John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea, a premium Canadian stock screen service. Try it.
Don't chase hot stocks.
If you're a serious investor, you've probably heard this piece of wisdom hundreds of times. And generally it's good advice – but incomplete.
The full version should be: "Don't chase hot, expensive stocks."
The distinction is key. High-flying, overpriced stocks often lose steam and plummet to the ground. But high-flying inexpensive stocks can continue to fly high for some time – and they don't have as far to fall if their momentum wanes.
Used properly, momentum can be a big help in choosing which stocks to buy.
A great example of that is my Motley Fool-based strategy, which is inspired by an approach that Tom and David Gardner laid out in The Motley Fool Investment Guide.
The approach looks for stocks with good momentum – those that have outperformed at least 90 per cent of all stocks in the market over the past year (i.e., which have a relative strength of at least 90).
The key is making sure you aren't paying exorbitant prices for these high-momentum plays. My Fool-based strategy does so by using the price-earnings-to-growth ratio that mutual fund legend Peter Lynch made famous, targeting stocks with PEGs (P/E ratio divided by long-term growth rate) of about 0.5 or lower.
Since I started tracking the performance of various guru-based models more than nine years ago in the United States, my 10-stock Fool-based portfolio has been one of the top performers, gaining more than 13 per cent annualized during a period in which the S&P 500 has gained less than 4 per cent per year. My Canadian Fool-based portfolio, which I started tracking in August, 2010, has gained about 5 per cent annualized, while the S&P/TSX composite has returned less than half a per cent per year.
The Gardners aren't the only gurus to have used relative strength in their strategies. James O'Shaughnessy, another of the gurus upon whom I base my models, has made relative strength a key part of his growth-stock-picking approach – along with a key value component.
The model I base on his writings looks for stocks that have high relative strengths, but which also have price-to-sales ratios less than 1.5. Like my Fool-based portfolios, my O'Shaughnessy-based 10-stock portfolios have been very strong performers in both the U.S. and Canadian markets.
Last October I looked at some high-momentum, attractively valued Canadian stocks that got approval from my strategies. Since then the three picks have gained an average of 13.5 per cent through mid-August, while the S&P/TSX composite is down about 2 per cent over the same time period.
One of them was Metro Inc., which I've written about recently and which still gets strong marks from my O'Shaughnessy-based growth model. Here are a few others from the U.S. and Canadian markets that have both value and momentum on their side.
This Pennsylvania-based firm sells auto replacement parts and fasteners and products for the automotive aftermarket. It has a red-hot relative strength of 95, part of why it gets good marks from my Fool-based model.
The strategy also likes its high profit margins, its 25.7 per cent earnings-per-share growth rate in the most recent quarter, and its lack of any long-term debt. In addition, Dorman's shares trade at a reasonable 0.53 P/E-to-growth ratio, indicating it has more room to run.
Dorman also gets high marks from my Momentum Investor model. A few reasons: Its relative strength is high and has been increasing in recent months; its return on equity is 18.6 per cent; and it has raised its earnings per share in each year of the past half-decade.
Finally, my Lynch-based model likes the stock, thanks to its 34.4 per cent long-term EPS growth rate and its lack of any long-term debt.
Home Capital Group Inc.
Toronto-based Home Capital Group is the parent of Home Trust Company, a mortgage lender.
Home Capital Group gets high marks from a diverse group of my models. My Momentum Investor approach likes its relative strength, which is 94, as well as the 22.6 per cent growth rate in its earnings per share in the most recent quarter.
My Lynch- and Motley Fool-based models also like the stock, thanks in large part to its strong growth and 0.42 PEG. And my Warren Buffett-inspired value approach is impressed that the firm has hiked its earnings per share in each year of the past decade.
This Tennessee-based small-cap company runs more than 700 discount stores in the southeastern United States. It has a strong relative strength of 87, part of why my O'Shaughnessy-based growth model likes it.
Two more reasons: The firm's shares are cheap, trading for just 0.3 times trailing 12-month sales, and it has upped its earnings per share in each year of the past half-decade. Fred's also gets high marks from my Lynch-based model, thanks to its reasonable PEG and low debt.
Full disclosure: I own shares in Dorman.