One of the great debates you will hear everywhere from the frenzied trading floors of Wall Street all the way to the quiet ivory towers of academia is that of value stocks versus momentum stocks. It’s actually a silly argument as both have tested by the quants and practiced by investors, and the simple truth is that they both work.
Cliff Asness of AQR Capital Management recently did a study and found that both worked and provided market-beating returns. Value stocks work over longer time frames and momentum stocks tend to outperform in the shorter 6- to 12-month time frames, so they tend to be negatively correlated. When momentum is winning, value lags the shorter-term strategy, and when value is winning the shorter-term approach lags value.
Investor who split their portfolios between these two approaches could actually outperform the market with a lot less volatility, according to the research.
Josef Lakonishok of LSV Asset Managemnt has found another way to combine value and growth. Rather then pair the two strategies, he chose to combines them. He looks for stocks that are undervalued based on things like price-to-book value, price-to-free-cash-flow and price-to-earnings. He then narrows that universe to find those stocks that are exhibiting price momentum that indicates investor’s perception of the company is changing and the share price may be headed towards the actual value of the company.
The approach works pretty well, as his firm was just named Lipper’s Best Small Equity Fund Group for 2014. It has outperformed the market 70% of the three month periods in the two decades since the firm was founded.
It’s a rather simple exercise to screen for some stocks that are undervalued and have started to show signs of price momentum over a sixth-month period. I ran a simple screen that looked for stocks that are trading below book value and have margin of safety in the balance sheet. I limited my search to just those cheap stocks that had low debt-to-equity ratios and current ratios of more than 2. I then simply ranked them by six-month return to identify those with positive short term momentum. I added a requirement for positive one month momentum as well to avoid those that might have peaked and lost momentum recently.
We got a pretty interesting — albeit short — list of stocks that are cheap, have safe balance sheets and have positive price momentum. It is a pretty diverse group of companies. Hecla Mining (HL) is a silver miner that trades at just 88% of book value with a current ratio of 2.2 and a debt to equity ratio of 0.38. Pericom Semiconductor (PSEM) makes semiconductors used in a wide variety of devices. The company has no debt, a current ratio of 6 and trades at 98% of book value. Transworld Entertainment (TWMC) has a chain of music and video stores, and it trades for just 70% of book value. TWMC also has no debt and a current ratio of 3.7. Renewable Energy Group (REGI) is in the biofuels business and trades at just 70% of book value well. The company has a current ratio of 3.6 and a debt-to-equity ratio of just 0.07.
Note: Most of these stocks are very thinly traded, so be sure to do thorough research before buying, and use stop losses and limit orders to protect your investments.
It has been proven that value and momentum work well on their own. According to the research form LSV Asset management, they work pretty well in combination, too, providing higher returns and lower overall portfolio risk. This is an idea worth additional consideration by most individual investors.
As of this writing, Tim Melvin was long PSEM and TWMC.