Momentum Investing Is Still Alive: 5 Stock Picks That Could Benefit

 | Jun 26, 2017 | 3:04 PM EDT
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On the face of it, the idea of momentum investing runs counter to the first commandment of investing: buy low, sell high. By definition, a momentum strategy requires riding the wave of a well-performing stock -- holding on to "winners" and selling "losers" -- a notion that the wise investor might interpret as a knee-jerk, emotional, "hot potato" reaction to market information. Couple that with the fact that momentum investing has shown disappointing returns over the past decade, and you might sour on the idea altogether.

But don't jump the momentum ship just yet.

Janet Brown is president of FundX Investment Group and editor of the firm's NoLoad FundX newsletter, which offers mutual fund recommendations to clients. In a recent Wall Street Journal article, Mark Hulbert (of Hulbert Financial Digest) reports that the momentum-geared funds recommended by the newsletter were the top earners for the 25 years through 2007, but have "since lagged behind the market by 3.1 annualized percentage points." However, periods of underperformance are a fact of life with most (if not all) investment strategies.

Over the long term, momentum has performed well. Hulbert cites Fama-French data showing that, from 1927 through March 31 of this year, "the top decile momentum portfolio beat the S&P 500 by 6.6 annualized percentage points (before transaction costs)." Brown's firm stands by the momentum approach, says Hulbert, and "doesn't believe the strategy has permanently lost its market-beating potential."

In a 2014 paper titled "Fact, Fiction and Momentum Investing," AQR's Cliff Asness and a group of his colleagues set about to debunk numerous "myths" concerning momentum investing, including those concerning its reliability as a direct factor, limitations due to trading costs, and the strategy's high turnover compared to other strategies. An excerpt of the paper's introduction reads as follows:

"Please note, of course, that we make no claim that momentum works all the time. In fact, of late (this year and the last few years), momentum as a strategy has had a more difficult time. Still, the fact is momentum is a risky variable factor (as they all are) with an impressive long-term average return that survives all the attack (myths) hurled against it."

One factor that could threaten the efficacy of a momentum strategy is a heavy inflow of funds, but this doesn't seem to be occurring. Hulbert's article cites findings by Yale University finance professor (and AQR principal) Tobias Moskowitz that showed no "overwhelming increase over the past couple of decades in the amount of money invested in the highest-momentum stocks," and that he has "seen no evidence that there has been any change in investor psychology that would call into question momentum's long-term potential."

Since 2003, I've been running a model portfolio on Validea that utilizes momentum, both at the stock and industry level. While this momentum model incorporates a host of other investment measures, it seeks out strong price performers by looking for stocks with a relative strength above 80 and also near-term price momentum by seeking out those issues that have outperformed the market over the last four months. In addition, the model rewards stocks in industries where there is price momentum across more than one stock, indicating that the overall industry has some wind at its back.

I run portfolios that are rebalanced monthly, quarterly and annually, and as you my suspect with a momentum-focused approach, more frequent portfolio rebalancing and review tends to lead to better performance. The Momentum portfolio (10-stock, rebalanced monthly) has returned 268.9% and has outperformed the market by 125.5%. In 2016, it returned 15.0% versus the S&P 500's 9.5% gain and, year-to-date, it has grown by 14.1% compared to 8.8% for the S&P.

Each of the stocks below passes the Momentum Investor model on Validea as well as other strategies I run, which are based on the stock-picking methods of legendary investors such as Peter Lynch, Joel Greenblatt and Warren Buffett.

Keep in mind, most of these are small-cap names and have exhibited exceptional price strength so you should only consider buying these in the context of a diversified portfolio and also understand these stocks may be quite volatile both to the up and downside.

1. Arista Networks, Inc. (ANET) is a supplier of cloud-networking solutions that use software innovations to address the needs of internet companies. The company earns a perfect score under our Validea Momentum investment strategy due to a more than doubling in earnings-per-share growth over the most recent quarter, and earnings growth over the past five years of 36.23% (anything above 25% is considered exceptional by this model). The recent share price of around $158 falls within 15% of its 52-week high, another positive sign.

The company is also favored by our Martin Zweig-based investment strategy due to the fact that revenue growth (50.98%) exceeds earnings growth (48.76%), a requirement of this screen. EPS has increased each year over the last five years, which adds appeal.

2. Heska Corporation (HSKA) sells veterinary diagnostic and specialty products, and earns high marks from our Momentum stock screening model based on its five-year average EPS growth of 28.86% as well as its price performance compared to the overall market, as evidenced by relative strength of 97 versus the minimum requirement of 80.

The company also scores well under our Motley Fool-inspired investment strategy, which likes its after-tax profit margin (trailing 12-month basis) of 11.27% compared to the minimum requirement of 7%. This screen also favors the company's debt-free balance sheet and the stable level of research & development spending, which allows it to maintain and improve products and technology.

3. Hudson Technologies Inc. (HDSN) is a small-cap refrigerant services company that earns high marks from our Motley Fool-based investment methodology due to its after-tax profit margin of 11.56% (based on trailing 12-month results), well above the minimum requirement of 7%. The stock's relative strength of 96 is considered favorable versus the minimum requirement of 90, and long-term debt is low compared to equity (0.11%).

Our Momentum stock screening model likes the average annual earnings growth over the last five years of 48.43%, nearly twice the best-case level of 25%.

4. Essent Group Ltd. (ESNT) is a private mortgage insurance company that earns a perfect score under our Momentum investment strategy due to most recent quarter-over-quarter EPS growth of 38.46%, more than double the minimum requirement of 18%. The recent share price of around $36 is within 15% of the 52-week high, another positive sign under this model, and return-on-equity of 18.6% exceeds the 17% minimum required to pass this screen.

The company also earns high marks from our John Neff-based investment methodology for its sales growth of 63.1% and positive free cash flow of $2.93 per share.

5. Paycom Software, Inc. (PAYC) is a provider of a cloud-based human capital management (HCM) software solutions that provide functionality and data analytics to manage the employment life cycle from recruitment to retirement. The company earns a perfect score under our Momentum investment strategy for its quarter-over-quarter growth in EPS of 37.50%, well above the minimum requirement of 18%.

The recent share price of about $72 falls within 15% of the 52-week high, a plus under this model. Return-on-equity of 38.4% is more than double the required minimum of 17%.

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