The Holy Grail of Investing

06/05/2013 9:00 am EST

Focus: STRATEGIES

James Fink

Editor, Jim Fink's Options for Income and Stocks to Watch

Here's a time-proven formula that combines two different strategies for longer-term success, says Jim Fink of Investing Daily.

Small-cap stocks are arguably more vulnerable to economic recessions (due to fewer financial resources to weather bad times), and low-valuation stocks arguably sport low valuations because their businesses are distressed and thus at risk of never recovering to full health.

Advocates of market efficiency argue that these added risks cause stock prices of these companies to sell at a discount, and subsequently generate abnormally large returns if the companies end up succeeding.

On the other hand, advocates of market inefficiency argue that small-cap and value stocks outperform for irrational behavioral finance reasons, rather than the rational discounting of increased risk. Specifically, small-cap stocks are underfollowed and ignored by Wall Street because they earn their money from advising large institutional investors that focus on large companies.

Value stocks that aren't troubled, but simply slow growers, are similarly ignored unjustly. It's the essence of human emotion to sell stocks until their market prices are pushed below intrinsic value and buy stocks until their market prices are pushed above intrinsic value. Shrewd investors then swoop in to take advantage of these stock-price inefficiencies by buying negative-momentum value stocks and selling positive-momentum stocks.

Momentum can be exploited in two completely opposite ways. Value investors profit if they successfully bet that the momentum has gone too far and will reverse direction, whereas momentum investors profit if they successfully bet that the momentum will continue in the same direction.

Momentum by its very nature continues in the short term and reverses in the long term. A rubber band can stretch very far, but it eventually snaps back.

The holy grail of investing involves finding investments that individually produce strong returns over time, but that also have a negative correlation with each other that reduces or eliminates downside volatility of the portfolio as a whole and smoothes out returns. That benefits from momentum both ways—as a short-term continuation trade and as a long-term reversal trade.

In a 2012 paper, hedge-fund manager Clifford Asness of AQR Capital studied value (low price to book value) and momentum (12-month price appreciation) characteristics in the stock markets of eight different countries.

They found that both significantly outperform everywhere in the world (except that momentum doesn't work in Japan). Asness found that a value portfolio rebalanced annually and a momentum portfolio rebalanced monthly both outperformed the overall stock market, with momentum's outperformance almost double value's outperformance.

But what was truly amazing is that a 50-50 combination portfolio of both strategies performed best of all, by almost double the momentum strategy's outperformance! The reason is the negative (i.e. good) correlation of -0.65 (best possible is -1.00), which makes sense, because momentum works when price continues in the same direction and value works when price reverses.

Fortunately, there is another measure of momentum that offers robust outperformance, and yet is much more long-lasting and doesn't require monthly rebalancing to work. Author James O'Shaughnessy formulated a stock screen called "Trending Value" that filters stocks in two stages:

  • Screening for value stocks based on a composite of six different low-valuation criteria (e.g., price-to-earnings, price-to-sales, price-to-free cash flow)
  • Selecting the value stocks with the highest six-month price momentum

Stocks that exhibit both value and momentum characteristics are probably much more stable and suffer less downside volatility than pure value and pure momentum stocks, so one could argue that the Asness stocks need the negative correlation effect much more than O'Shaughnessy's stocks would.

Bottom line: A small-cap equity portfolio composed of 50% value stocks and 50% momentum stocks, based on 52-week highs, may turn out to be the holy grail of stock investing.

Read more from Investing Daily here...

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