The supposed benefits of buying stocks low and selling them high is a lie, according to one investor. Momentum investing is the way to go and here's how to apply the model to yourself.
This article was originally published by Zacks.com.
Before you write me off as some kind of heretic, let me clear something up. I am actually a diehard value investor. And, yes, for a long time I bought into the allure of buying low and selling high as the road to investment success. However, after the early years of futility I found a better, more profitable path.
I am talking about an investing method that uncovers timely stocks experiencing phenomenal levels of momentum. Not just technical momentum. But earnings momentum as well, which is the main "cause" behind the "effect" of ever higher stock prices. And yes, in this method one can be diligent enough to apply value principles to avoid overpriced stocks.
Below I will share the virtues of this momentum model and how to apply it yourself. First, I want to explain to you…
Why "buy low, sell high" doesn't really work
In a perfect world scenario, the prudent value investor uncovers a healthy, growing company that has been neglected by other investors, leading to a ridiculously low valuation. He or she scoops up this stock for peanuts and then patiently waits for the rest of the world to see the error of their ways. After the stock price rockets higher, the investor sells out and seeks to "rinse and repeat" with the next value stock.
I admit that sounds great. And it can happen every now and then. But far too often the stock is not neglected. Its price is down for very good reasons, which will keep it down for a long time. Here are two of the most common reasons:
• Earnings outlook on the decline
Most investors have the false belief that year-over-year earnings growth is what moves stocks. In-depth research clearly shows this not to be the case. In fact, stocks with the highest growth rates actually have the lowest annual returns (and amazingly those with the lowest growth rates actually provide the best returns).
The reality is that beating earnings expectations is even more important. Meaning that a boring utility stock that grows at 4% a year versus a 3% estimate will crush the returns of a nano-tech stock whose earnings growth expectations slow from 40% to 30%.
• Insiders know what's wrong … but you don't
This is especially true on smaller stocks that have little or no analyst research coverage. So when investors analyze the stock they are mostly just reading company press releases and annual reports. To be honest, these are nothing more than marketing pieces filled with spin from the company to get you interested in the stock. Unfortunately, insiders and deep-pocketed professional investors know what's wrong with the company and why the share price is rightfully in the toilet.
(Hint: If a company has more than 10% of its shares shorted, then most likely the pros know there is trouble with the company and you should take that as a warning to stay far away.)
Momentum trading as easy as 1, 2, 3
OK. So if the age old value investing approach is a bust, then what does work? The answer is a potent combination of the 3 elements below:
1. Earnings Momentum
When companies are experiencing positive earnings momentum, it means that most everything is going right — i.e. they have a great management team, first-rate products and services, happy employees and delighted customers.
These aspects have a self-reinforcing quality that will keep the company headed in the right direction for an extended period of time. The result being a string of positive earnings reports well above expectations and a booming stock price. The best way to uncover earnings momentum is to find stocks enjoying large upward estimate revisions.
2. Technical Momentum
Isaac Newton had it right: "A body in motion tends to stay in motion."
So you should seek stocks whose share prices have been on the rise. Not just in the last few weeks, but over a longer stretch as well, so you know it's not a fluke. This greatly increases your chances that other investors are aware of the positive aspects of the stock … and likely to stay that way.
I know on the surface it sounds antithetical that these stocks could be on the rise and trading at a discount at the same time. But it happens quite often. Sometimes it's because their industry group is out of favor. Or that the stock has just had a round of profit taking that pushes down the price 10% to 20% and now is ready to make new highs.
In this method, we are not seeking deep value stocks with low odds of success. It's about finding momentum stocks trading at discounted prices. When you add it all up you get:
More timely trades + higher % success rate = handsome profits.
Read more about finding the best momentum stocks.
Steve is the Executive VP in charge of Zacks.com and all of its subscription services.