Adding Relative Strength to Value

Recently, a reader made a comment on one of our articles about value stocks. The reader agreed that the stocks sounded like good investment opportunities but wondered when the stocks were likely to move. To answer that question, we need to look beyond value. Another investment tool, relative strength (RS), is better suited for that answer.

RS is a term used by technical analysts. It is a measure of comparative performance. In other words, RS answers the question of whether or not a stock or an ETF is outperforming the market. If the stock is beating the market, it is said to have high RS. A stock whose price action is lagging or underperforming the market is said to have low RS.

In the academic community, RS is called momentum, a subject that has been widely studied. The conclusion is that stocks with strong momentum tend to outperform the market. The studies measure momentum over periods of 3 to 12 months and found any time within that window works.

The chart below, from Dr. Kenneth French of Dartmouth College, is an example of the research. This chart shows the performance of small and big cap stocks segmented by momentum. “Small Hi” shows small cap stocks with high momentum. From 1927 to 1999, this group delivered the best gains.

Calculating momentum is fairly straightforward. For example, if a stock has outperformed the market over the past six months it is likely to outperform in the next six months. This won’t always work. But, in the long run, an investor should expect to beat the market by investing in high RS stocks.

The problem is these tend to be the stocks that decline the most in a market downturn. Momentum investors can experience large losses for extended periods of time. To minimize those risks, some analysts suggest combining value and momentum.

From Theory to Practice

We followed that approach in creating this week’s screen. We combined income, low price and RS. WE used the free screening tool at FinViz.com to find stocks with dividend yields of at least 3%, priced under $5 and a 52-week return of at least 30% which is a larger return than the S&P 500.

We included an income requirement to add to the potential returns of the strategy and to cushion the downside. Even if a bear market develops, dividends provide some level of return even as prices decline.

The stocks that passed, using the FinViz.com data, are:

  • Companhia Energética de Minas Gerais (NYSE: CIG) engages in the generation, transmission, distribution, and sale of electricity in Brazil. The company generates electricity through renewable energy sources. The company operates hydroelectric plants, thermoelectric plants, and solar plants with a total installed capacity of approximately 8,000 megawatts in 10 states of Brazil.. It is also involved in the telecommunications and energy solutions consulting businesses; exploitation of natural gas; sale and trading of electricity; and acquisition, transport, and distribution of gas and its subproducts and derivatives, as well as provision of technology systems and systems for operational management of public service concessions, including companies operating in electricity, gas, water and sewerage, and other utility companies.

 

  • Deswell Industries, Inc. (Nasdaq: DSWL) manufactures and sells injection-molded plastic parts and components; and assembles electronic products for original equipment manufacturers and contract manufacturers. The company produces plastic parts and components that are used in the manufacture of consumer and industrial products, which include plastic components of electronic entertainment products. Some of these products include, cases for flashlights, telephones, paging machines, projectors, and alarm clocks; toner cartridges and cases for photocopy and printer machines.

 

  • Institutional Financial Markets, Inc. (NYSE: IFMI) is a publicly owned investment manager focusing on separate client-focused fixed income portfolios. The company also manages funds and collateralized debt obligations for its clients. It invests in the fixed income and alternative investment markets across the globe. The firm’s fixed income investments include U.S. trust preferred securities, European hybrid capital securities, Asian commercial real estate debt, mortgage backed securities, and asset backed securities.

 

  • National American University Holdings, Inc. (Nasdaq: NAUH) owns and operates National American University (NAU) that provides postsecondary education services primarily for working adults and other non-traditional students in the United States. The company offers associate, bachelor’s, master’s, and doctoral degree and diploma programs in business-related disciplines, such as accounting, applied management, business administration, and information technology; and in healthcare-related disciplines, including nursing and healthcare management. The company also provides courseware development, technical support, and online class hosting services to various colleges, technical schools, and training institutions in the United States and Canada.

 

  • Taitron Components Incorporated (Nasdaq: TAIT) supplies original designed and manufactured (ODM) electronic components, and distribution of brand name electronic components. It distributes discrete semiconductors, commodity integrated circuits, optoelectronic devices, and passive components. The company also provides value-added engineering and turn-key services focusing on providing contract electronic manufacturers (CEMs) and original equipment manufacturers (OEMs) with ODM services for their turn-key projects. It serves other electronic distributors, CEMs, and OEMs in the United States, Mexico, Brazil, Taiwan, China, Canada, and internationally.

 

  • VOC Energy Trust (NYSE: VOC) acquires and holds a term net profits interest of the net proceeds from production and sale of the interests in oil and natural gas properties in the states of Kansas and Texas. The company has 80% term net profits interest of the net proceeds on the underlying properties. In 2016, its underlying properties had interests in 496.6 net producing wells and 55,851.6 net acres; and had proved reserves of approximately 3.2 million barrels of oil equivalent (MMBoe) attributable to the portion of the Kansas underlying properties, and approximately 5.1 MMBoe attributable to the Texas underlying properties.

Remember, There Are Risks

The fact that they all have high RS indicates they are likely to beat the market over the next year. However, these are also the types of stocks that can sell off sharply on bad news. The news could be a disappointing earnings report or even bad news within the stock’s sector.

The risk means it could be best to trade a basket of high RS stocks. With that strategy, a sell off in one stock will have less impact on the portfolio. The studies which demonstrate the success of momentum strategies are all based on the performance of a portfolio rather than just one individual stocks.

It’s also important to note some high RS stocks will be in pullbacks. This is the case with CIG.

Other high RS stocks will be in strong up trends. This is the case for DSWL.

Some investors are uncomfortable buying new highs and they may prefer to create a portfolio of high RS stocks in pullbacks. Other investors may decide it is better to buy new highs since those are stocks in confirmed up trends.

These charts illustrate the fact that even though RS is a quantitative tool, there is room to create a strategy that accommodates your risk profile. That is important to consider since you should only trade a strategy with a risk profile that is comfortable for you.

If you cannot accept the risk of any strategy, you are likely to give up on that strategy at the worst possible time, which is when the strategy is in a drawdown. With momentum strategies, you should expect the worst drawdowns to be larger than the decline in the S&P 500.

Despite the large drawdowns, in the long run, these strategies have been proven to work. You may find, as many others have, that momentum could be the key to unlocking short-term gains in a value strategy.