Credit: Shutterstock photoMomentum investing, or buying stocks that have been performing well based on the assumption that they will continue to do so, is counter-intuitive and often misunderstood because it resembles performance-chasing, an investing no-no.
In fact, however, investors subscribing to a momentum strategy are really capitalizing on the emotional and irrational reactions of performance chasers by systematically identifying and buying stocks that are on the rise. Momentum investors, while gravitating toward well-performing stocks, are doing so in; (1) a rule-based manner with entry and exit plans in place, and (2) with a view toward the short- and intermediate- term, rather than the long-term view of value investors.
The term momentum refers to the fact that investments that have performed tend to continue to perform well and vice versa. Data in the Fama-French database illustrate that the risk premium associated with the momentum strategy of investing leads to long-term outperformance:
Source: Larry Swedroe and Andrew Berkin
Like most investment strategies, the momentum approach doesn't work all the time and has its own set of challenges. If not executed well, it's high-turnover structure can end up being costly or lead to tax inefficiencies. The strategy can also be tricky since it attempts to benefit from the irrational behavior of other investors which, by its very nature, can also reverse quickly and leave a momentum investor holding the bag. For this reason, many investors use stops, or automatic sells that are triggered if a stock falls by a certain percentage.
On Validea, we run a stock screening model that combines the momentum approach (both at the stock and industry level) with a series of fundamental factors. By joining momentum with other quality, growth and ownership criteria, investors can find stocks that are exhibiting price strength and that are supported by the underlying business fundamentals. The optimal portfolio using the momentum model is a quarterly rebalanced, 20-stock strategy. Each quarter, the strategy is re-run and the top names come into the portfolio at that time while stocks that have fallen in score are removed. The portfolio has returned 304 percent over the last fourteen years (10.9% annually) compared to 129% for the S&P 500 (or 6.3% annually). In 2016, the portfolio returned 15.2 percent (versus 9.5 percent for the S&P 500). The portfolio's best year was in 2007, where the portfolio returned by 39% and the worst year was 2008, as you might expect, where the model fell by 44.3%. Historically, the model has generated an accuracy rating of 54%, meaning that out of the 20 positions held approximately 10.8 of them appreciate in price, on average, over time. Surprisingly, the Momentum portfolio carries a beta 0.98 using the daily returns.
At a summary level, the strategy look at the following measures to assess a stocks attractiveness.
Earnings-per-share represents an integral part of a momentum strategy, which looks for persistent year-over-year growth and both quarter-over-quarter and annual growth to be a minimum of 18%.
Share price is preferred to fall within 15% of the 52-week high, as this would indicate that the stock is potentially close to reaching a new high if trading volume were to climb to above-average levels. Relative strength (price performance compared with overall market) over the past year should be no less than 80, but preferably 90. To assess a stock's short term momentum, the model looks at the 4 month relative strength line and wants to see an uptrend compared to the overall market.
Leverage: This strategy prefers companies that have consistently reduced debt over the last 3 years or have debt-equity ratios of less than 2 (this criterion does not apply to financial firms).
Return-on-equity is required to be at least 17%.
Shares outstanding of under 30 million is preferable, as fewer shares leads to bigger price jumps when demand surges.
Insider ownership of at least 15% is preferred under this strategy because where there is strong insider ownership, management is more likely to act in the best interest of the company.
Industry appeal is considered adequate if at least one other company has a relative strength of above 80.
I have identified four stocks that score highly based on momentum-focused fundamentals. Keep in mind, these stocks have all exhibited very strong price increases over the past one year. Investing in momentum names like these can be rewarding but it doesn't go without risk.
Trinseo S.A. ( TSE ) is a materials company that produces synthetic rubber, latex and performance plastics. The company earns high marks under our momentum stock screen based on its quarter-over-quarter growth in earnings-per-share of 34.91% and average annual EPS growth over the past five years of 28.10% (compared to the minimum requirement of 18% for each). The stock's price performance compared to the greater market (relative strength) is considered exceptional at 95 (minimum requirement of 80). Leverage has steadily decreased over the last 3 years, and return-on-equity of 73.6% is more than four times the minimum requirement (17%).
Thor Industries ( THO ) manufactures a range of recreational vehicles in the United States to sell primarily in the United States and Canada. The company earns a perfect score under our James O'Shaughnessy-based investment strategy due to persistent growth in earnings-per-share and price-sales ratio of 1.06 (based on trailing 12-month sales) versus the maximum allowed of 1.5. Our Peter Lynch-based stock screening model likes THO's price-earnings as it relates to growth in earnings-per-share. This ratio, called the PEG ratio, is required to be less than 1.0. At 0.86, THO meets this criterion. Price-earnings ratio of 19.6 shows well against the maximum allowed by this model of 40. Leverage is favorable with a debt-equity ratio of 25.65%. Our momentum-focused stock screen likes THO's quarter-over-quarter EPS growth which, at 53.61%, is nearly triple the required level (18%). Current share price ($106.04) is very close to its 52-week high ($108.45), a plus under this model.
Ubiquiti Networks, Inc. ( UBNT ) develops performance networking technology for service providers and enterprises. The company earns a perfect score under our momentum stock screening model based on its 5-year average annual earnings growth which, at 114.88%, which is more than 4 times the optimal level of 25%. Quarter-over-quarter EPS growth of 40.98% easily meets the 18% minimum requirement, and share price performance is strong at a relative strength of 91. Return-on-equity of 50% and debt-equity of .37 add appeal.
Argan Inc. ( AGX ) , through its subsidiaries, provides engineering, construction, and operations management services as well as industrial fabrication and field services. It is favored by our momentum screening model due to its quarter-over-quarter earnings-per-share growth of 61.11%, which is more than triple the required minimum of 18%. Relative strength of 94 indicates strong price performance, and return-on-equity of 23.8% well exceeds the minimum requirement of 17%. AGX also earns high marks from our Joel Greenblatt-based stock screen in light of its earnings yield of 11.44% and return-on-total capital of 43.98%. The company's debt-free balance sheet adds appeal.
In conclusion, by combining a momentum factor with other fundamental criteria, an investor can identify solid stocks with price strength that is built on a solid foundation.
At the time of publication, John Reese and his clients were long TSE, THO, UBNT and AGX
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
