John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
With the stock markets consistently reaching new highs since the late-June swoon, it can be difficult to find stocks that have not gotten overheated.
What's more, the industries that led the way for part of that runup have shifted significantly. Through June, the leading market performers were defensive stocks such as utilities, telecommunications and health care. But since then, as the market continued to rally, financials and technology stocks have come out on top.
Investors who didn't pivot – either because they didn't see the change happening or didn't want to give up on their existing strategies – missed an opportunity.
One of the tricks of momentum investing is to avoid overpaying for stocks that have done the best. Hot stocks can have an irresistible lure, and strong performers tend to continue on that path, at least in the short-run, while market losers tend to lag. But even some high-fliers will come crashing down eventually.
Analysis by the global investment firm AQR Capital and research from prominent investors such as Jim O'Shaughnessy, chairman of O'Shaughnessy Asset Management, point to the benefits of momentum investing, which is a strategy that evaluates the relative strengths of stocks and sectors. An uptrend in relative strength indicates the stocks that are doing better than others and the market in general.
In his book, What Works on Wall Street, Mr. O'Shaughnessy wrote that from 1927 through 2009, stocks with relative strength in the top 30 per cent or higher had annualized returns of 12 per cent or more, compared with returns of 10.5 per cent for his all-stock universe. That is to say, those with a relative strength above 70 are the momentum stocks to look for. Momentum investors should also look for stocks that are trading within 15 per cent of their 52-week highs, an indication that another price breakthrough is possible.
By looking at the top-performing industries and companies, investors can get a sense for when it's time to shift their portfolios to catch stocks at the right time. In the United States, the top performing industry lately is gold and silver, with an average price-to-earnings ratio of 54.1, price-to-sales of 4.8 and a relative strength of 94. Mobile homes and recreational vehicles are second, with P/E of 16.8, price-to-sales of 0.9 and relative strength of 83. Water utilities were third at P/E of 26, a price-to-sales of four and relative strength of 82.
In Canada, home furnishing stocks topped the list, with P/E of 22.35, price-to-sales of 2.44 and relative strength of 87. Wineries were next at P/E of 20.36, price-to-sales of 1.19 and a relative strength of 82 and precious metals were third, with P/E of 18.4, price-to-sales of 7.5 and a relative strength of 77.
Pure momentum investing can be difficult to implement in an investment strategy, a result of the constant churning of one's portfolio and given the fact that momentum stocks can, and will, go through periods when they are out of favour. Many momentum investors implement tight stop losses, which is a technique used to limit losses by selling a stock after it drops a certain percentage. Stops can sometimes be useful, although they can also mean selling too prematurely.
A better way to integrate in momentum is to use a high relative strength factor as one of multiple criteria when searching for stocks. Combining momentum with other fundamental factors can give the investor confidence that the stock is a good investment for reasons other than just strong price performance. For instance, the Momentum investor model I run utilizes more than a dozen distinct fundamental criteria, including assessing earnings growth and profitability metrics. Furthermore, it keys in on high relative strength names and also the top performing industries. In the Canadian market, the Momentum investor portfolio I track is the best performer and has returned 14.0 per cent per annum versus 3.6 per cent annually for the S&P/TSX composite index over the past six years.
Shown in the table below are five stocks (three U.S.-listed and two Canadian-listed firms) that score highly based on multiple guru models, including ones that utilize high relative strength as one of the input factors.