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Hot stocks even a value investor can respect

What are we looking for?

Momentum stocks with value.

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This week, we've been looking at the many ways in which investors can use market "momentum."

Academic evidence suggests there's a surprisingly strong tendency for securities that have surged in price over the past few months to keep on going up, at least for another couple of months. Investors who simply buy hot stocks and hold onto them for a short time often do well.

There are, of course, caveats to this rather rudimentary approach. The market can suddenly reverse direction, sending you to a loss. And the big returns that exist in the academic literature often dwindle if you change your definition of momentum just a little bit - looking at price and volume changes over nine months instead of three months, for instance.

Still, investors should keep a close eye on momentum. If nothing else, a strongly rising price suggests that other people are growing convinced of a stock's virtues.

Aswath Damodaran, a professor of finance at the Stern School of Business at New York University, suggests in his book Investment Fables that one way to temper the high risk of a momentum strategy is to look for ways to eliminate the most troublesome stocks from your portfolio.

In keeping with that line of thought, we went looking for stocks that have had at least a 20-per-cent total return year-to-date, while also possessing price-to-earnings ratios below 18 and a dividend yield of 1 per cent or more. In other words, we searched for momentum stocks that value investors can respect.

What we found

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Only 16 stocks traded on the Toronto exchange met our criteria. They come from a wide variety of industries. So how does an investor begin to assess them?

That depends upon your approach to investing. Value investors will want to drill down into each individual stock to assess the strength of its underlying business.

Momentum investors will consider other factors. Prof. Damodaran suggests looking not only at price momentum, but also at trading volume (rising volume indicates positive momentum) and recent earnings surprises. Yet another factor to consider is analyst consensus - a momentum strategy is most effective when all analysts have similar forecasts for a company's earnings, and the company beats them.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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