Beating the S&P 500 index by investing in large cap stocks has been a formidable challenge for most mutual fund managers. Most mutual funds underperform the S&P 500 index after fees and expenses. Only some mutual funds beat the S&P 500 index. And, the outperformance is usually not more than a couple of percentage points. Fund manager James O’Shaughnessy combined a variation of value and momentum investing strategies in his book What Works on Wall Street. This is an excellent book to learn about several quantitative investment strategies that are pursued by fund managers and investors. One of the screens he devised is picking the stocks that have PE ratios below 20, and then buying the ones with the highest one-year price appreciation. O’Shaughnessy says the following about why this strategy works:
“I believe that adding relative strength to a value portfolio dramatically increases performance because it picks stocks just after investors have recognized that they are bargains and are buying them once again. All the value factors that make them good buys are still in place, but the addition of relative strength helps pinpoint when investors believe the stocks have been oversold.”
Backtesting this strategy for 52 years returned an average annual compound return of 14.9% vs. 11.7% for the large cap universe. Basically, this strategy beats the S&P 500 index by 3 percentage points per year. The downside risk of this strategy is also nearly 15% less. Of course, these results are based on average returns. The annual performance of the strategy may significantly deviate from these values.
In case you want to test this theory out, Insider Monkey, your source for free insider trading data, obtained the list of stocks with PE ratios below 20 from Google Finance and ranked these stocks based on their 1-year returns. Here are the top 30 stocks that are expected to beat the S&P 500 by three percentage points:
| Company | Ticker | Market Cap | PE Ratio | 52-week Return |
| Altera Corporation | ALTR | 15.69B | 18.26 | 91.92 |
| National-Oilwell Varco, Inc. | NOV | 32.41B | 19.52 | 73.69 |
| Humana Inc. | HUM | 12.84B | 11.76 | 69.29 |
| Marathon Oil Corporation | MRO | 38.42B | 14.97 | 63.33 |
| UnitedHealth Group Inc. | UNH | 53.84B | 11.47 | 61.3 |
| Deere & Company | DE | 41.05B | 19.58 | 60.98 |
| El Paso Corporation | EP | 14.84B | 19.55 | 60.58 |
| Discover Financial Services | DFS | 13.55B | 10.95 | 59.78 |
| Cummins Inc. | CMI | 23.65B | 19.13 | 59.53 |
| Magna International Inc. | MGA | 12.41B | 12.24 | 56.35 |
| Limited Brands, Inc. | LTD | 13.15B | 17.03 | 51.05 |
| Agrium Inc. (USA) | AGU | 14.26B | 19.55 | 45.87 |
| EI du Pont de Nemours | DD | 52.74B | 15.86 | 43.82 |
| Freeport-McMoRan | FCX | 52.08B | 10.72 | 43.6 |
| Time Warner Cable Inc. | TWC | 26.28B | 19.84 | 43.53 |
| Viacom, Inc. | VIA.B | 29.93B | 16.13 | 42.66 |
| CIGNA Corporation | CI | 12.70B | 9.57 | 41.9 |
| Eaton Corporation | ETN | 18.23B | 17.29 | 41.59 |
| The Mosaic Company | MOS | 33.43B | 14.81 | 40.87 |
| Philip Morris International | PM | 124.32B | 17 | 40.62 |
| Chesapeake Energy Corp | CHK | 22.14B | 14.37 | 40.05 |
| TELUS Corporation (USA) | TU | 16.25B | 15.88 | 39.82 |
| CSX Corporation | CSX | 29.01B | 18.05 | 39.78 |
| WW Grainger, Inc. | GWW | 10.53B | 19.5 | 39.11 |
| Reynolds American, Inc. | RAI | 21.63B | 15.69 | 37.93 |
| Valero Energy Corporation | VLO | 16.12B | 14.61 | 37.74 |
| Cliffs Natural Resources Inc | CLF | 12.71B | 9.34 | 37.57 |
| Parker-Hannifin Corporation | PH | 15.27B | 15.92 | 36.27 |
| Aetna Inc. | AET | 15.91B | 9.99 | 35.9 |
| Union Pacific Corporation | UNP | 50.75B | 17.77 | 35.5 |
Some of these stocks are very popular among hedge funds. T. Boone Pickens is extremely bullish about the top stock in this list, National Oilwell (NOV). Jim Simons’ Renaissance has ALTR in its portfolio. David Tepper’s Appaloosa and Roberto Mignone’s Bridger are bullish about United Health (UNH). John Burbank’s Passport Capital and Phil Falcone’s Harbinger like Cliff Natural Resources (CLF).
In terms of number of hedge funds with positions, Viacom tops the list of most popular stocks. Eric Mindich’s Eton Park had $555 Million in Viacom at the end of December. Chase Coleman’s Tiger Global had nearly $300 Million, and Larry Robbins’ Glenview had $137 at the end of December. “We like the stability and growth of cable networks based upon the growing and recurring nature of affiliate fees, and we are in the recovery phase of ad spending coming off of the 08/09 recessionary pullback… the business remains highly cash generative with free cash flow equal to approximately 110% of net income,” Robbins said about Viacom in his latest investor letter.
Chesapeake Energy tops the list in terms of dollar amount invested by hedge funds. Thirteen funds own $2.26 Billion in CHK stock. Legendary activist investor Carl Icahn revealed a 5.8% stake in CHK on December 20th and CHK immediately jumped 3%. However, that wasn’t the end of it. Even if you had waited till the last day of trading in 2010 and bought CHK at the close, your return could have been more than 30% in four months.
