Playing the Odds – The Confluence of Value, Quality, Momentum and Timing

It is widely held that more than 80% of fund managers fail to outperform their benchmark. What is less known is that most private investors tend to also underperform. Stockopedia’s own Ed Croft recently announced at the UK Investor show that a study of 78,000 U.S. brokerage accounts revealed the average investors underperformed the market by 3.7%. This is not an isolated instance. The percentages differed but the same held for UK and Taiwanese investors. Croft covered a number of reasons for this but suggested results might be improved if investors focused on quality stocks having good value and momentum.

It was satisfying to finally have someone of influence validate the investment strategy I have held for some time. The importance of value was made evident to me early on by Ben Graham’s work, although I prefer The Intelligent Investor to the drier Security Analysis mentioned by Croft. I am a fan of Buffett’s quality with value investment method and have read most of the books written about Buffett and his way of investing.

The trouble with a value only approach is that these companies are a one-time affair with no staying power. Once they reach their fair value, there is no driving force to propel them higher, forcing investors to look elsewhere for further returns. This was Buffett’s take-home lesson from his time under Graham. Theoretically, adding quality to the mix should provide the engine for continued high returns. The problem with this approach is these companies can go unrecognized for a long time. In the interim, investors usually become disillusioned and turn elsewhere with little to show for their time and trouble. As an example, I have a list of three dozen companies meeting both value and quality metrics that have gone nowhere since 2014.

For more timely returns, it seems what is needed are companies in the limelight, capturing investor’s imaginations, that also have quality at good value. And so, we arrive at the concept of momentum. Momentum stocks are not a new idea. Momentum investors have been around since the early 1900’s. One of the most notable was Jesse Livermore. Back then they were called speculators, which is likely a more apt term for Livermore who had a knack for making and losing fortunes. Livermore would follow hot stocks but also bet against the market. Back in the panic of 1907 his short holdings were causing enough consternation in the market that J. P. Morgan, who was attempting to prop up Wall Street in an effort to stave off a panic, sent him a personal message in October requesting that he stop shorting the market. Livermore acquiesced pocketing $3 million, but could have made more. He was only 31 and only seven years older when he declared bankruptcy in 1914. Livermore’s short replay in 1929 was even more profitable making him $100 million ($1.1 billion in 2016 dollars). Livermore once again lost it all and filed for bankruptcy in 1934. That is a ride most investors would prefer not to emulate. Later on, Jack Dreyfus, the Lion of Wall Street, took on a similar mantra but with far more consistent long-term results. He later used the same investment methods in the Dreyfus funds he founded.

It is easy enough to set up stock screens that cull through all stocks for value and quality. Parameters like low PE’s, high return on equity, high earnings and sales growth certainly come to mind. What is more difficult, however, is getting at the momentum factor of the equation. For this post I have chosen the IBD 50, a weekly adjusted list by Investor’s Business Daily, since it attempts to identify top growth stocks meeting metrics like high relative strength. It also has the advantage of having an ETF associated with it, FFTY, which allows us to track its performance.

Momentum investing by itself does not insure success since such stocks tend to underperform when markets struggle. Comparing FFTY’s performance since inception to the S&P 500’s, as indicated by the chart below, shows this batch of momentum stocks underperformed the S&P 500 for much of 2015-2017. It was only recently that it began outperforming. Even then, FFTY underperformed the index during the downturn this past February as seen in the subsequent chart.

It would, therefore, seem there is room for improvement by considering stocks at the confluence of all three approaches: value, quality, and momentum. Those embarking on such an endeavor should be ready to compromise, however. When Croft applied six simple rules, two each for each approach, to the U.K. market, he only found four that meet his six criteria out of 2600 stocks listed in the London Stock Exchange. This leaves investors with two problems. One is stock concentration. While some of us do not mind a concentrated portfolio, this is not an option for most money managers. Second, inevitably these stocks tend to be obscure and undiscovered stocks, which places them in the small to mid-cap category. Investors with deep pockets, the real market movers, will therefore have a difficult time buying a large enough stake to move the needle without price distortion.

The main problem lies with value vs. momentum. Momentum stocks made that grade because their recent price increases outpaced the market. That is at loggerheads with value where low PE’s are preferred. A quick summary of FFTY indicates as much with an average PE of 41.1 and an average dividend yield of 0.16%. A quick check of this week’s IBD 50 membership found that only four companies (DQ, LGIH, MU, HCC) had PE’s lower than the 15 Croft suggested as limiting criteria. Of those, only Warrior Met Coal, Inc. (HCC) paid a dividend – Croft’s second criteria for value. Nevertheless, at 0.88% it paled in comparison to Croft’s 3% yield mark or the S&P 500’s 1.83%, hardly a hallmark of value. Then again, it is selling at 3.1 PE – the lowest PE for the group.

To follow up on the dividend criteria, 14 companies in today’s IBD 50 pay out dividends. Of those only three, Rexford Industrial Realty (REXR), Synovus Financial Corporation (SNV) and Viper Energy Partners LP (VNOM) have dividends that match or exceed the S&P 500’s. Of those, only VNOM exceeded Croft’s 3% mark. Actually, its 7.95% dividend yield is very attractive considering its other favorable characteristics (PEG 0.79, ROE 15.3%, DE 10.2%, 2 year average sales growth 61.5%, 2 year earnings growth 178%, 2 year average equity growth 38.7, 2 year average cash flow growth 55.2%). Yet, its PE ratio of 28.3 would have kept it out of Croft’s list.

Given the above, one would have to set a fairly low value bar to have any stocks to look at. Considering the S&P 500 is now selling at a 24.3 12-month trailing PE, perhaps a PE below 20 would be a good compromise. Unfortunately, when quality criteria are applied even that bar is not low enough for the IBD 50. For that reason, I have used a PEG ratio of 1.0 or less in this study when PE’s exceeded 20.

I tend to use higher quality criteria than Croft and for this study I used the following:

Return on Equity > 20%

2 Year Average Sales Growth > 20%

2 Year Average Earnings Growth > 20%

2 Year Average Growth on Equity > 15%

DE < 100%

It is a long list but having gone soft on value I wanted to make sure I was looking at truly good quality. The one point where I was more lenient than Croft was in the debt/equity ratio, DE. Some very capital dependent industries such as real estate, would have been totally excluded with more stringent criteria.

The above criteria were applied to members of the IBD 50 from November 24, 2017 and their six-month performance charted. Only four stocks met the criteria and these, along with key statistics are shown in the table below. None of them were perfect fits. Although cash flow growth is not one of the criteria used, it is still good to keep it in mind and LGI Homes (LGIH) had negative cash flow for each of the past three years. Lam Research (LRCX) had a PE of 22.1, above the mark. Yet, its PEG ratio was 0.45 and met all the other criteria, sometimes by a wide margin. MKS Instruments, Inc. (MKSI) saw earnings go down in 2016. As a result, its 2 year earnings growth rate is reported, rather than the 2 year average. SolarEdge Technologies, Inc.’s (SEDG) PE, even with its PEG, does not meet the criteria today, but back on November 24, 2017 its PE was 22.2 with a similar PEG so it would have squeezed in.

For those curious what the performance of the four stock composite would have been compared to FFTY from inception, the chart below provides the answer. It would have trounced it. That is not a fair comparison, however. These stocks were added to the IBD 50 because they had outpaced the market. Given FFTY’s failure to keep up with the market until August 2017, it makes sense the four stock composite should outperform. More to the point is how they fared once added to the IBD 50.

The subsequent chart shows the composite’s performance since the November 24, 2017 starting point. The composite has done marginally better than FFTY and the S&P 500 but that is mostly due to SEDG’s rise. Note the composite, after keeping pace with FFTY from November until late January, declined even further than FFTY in February.

It is noteworthy that two stocks in the composite, LRCX and MKSI, are no longer in the IBD 50, ostensibly because they were no longer performing to par. Still, the average of the two managed to outgain FFTY, albeit by a scant 0.4%. In principle, FFTY should have outperformed since it is a dynamic index, updated every week, where underperforming stocks are replaced by more promising ones. It is curious that FFTY underperformed for such a long time after inception and continues to underperform since the November 24, 2017 marker. It is almost as if, by the time the highflyers were added to the index they had run out of gas. It gives credence to another point Croft made in his presentation – investment press recommendation had a tad less than a 50% batting average.

At least for this time period and for this very small, statistically insignificant sample, it seems combining value, quality and momentum can marginally outperform the market. Is there a chance investors may do even better? Indeed, if they also take into account the timing of buys and sales. As the last chart shows, stock prices fluctuate, sometimes wildly. Nothing new there. But sometimes investors can’t help feeling wronged by a losing stock and they jettison them from their portfolio intent on never looking at them again. Yet, a true quality stock with continuing good fundamentals should eventually have its value recognized and outperform. It is just a matter of timing. Case in point, I have witnessed through the years that previous, quality IBD 50 members rejoin the list after a respite. The problem is when do we know when to sell an issue before it has an outsized decline and when is it safe to go back in and secure the bulk of gains?

To help with timing I use the Dive charts I introduced them in previous posts. Below are the one year Dive charts for each of the four stocks. Since these stocks had outstanding fundamentals throughout 2017 and I don’t have the exact date they were added to the index, I will use logical entry points within 2017 but prior to November 24.

What you need to look for in these charts are quiet regions near the baseline I call the Lower Channel. In the case of LGIH the chart breached the lower channel August 24, indicating a top was near and a drop imminent. The high that day was 45.15 so a 10% drop, the typical minimum drop, would have meant a 40.65 bottom. LGIH came close to that the next week at it dipped as low as 40.73 August 29. The chart would reach its stretching point (maximum depth) two days later. Aggressive investors may want to wade into a stock then for maximum profits but I prefer to wait until things settle down and the chart regains its lower channel. That took place September 11. You could have gone in the next day at 45. The chart breached the lower channel again October 2 warning a top was near again. You could have exited the next day at 49 for an 8.9% gain. After spiking down for a couple of days, the chart would regain its lower channel October 10. LGIH could have been purchased the next day, this time at 53. Things were pretty quiet until November 6, when the chart breached its lower channel again. The signal for an approaching top does not mean you sell right away. The market could continue up for days but you should be attentive. The market closed at 65.07 the next day. It would go as high as 66.13 but then dropped to 60.83. Getting out at 65 would have meant a 22.6% profit. There was a lot of turbulence in the chart from then until today with only a day or two spent here and there within the lower channel. This was an indication to stay away from the stock. The net tally would have been a 31.5% profit.

Early September 2017 to November 29, 2017 was a quiet period in the LRCX Dive chart. During that time the stock went from a 162.84 low to a close of 194.64. One could have easily bought at 165 on the first trading week in September. LRCX went as high as 219.7 on November 21. I follow William O’Neil’s trading rules and usually get out when a stock has dropped 8% from a high so that would have meant getting out at 202. That level was reached November 29 when the stock dropped nearly 9%. This was also a day when the Dive chart breached its lower channel indicating a drop was imminent. Sometimes lower channel breaches come after a top and serve as confirmation that a drop is near. The high that day was 211.87, indicating a drop to at least 190. LGIH would drop to 175.8 the next week. Getting out at 202 would have secured a 22.4% profit.

If LGIH’s ride from early November seemed rough, LRCX’s ride, according to its Dive chart, would have been veritably wild. The chart indicates no one should have been in the stock from November 29 on as LGIH’s Dive chart would not stabilize again for any period of time until May 8, 2018. It closed that day at 199.72. Going in at 201 the next day would have brought you to the close on May 11 with just a 0.2% gain for a net gain of 22.6%.

MKSI’s Dive chart was much quieter than the previous two but it did have an exclamation point – an ugly spike down November 21, 2017. Pundits at the time were clueless about the day that saw 9.56 million shares change hands, vs. a past month average of 504,000 shares, with little price movement to show for it. The stock closed down 0.33% that day. Like LGIH, MKSI had a whisper quiet late summer to November Dive chart. After a bout of selling during the summer into mid-August it regained its lower channel August 21. One could have bought in at 79 the next day. MKSI would not breach its lower channel until October 25, indicating a top was imminent. The high that day was 106.7 indicating a dip to as low as 96. One could have sold the couple of days later at 107 for a profit of 35.4% as the stock gave signs of struggling. It would top out at 110.6 October 31 and go down as low as 88.1 December 5.

MKSI’s chart would regain its lower channel December 18 and one could have bought the stock the next day at 98. The stock breached its lower channel again January 31, 2018 after which it went on a volatile ride along with the market. One could have sold during the next several days at 105 for a 7.1% profit. The stock would go as low as 94.5, just short of its predicted 93.2% drop from the January 31 high. MKSI’s chart did not settle down until February 23, at which time it regained its lower channel. Going in the next day at 113 may have kept you in the stock until March 27 when the stock breached its lower channel again. I write “may” because MKSI had reached a top of 128.28 two weeks earlier and an 8% drop would have meant a 118 exit. That level was reached the day before. Investors could have still exited at that price March 27 for a 4.4% gain. The high that day was 122.6 so a 110 bottom was on tap. MKSI would actually dip to 99.11 April 25. Its Dive chart would not regain its lower channel until May 7. One could have bought MKSI at 110 the next day and closed May 11 with a 3.4% profit for a net 50.3% profit.

It would seem SEDG, with its large profit for the period, should have been an easy trade. One just buys and holds. However, without the benefit of hindsight the SEDG trade was the most difficult of the four and not at all a smooth ride to the top. The problem was there were many tradable moments, which are time consuming and can become exhausting. It goes to show how difficult cashing in on big winners can be.

SEDG’s Dive chart was deceptive, just a little busier than MKSI’s at first glance. They both had a quiet spot by the time mid-August rolled around. It regained its lower channel August 18 after a mild bout with volatility. One could have purchased SEDG the next trading day at 26.5. There were two minor, sharp dives in the chart where, had you sold, it would have been a wash. These took place September 12 and 27. Buyers could have gotten in both occasions at the same price exit price.

The chart breached its lower channel again November 8 and had a stretching point November 9. Here is where the math behind the charts becomes important. Volatility and volume are large components. If there is a big jump in price and volume, as took place on both days, the combination will overwhelm contributions from the other components. In effect, you get a false dive. Being aware of this, one would not have been concerned with the dive signal but would have remained vigilant for developments. SEDG would top out at 39.9 November 24. A dip to 36.7 would have been an 8% drop from a high and an exit point. That took place November 29 when one could have sold at 36.5 for a 37.7% gain. Two days earlier the Dive chart had once again breached its lower channel. With a high that day of 39.45 a drop to at least 35 was predicted. The stock would drop as low as 32.9 December 1.

The stock would regain its lower channel and go into a quiet period December 18. One could have gone in the next day at 39 but would have been given a heads-up January 2 when the Dive chart breached its lower channel again. One could have gotten out the next day at 39 before the stock lunged to 30.8 February 9. Then the fireworks began again. Just as before, there was a false dive, a huge one, when the stock gapped up in four times its usual volume. Rather than an exit signal, an astute investor would have taken it as a jump in signal. SEDG could have been bought at 46 that or the next day and ridden until the next signal April 10 exiting at 55 for a 19.6% gain. Thereafter, they could have come back in at 53 when SEDG once again regained its lower channel just in time to see it jump up on May 10 and close out May 11 with a 21.3% gain. The net profit would have been 78.6%.

Note all profits are net not compounded. If the latter were the case, profits would have been 33.5%, 22.6%, 56.5%, and 99.8% for LGIH, LRCX, MKSI, and SEDG, respetively. As it was, the average net profits of 45.8% more than doubled FFTY's gains of 18.3% for the period August 18, 2017 to May 11, 2018.

#stockmarket #LearninghowtoInvest #TechnicalAnalysis #ValueStocks #QualityStocks #MomentumStocks

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