You want to key in on cheap stocks that get hot for an extended period, and are still undervalued.Getty Images/iStockphoto
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.
If you've been to one of the myriad of trendy juice bars that have popped up across North America in recent years, you might be familiar with the idea of the "power boost shot": Take a healthy, tasty juice drink and kick it up a notch by adding a shot of a nutrient-rich "booster" such as wheatgrass or protein powder, which, on their own, would not exactly tickle your taste buds. The result is a turbocharged combination of sweet-tasting nutrition.
In the stock market, value investing is like the base juice drink. By itself, it gets your portfolio plenty of "nutrients" needed for growth. From 1927-2014, value stocks (those that trade at low values compared to their earnings, sales, book value, or other business measures) averaged annualized returns of 12.9 per cent, according to the data of financial researcher Kenneth French, while growth stocks (those that trade at high values compared with their business fundamentals) averaged 9.4 per cent.
But there is a way to further enhance your value investing portfolio with a "power boost." The trick? Adding a shot of momentum to your stock-picking strategy. In other words, buy stocks that have been red-hot.
That idea might make value investors cringe. After all, value stocks are often cheap because they have been declining in the face of some overblown concern, which can push the price of a good company's shares down well below where they should be based on the business's fundamentals. That creates an opportunity for value investors. Many stocks with strong momentum behind them, meanwhile, become overpriced compared with their fundamentals, making them just the sort of stock that a good value investor avoids.
But value stocks aren't always falling. Nor are red-hot stocks always expensive. While they are often portrayed as polar opposites, value and momentum are really two separate concepts. Value metrics give you a snapshot of what a stock's valuation is at a given time, regardless of whether the stock has been rising or falling.
You'll find plenty of cases in which a stock is so cheap that it can get quite hot for an extended period, and still be undervalued.
Those are the kind of stocks you want to key on. That's a lesson I first learned from James O'Shaughnessy, whose classic book, What Works on Wall Street, examines how dozens of strategies that use different variables would have fared over several decades. One of O'Shaughnessy's major findings was that just about any successful strategy incorporated a value component – even approaches that focused on high-growth, strong momentum stocks. In fact, the five strategies he tested that would have produced the best risk-adjusted returns from 1965 through 2009 all included both value and momentum variables.
The case for combining value and momentum goes beyond O'Shaughnessy's work – and beyond stocks. In a 2012 paper entitled "Value in Momentum Everywhere," Clifford S. Asness, Tobias J. Moskowitz, and Lasse Heje Pedersen examined eight different asset classes, ranging from US stocks to Japanese stocks to currencies to commodities. They combined value and momentum a bit differently, looking at how portfolios of growth and value performed separately for each asset class, as well as how a combined portfolio (50 per cent value assets, 50 per cent momentum assets) fared. In every case, the combined value/momentum portfolios produced better risk-adjusted returns down the value and momentum portfolios did separately over the long run.
The idea of combining value and momentum in a single stock-picking strategy makes a lot of sense. Momentum is a powerful force in investing. We human beings have a tendency to follow the crowd, which means today's winners tend to keep winning. The problem occurs when the crowd pushes the winners far past fair value – tech stocks of the early 2000s are probably the best example of that. At some point (and there's no way of telling precisely when), momentum won't be enough to keep a vastly overvalued stock rising; when that happens, it's often as though investors realize that the emperor has no clothes – that the stock is worth nowhere near what people have been paying it – and the trend can reverse. Before you know it, all of your gains can be wiped out.
When you combine momentum with value, however, you avoid the risk involved with those high-flying, overpriced stocks, while still getting the benefit of the market's momentum.
What sort of stocks currently have that value-plus-momentum combination? Here are a few that my Guru Strategies (which are based on the approaches of James O'Shaughnessy and other investing greats) think fit the bill.
- JetBlue Airways Corp. (JBLU-Nasdaq): This upstart New York-State-based airline (market cap of $8-billion U.S.) has a 12-month relative strength of 96 (meaning it has beaten 96 per cent of stocks in the market over the past year), yet it still trades for reasonable 1.3 times sales and 15 times earnings. It’s a favourite of the strategy I base on the writings of mutual fund legend Peter Lynch.
- Exco Technologies Ltd. (XTC-TSX): This Ontario-based industrial (market cap $600-million) supplies parts and technologies for the die-cast, extrusion and automotive industries. It has a 12-month relative strength of 88, and still trades for about 15 times earnings and 1.2 times sales. It’s a favourite of the strategy I base on the writings of star fund manager Joel Greenblatt.
- Maiden Holdings Ltd. (MHLD-Nasdaq): This Bermuda-based reinsurer (market cap $1-billion) has a 12-month relative strength of 83, but trades for just 0.45 times sales and 11.4 times earnings. It’s another favourite of my Lynch-based model.
Disclosure: I'm long MHLD.
John Reese