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How to
Capitalize on Momentum
Momentum strategies
don’t get the attention they deserve.
Despite their heavy use
by hedge fund managers and other pros, TV pundits and other market sages
generally only refer to momentum strategies in a negative context. For
example, “the momentum crowd has driven the stock of XYZ
Company up to outrageously overvalued levels.”
This came to mind the
other day when I perused a note from Paul Rabbitt, president of Rabbitt
Analytics, and an admitted momentum practitioner.
Rabbitt’s note tallied
the performance of ‘strong buy’ rated stocks based on his “Q-Stock Rank,”
a momentum-based rating system.
According to Rabbitt,
since 1992, his ‘strong buy’ rated stocks returned 25 percent, on average,
annually, compared to 9 percent for the S&P 500.
Rabbitt’s data verifies
what I’ve observed on my own. Momentum strategies work, if you understand
how to apply them.
What is a momentum stock
picking strategy?
Momentum Defined
Details vary, of course, but all momentum strategies include three
basic requirements.
First, the stocks must
have already outperformed the overall market. Second, the underlying
companies must have exhibited strong historical earnings growth. Third,
analysts must be forecasting that the already strong earnings growth will
accelerate in future months.
Momentum players rely on
screening programs to find stocks meeting the criteria they’ve found works
best. Typically, these screens turn up long lists. For instance, Rabbitt’s
‘strong buy’ list contains 250 stocks.
That’s too many stocks
for most of us to buy. But, at least in my experience, momentum screens
produce great lists of candidates worthy of further in-depth research.
You can find Rabbitt’s
top-rated stocks, or see how your stocks rate, on his
rabbittanalytics.com site. You can try it free for three weeks, but
after that you’ll have to pay $349 per year. His Q-score ranks stocks on a
scale of 0 to 99, where higher is better. He rates stocks with Q-scores of
90 to 99 as ‘strong buys.’
If Rabbitt’s price is
too steep for you, I’ve devised a screen that you can run to find your own
momentum candidates.
Momentum Screen
To run it, you’ll need to use MSN Money’s free Deluxe Screener,
which is the only one I know of that offers the needed screening
parameters. Find it from MSN Money’s homepage
(moneycentral.msn.com) by selecting
Investing and then
Stock Screener
(left menu). If you’ve never used it, you’ll need to download free
software and you will probably spend one or two hours learning how to set
it up. However, in my view, it’s time well spent (In the interest of full
disclosure, you should know that I also write columns for MSN Money).
My screen searches for the three criteria common to all momentum
strategies: A strong price chart, rapid historical earnings growth,
and accelerating future earnings growth expectations. I’ll describe each
in detail. In instances where the terminology
might be confusing, I’ve included the label used by MSN to identify the
search criteria in parenthesis.
Strong Price Chart
A strong price chart means that a qualifying stock must have already
outperformed the overall market. Relative strength measures a stock’s
price performance over a specified timeframe compared to the overall
market. For example, a 12-month relative strength of 70 means a stock has
outperformed 70 percent of all stocks over the past 12 months.
MSN’s screener offers three relative strength search timeframes: 3-months,
6-months, and 12-months. Most momentum strategies require strong 12-month
relative strength, so I start by specifying a minimum 90 percent relative
strength over the past 12-months.
Then, to insure that the stock isn’t burning out, I set minimums for the
shorter available timeframes, but will less stringent requirements.
Specifically, I required three and six month relative strengths of 65 and
75, respectively.
Historical Earnings
Growth
Momentum strategies typically require strong earnings growth over the past
year, with that growth accelerating in the most recent quarter.
So I required at least
20 percent annual earnings growth for the latest fiscal year (EPS Growth
year vs. year), and 25 percent year-over-year growth for the most recent
quarter (EPS Growth qtr vs qtr).
Future Earnings
Growth
Continuing with the accelerating earnings growth theme, I specified that
analysts’ consensus forecast earnings growth for the current year (Current
year growth rate) must be at least 30 percent, which is higher than the 25
percent growth I required for the last quarter.
Also, and this is a key
momentum criterion, the analysts’ consensus earnings forecasts for the
current year must be higher than they were three-months ago. You can
stipulate that requirement by using the “Earnings Estimate Increased”
parameter (Advisor FYI menu) and specifying that the estimated earnings
must have increased during the last quarter.
My screen listed 29
momentum stock candidates. If that’s too many to analyze, sort the list
with the highest 12-month relative strength stocks at the top (click on
the column label) and focus on the stocks at the top of the list.
When I did that, the top
rated stocks were electrical wire manufacturer Encore Wire, fruit and
energy juice maker Hansen Natural, human resources outsourcer Administaff,
electronic manufacturing outsourcer Multi-Fineline Electronix, mine
equipment maker Joy Global, and medical clinical research outsourcer
Kendle International.
My screen is
rudimentary, and will probably not produce results comparable to Rabbitt’s
Q-Stock system. Further, as with all screens, consider the results as
research candidates, not a buy list.
published 3/19/06 |
