John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.
The trick to value investing is finding cheap stocks of well-run companies that are about to rise but haven't yet caught the attention of investors.
It is in some ways the opposite of investing based on price movements, or momentum, a strategy that involves picking stocks that are already on an upswing with the expectation they have further to run.
Value investors are supposed to focus on a company's numbers and not be swayed by technical analysis, however. Momentum investing is, after all, partly a self-fulfilling prophecy. When stocks are trading higher, more people pile in and push them still higher. That trend was last year's story in the tech sector, repeated earlier this year as an unprecedented wave of investor money flowed into funds tracking big companies.
Yet, value and momentum styles are the best performers over the eight years Validea has been tracking portfolios of Canadian stocks modelled on those two strategies. Could they be the odd couple?
Historically, value stocks have outperformed growth stocks, something explained by the so-called "value premium." Value stocks are riskier than growth stocks in sluggish economic times and less risky than growth stocks when times are good.
Digging down further, value stocks represent companies that have capital tied up in equipment or other assets they aren't using at the moment. They also tend to be leveraged. So in weak economic times, their stocks don't keep pace with growth stocks. Their overcapacity and lack of manoeuvrability makes them look unattractive compared with nimble growth companies.
But when economic times improve value, companies can use that idle equipment, while it's harder for growth companies to increase capacity. The tables flip and value stocks look relatively more attractive.
Our computer model that emulates Warren Buffett's investment approach looks at a decade's worth of earnings to see if they are predictable, plus return-on-equity and return-on-capital ratios to see how high long-term profitability stacks up, as well as other factors. Since August, 2010, a 10-stock portfolio of large value firms produced an annual return of 13.2 per cent, compared with a 3.8-per-cent gain in the TSX.
The idea behind value investing is that you are buying a stock below its intrinsic value and just waiting for markets to revert to the mean. This requires discipline and the willingness to wait, of course, sometimes for a long time.
But say you don't want to wait. You can use a momentum strategy that bets on market psychology. The momentum effect is a term that describes stocks that have been performing strongly and will continue to go up in the near future. It is supported by behavioural patterns that favour hot stocks and a confirmation bias.
A momentum investor is buying a stock as it is on an upswing and waiting for a short period for it to rise even more before the profit can be locked in. The investor needs to be able to spot trends quickly. Unlike value, it is a strategy hinged in price movements, not fundamental analysis. But like value investing, momentum strategies often go through bouts of underperformance. And investors typically don't sell their winners when they need to and hold their losers too long, waiting for a rebound.
Validea's momentum model – which tracks the strength of a stock's performance relative to others, and other fundamental measures – was up 13.8 per cent annually since 2010, also beating the TSX's return of 3.8 per cent in the same time-frame.
Obviously these are two very different strategies, but they performed similarly against the market, a confirmation that diversification can help boost investor returns.
To give you an idea of how these strategies play out, below are some stocks that pass the tests of model tracking the style of Mr. Buffett and the momentum model.
- Alimentation Couche-Tard (ATD.B): A leader in Canada’s convenience store sector, this stock passes the test of the model tracking Mr. Buffet’s investing style. It has predictable earnings and an expected return of 18 per cent, what Mr. Buffett would consider a great return.
- Canfor Pulp Products (CFX): This operator of pulp and paper mills fits the momentum model. The stock has a relative performance strength of 89 and is trading just shy of its 12-month high.
- Air Canada (AC): This airline also fits the momentum model, although not the Buffett model despite his recent embrace of airline stocks. It has a high relative strength of 97 and is trading near its 12-month peak.