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Investment Ideas Thinking about momentum investing? Here are three stocks to consider

For bargain-hunting value investors, watching the stock market’s more or less steady climb higher over the past few years must have felt like finding a stray $20 bill on the ground – right next to a grizzly bear.

Buying stocks when their prices are on an upswing would seem to be just as risky as reaching near the grizzly for that $20 bill. But many value investors have been able to make up for underperforming value strategies by taking the plunge into momentum investing for part of their portfolios.

In order to pull this off, investors steeped in the discipline of evaluating a company's books have to take a couple of mental leaps.

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Momentum investing is about watching charts, not analyzing financial measures such as book value or earnings growth. In its most basic form, momentum investing means buying stocks that are beating their index over a 12-month period and selling those that are lagging.

Some add a twist that compares the relative price strength of competing assets. For instance, an investor would look at a 12-month gain of 10 per cent in the S&P 500 next to a 5-per-cent gain in the FTSE 100 over the same period and conclude that the S&P 500 is exhibiting more relative momentum. As a result, a momentum investor would favour the S&P 500 over the FTSE 100.

Value investors who want to add a little momentum to the mix have a big leap to make: They have to accept the seemingly contradictory act of buying stocks near their 12-month highs, rather than using the traditional value approach, which is to do research to find relatively cheap stocks.

Wesley Gray, of the advisory firm Alpha Architect, displays a grizzly taxidermy mount in his office to remind him of the hazards of the strategy. He talked about momentum investing – using the $20 example – during a recent podcast with Cliff Asness, the co-founder of AQR Capital Management, who is also a well-known momentum investor.

The value strategy appeals to many investors because it is logical. Success comes from buying a beaten-down stock of a quality company and holding it in order to maximize return potential. Risk is a major consideration here. Cheap stocks are presumably riskier because those companies have less cushion to survive a market downturn. Over time, value investors earn a premium for owning riskier stocks.

Momentum strategies look more at behaviour. Rather than fundamentals driving the price of the stock, it’s the stock price that drives the fundamentals. A soaring stock price attracts more investors, boosts the resources available to the company to invest and acquire and attracts a talented work force. All this would presumably show up in better financial performance, reinforcing the stock gain.

But then human behaviour factors in. Investors often underreact to positive, unexpected news, such as a company beating analysts’ profit forecasts. Or they overreact to a stock, piling in as it soars higher. Or they refuse to let go of losers while selling winners.

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Of course, Mr. Gray and Mr. Asness acknowledge there are risks inherent in the momentum strategy, a major one being that there can be plenty of pain involved. Since the world rarely works the way a perfectly constructed statistical model would, there are going to be big negative events that toss cold water on the trade. And constantly churning a portfolio to keep up with the charts creates added costs and chips away at returns.

Still, momentum has proven to be a decent counterpart in a portfolio that includes value investments, so it may be worth taking a look. The diversification alone could help die-hard value disciples ride out the momentum wave until their tried-and-true strategy returns to favour.

Below are three stocks that currently score highly on a momentum model we built at Validea to track the strategy developed by Mr. Gray in his book Quantitative Momentum, co-authored with Alpha Architect cohort Jack Vogel. They, along with other academic studies, have shown that intermediate-term momentum is more predictive of future stock price performance than very short or longer-term momentum. Their method of calculating intermediate-term momentum is to subtract the one-month return from the 12-month return.

Cadence Design Systems Inc. (CDNS-Nasdaq) – The 12-month return minus one-month return is 61 per cent, which puts shares of this electrical component maker in the top rank of stocks using this momentum indicator.

Erie Indemnity Co. (ERIE-Nasdaq) – Shares of this property and casualty insurance company displays both fundamental momentum (that is, improving fundamental trends) and strong price momentum, with a 12-month minus one-month return of 73 per cent.

O’Reilly Automotive Inc. (ORLY-Nasdaq) – This maker of auto supplies ranks in the top 10 per cent of momentum stocks, with a 12-month minus one-month return of 38.7 per cent.

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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.

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