Out-of-Sample Test of What Works on Wall Street (O’Shaughnessy’s Cornerstone Strategies)

In the mid-1990s, James O’Shaughnessy identified “cornerstone value” and “cornerstone growth” as best-of-breed equity investment strategies. The former emphasizes dividends among large-capitalization stocks, and the latter momentum/earnings growth for a broader universe. Based on Standard and Poor’s Compustat data, he found that the value (growth) strategy returned an average 15% (18%) per year over a backtesting period of 1952-1994, compared to 8.3% for the S&P 500 Index. He implemented these two strategies in late 1996 via mutual funds and publicized them in early editions of his book What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time. He subsequently sold the mutual funds (which apply slightly different portfolio formation rules from those specified in the original research) to Hennessy Funds in 2000, where they survive as the Hennessy Cornerstone Value Fund (HFCVX) and the Hennessy Cornerstone Growth Fund (HFCGX). Has 14 years of out-of-sample performance of these two mutual funds confirmed the motivating backtests? Using self-reported annual total returns for HFCVX, HFCGX and selected benchmark indexes during 1997 through 2010, we find that:

According to Hennessy Funds, they specify the holdings of HFCVX and HFCGX annually by “strictly adhering to the following time-tested, quantitative formula[s]” applied to the Compustat database, as follows:

HFCVX managers screen for large capitalization value firms (excluding utility companies) based on: (1) market capitalization above the average of the database; (2) number of shares outstanding above the average of the database; (3) 12-month sales 50% greater than the average of the database; and, (4) cash flow above the average of the database. They then select the 50 stocks with the highest dividend yield.

HFCGX managers pursue a strategy that “marries value with momentum” via screening based on: (1) market capitalization above $175 million; (2) price-to-sales ratio below 1.5; (3) annual earnings higher than the previous year; and, (4) positive returns over the past three and six months. They then select the 50 stocks with the highest 12-month past return. [Item (1) may have grown over the years.]

The following chart compares the average (arithmetic mean) annual returns of the funds and relevant benchmark indexes over the entire 1997-2010 sample period, with one standard deviation variability ranges.

HFCVX underperforms both its benchmark Russell 1000 Value Index and the S&P 500 Index. The fund underperforms the S&P 500 Index by about 0.5% per year, compared to the backtested average annual outperformance of about 7%. Also, its standard deviation of annual returns (20.1%) is higher than that for the benchmark Russell 1000 Value Index (18.7%). Backtested outperformance has not persisted over a 14-year out-of-sample implementation.

HFCGX outperforms both its benchmark Russell 2000 Index and the S&P 500 Index. The fund outperforms the S&P 500 Index by about 2.5% per year, compared to the backtested average annual outperformance of about 10%. Its standard deviation of annual returns (21.2%) is about the same as that for the benchmark Russell 2000 Index (21.1%). Backtested outperformance has persisted at a subdued level over a 14-year out-of-sample implementation.

For a different perspective, we look at cumulative returns.

The next chart tracks the year-end values of $10,000 initial investments in each of HFCVX, HFCGX and benchmark indexes at the end of 1996 through the end of 2010. Results confirm that HFCVX (HFCGX) has consistently underperformed (outperformed) its benchmark index.

Possible reasons that the out-of-sample performances of these funds fall well short of their backtested performance are:

• The out-of-sample test is short and unlucky for the strategies.
• Backtests exclude trading frictions.
• The market changed. For example, the expansion of stock buybacks in lieu of dividends is largely absent from the backtest period and may disrupt the dividend-based strategy of HFCVX.
• The market adapted since publication of the cornerstone strategies, with more and more investors competing for the abnormal returns from similar strategies.
•  Data snooping bias added material helpings of luck to the backtested performance.
• Wildness (non-normality) of stock return distributions makes average past return unreliable as a measure of expected return.
• Deviations by the fund managers from the original backtest specifications suppressed strategy performance.

In summary, as found for the “cornerstone” strategies, what worked on Wall Street in past decades may or may not work in future decades. Changing/adaptive investment environments, implementation compromises and frictions, bias derived from mining noisy data and non-normality of stock return distributions complicate strategy development.

You May Also Enjoy...

• A Few Notes on What Works on Wall Street
• The Wall Street Journal’s SmartMoney Fund Screen
• Out-of-Sample Test for a Stock Market Model
• CSI: Wall Street
• Stephen Leeb: Wall Street Wonder?