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Number Cruncher

The momentum approach to stock-picking Add to ...

What are we looking for?

Momentum. Stocks that are going up have a tendency to keep on going up – at least for the short term.

More on today’s screen

Craig McGee, senior consultant at CPMS, a division of Morningstar Canada, constructed the screen. He looked for rising stocks that are accompanied by improving expectations.

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To make the list, a stock had to be:

-among the 350 largest stocks in the Canadian market, based upon market capitalization;

-among the 25 stocks in that group with the best combination of one-year total return, upward revisions in earnings estimates over the past 90 days, and positive earnings surprises, as calculated by CPMS.

More about CPMS

CPMS provides quantitative North American equity research and portfolio analysis to primarily institutional clients. It covers more than 700 Canadian and 2,200 U.S. stocks, and spends a lot of time adjusting for unusual accounting items in each company’s quarterly results to make sure screens can perform correctly.

What we learned

A momentum approach can work – if you can shoulder the hefty transaction costs involved in constantly shuffling your portfolio.

Mr. McGee tested how the particular momentum strategy outlined above would have performed over the past 25 years. He assumed an equally weighted 25-stock portfolio that was refreshed every three months.

He found that the approach would have generated an annualized return of 24.6 per cent since the end of 1985, nearly tripling the 8.3-per-cent return for the S&P/TSX Total Return Index over the same period. The portfolio outperformed the index in 24 of 26 years, and lagged behind only in 2008 and 2009.

Mr. McGee says the success of the strategy highlights the importance of focusing on stocks with improving expectations. He cautions, however, that the approach would have required a tremendous amount of discipline to follow in real life.

Someone taking this momentum approach would, on average, have turned over every stock in the portfolio more than twice a year. Transaction costs weren’t factored into the return calculations, so the cost of buying and selling shares would have eaten into profits.

An investor would also have had to endure losing 46 per cent of his or her portfolio’s value from the end of June, 2008, to the end of February, 2009. Momentum can work, it seems – but you have to be prepared for volatility along the way.

Chart note

Grades shown are relative to 738 securities in the CPMS Canadian database.

Follow on Twitter: @IanMcGugan

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