What are we looking for?
U.S. companies showing positive momentum but trading below their industry medians.
The idea of combining value and momentum style-based investing can often be one way to avoid the fallacies of the value trap (when value investors pick stocks trading at a discount, only to find that they look even more undervalued as the stock price falls). With this in mind, I used Morningstar CPMS to rank stocks in our U.S. database (today this universe consists of 2,182 companies) on the following factors:
- Price change from month-end three, six, nine and 12 months ago (here, higher values are preferred to find companies moving in the upward direction);
- Standard deviation of earnings over the past five years (a volatility metric that measures how consistent a company’s earnings are, lower figures preferred);
To qualify, companies must be trading at valuations (specifically price-to-earnings, price-to-sales and price-to-book) that are at or below the median of the industry group to which they belong. (A figure of 0.7, for example, implies that the company has a valuation 30 per cent lower than that of the industry group.) The industry groups as defined by Morningstar are shown in the table.
Additionally, stocks must have an average daily trading volume of greater than US$9-million a day (this figure eliminates the bottom one-third of stocks by daily trading volume in our universe).
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used Morningstar CPMS to back-test this strategy from December, 1993, to April, 2018. During this process, a maximum of 20 stocks were purchased and equally weighted with no more than four for each economic sector. Once a month, stocks were sold if their rank fell below the top half of the ranked universe, or if the stock price fell by more than 15 per cent over the trailing three, six, nine or 12 months. When sold, the positions were replaced with the highest ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 14.2 per cent while the S&P 500 Total Return Index rose 9.5 per cent.
The stocks that meet our requirements for purchase are listed in the table below. It is always recommended to speak to a financial adviser or investment professional before investing.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.