through historical data patterns and strategic stock selection.

In this article, we’ll explore O’Shaughnessy’s unique contrarian approach, his four key stock selection strategies, and how investors can use these insights to build diversified portfolios designed to outperform over the next two decades.

Understanding O’Shaughnessy’s Contrarian Philosophy

Most investors expect the stock market to deliver around a 10% annual return over the long term. However, O’Shaughnessy points out this figure can be misleading due to inflation, which erodes real returns. His research, spanning data back to the late 1790s, shows that the inflation-adjusted long-term average return is closer to 7% per year.

The key insight is that markets move in roughly 20-year cycles. When returns exceed this average for a period, the market eventually reverts toward the mean—sometimes overshooting on the downside. Given that the average investor’s holding period is about 20 years (often saving from middle age until retirement), understanding these cycles is critical to managing expectations and risk.

The 20-Year Market Cycle and Capitalization Shifts

O’Shaughnessy’s analysis identifies a new 20-year trend that began around 2000. This cycle favors:

• Small- and mid-cap stocks
• Large-cap value stocks

This contrasts with the previous 20-year cycle, which favored large-cap growth stocks while small- and mid-cap stocks and large-cap value stocks underperformed.

Asset Allocation: Balancing Risk and Opportunity

Even when certain market segments are out of favor, O’Shaughnessy advocates maintaining exposure to them to achieve diversification. His recommendations vary by investor risk tolerance:

• Conservative Investors: 25% in micro-, small-, and mid-cap stocks; 75% in large-cap stocks.
• Aggressive Investors: 35% in micro-, small-, and mid-cap stocks; 50% in large-cap value stocks; 15% in large-cap growth stocks.

This approach balances stability with potential for higher returns from smaller, more volatile companies.

Portfolio Construction: The Right Number of Stocks

To reduce risk, O’Shaughnessy suggests:

• 25 stocks in micro-, small-, and mid-cap portfolios
• 10 stocks in large-cap portfolios

Smaller companies are generally more volatile, so a broader selection is required for adequate diversification.

O’Shaughnessy’s Four Stock Selection Screens

O’Shaughnessy developed four screening approaches that blend growth, value, and momentum criteria to identify stocks likely to outperform:

1. Large-Cap Stocks - Growth Market Leaders Screen

This screen focuses on:

• Companies with market caps larger than average
• Stocks with higher cash flow per share than average (a more reliable measure than earnings)
• Sales 1.5 times greater than average companies
• Price-to-sales ratio below average (indicating undervaluation)
• Positive earnings per share growth over the last 12 months
• Top 10 stocks by 52-week relative strength (price momentum)

This combination targets large, financially strong companies with growth potential and favorable valuations.

2. Small-Cap Growth and Value Screen

Designed to find “cheap stocks on the mend,” this screen filters for:

• Market caps between $200 million and $2 billion, adjusted for inflation
• Price-to-sales ratio less than 1.5
• Positive earnings per share growth over the trailing 12 months
• Stocks with above-average 13- and 26-week relative strength
• Final selection of 25 stocks with highest 52-week relative strength

3. Tiny Titans Screen

For aggressive investors seeking high risk/high reward, this screen hunts for micro-cap stocks with momentum:

• Market caps between $25 million and $250 million
• Price-to-sales ratio less than 1
• Top 25 stocks by 52-week relative strength

These micro-cap stocks often have less analyst coverage, offering untapped potential but significant volatility.

4. All-Cap Value with a Growth Twist Screen

This hybrid screen aims to:

• Exclude micro-caps but include all others above $200 million market cap (inflation-adjusted)
• Target stocks in the lowest 30% for price-to-sales and price-to-cash-flow ratios
• Focus on companies with high dividend yield (top 30%)
• Select 25 stocks with the highest 52-week relative strength

The approach balances value investing with a momentum growth component for better diversification and risk management.

Why Use Price-to-Sales and Cash Flow Ratios?

O’Shaughnessy prefers these metrics because:

• Sales are harder to manipulate than earnings and more stable over time.
• Cash flow reflects actual liquidity, stripping out non-cash accounting entries.
• Low ratios signal undervaluation, which historically correlates with higher returns.

The Role of Relative Strength (Momentum)

Relative strength measures how a stock has performed against the market over a period. Stocks with strong recent performance often continue to outperform in the near term. However, this can also mean they may be at peak prices, increasing downside risk if momentum reverses.

Historical Backtest Performance

O’Shaughnessy’s screens have been backtested from 1998 to the present, showing consistent outperformance versus the market when portfolios are rebalanced monthly with equal dollar amounts in each stock. While transaction costs were excluded, the results highlight the power of combining value, growth, and momentum in stock selection.

Summary: Key Takeaways

• Markets tend to move in 20-year cycles favoring different market caps and styles.
• The next two decades favor small- and mid-cap stocks and large-cap value stocks.
• Diversification across market caps is crucial.
• Use a mix of value, growth, and momentum screens for stock selection.
• Metrics like price-to-sales, price-to-cash flow, and relative strength improve selection quality.
• Holding around 25 stocks for small/mid-caps and 10 for large-caps balances risk and returns.

FAQs About O’Shaughnessy’s Contrarian Strategy

Q: What is contrarian investing?

A: Contrarian investing involves going against prevailing market trends, buying undervalued assets others are avoiding, expecting the market to correct over time.

Q: Why focus on small- and mid-cap stocks now?

A: Historical cycles suggest these stocks outperform over the next 20 years as they have been out of favor during the previous cycle.

Q: How often should I rebalance my portfolio?

A: O’Shaughnessy recommends monthly rebalancing to maintain equal-weight positions in selected stocks.

Q: Is this strategy suitable for all investors?

A: It suits investors with a 15-20 year horizon and the ability to handle volatility, especially in smaller stocks.

Conclusion

James O’Shaughnessy’s Predicting the Markets of Tomorrow offers a compelling, data-driven contrarian investment strategy rooted in deep historical analysis. By recognizing long-term market cycles and employing systematic stock selection screens blending value, growth, and momentum factors, investors can position themselves to capture the returns favored by the coming 20-year market trend.

Whether you’re a conservative investor seeking diversification or an aggressive trader hunting high momentum small-caps, O’Shaughnessy’s approach provides a robust framework to navigate market volatility and build portfolios aligned with evolving market dynamics.

If you found this article insightful, feel free to share it with fellow investors or leave your thoughts below. What’s your take on contrarian investing? Have you tried any of O’Shaughnessy’s strategies? Let’s discuss!