A Strategy Academia Discovered Really Works

Markets are efficient which means the current market price incorporates all available information and represents the true value of a stock. At least that’s what the Efficient Market Hypothesis (EMH) says. If the EMH is correct, there’s just no way to beat the market because the market price is correct and there cannot be any undervalued stocks when every stock is priced accurately. By now, you’ve probably identified some flaws with the EMH.

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  • One flaw is that some investment managers do consistently beat the market. The academic community has a ready-made answer to this. They point out that thousands, if not millions, of investors are trying to beat the market. Statistically, some of them will find success only by chance. So, Warren Buffett and other who beat the market year after year are nothing more than statistical anomalies according to adherents of the EMH.

    This brings us to another flaw of the EMH. Buffett and many other investors who consistently beat the market are value investors. If market prices reflect all available information, there’s no way value investing should consistently be able to beat the market in the long run. This problem doesn’t stump the academic community. They simply concede that value investing works as an anomaly to the EMH.

    An anomaly is defined simply as “something that deviates from what is standard, normal, or expected.” Researchers have found there are a number of anomalies to the EMH. All of these anomalies provide a way to maintain the theory for academics and each anomaly provides a potential path to profits for investors.

    The value anomaly is among the simplest to implement. This is also called the price-to-earnings ratio (P/E) effect although it works with any measure of value including the price-to-book (P/B) ratio or the price-to-sales (P/S) ratio. Over several decades, studies have shown that the risk-adjusted returns of the lowest P/E stock portfolios are as much as 7% per year larger than risk-adjusted returns of the highest P/E stock portfolios.

    Researchers have also demonstrated the size anomaly exists. This means small cap stocks tend to outperform large cap stocks by more than would be expected based on their higher volatility.

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  • While value and small cap stocks tend to outperform the market in the long run, these strategies are most useful for long-term investors. It can take years to achieve results with these strategies. Another anomaly, the momentum effect, can be more useful for short-term traders. Among academic researchers, momentum has been called the premier anomaly because it seems to work in all countries and with almost any type of asset.

    The momentum anomaly is the idea that stocks tend to trend for extended periods of time. Numerous studies have shown that stocks with strong past performance continue to outperform stocks with poor past performance. On average, the high momentum stocks seem to deliver an average excess return of about 1% per month.

    To benefit from momentum, we looked for cheap stocks with high relative strength. This week’s list includes five stocks.

    Cambium Learning Group, Inc. (Nasdaq: ABCD)is an educational solutions and services company that provides evidence-based solutions and expert professional services to empower educators and raise the achievement levels of students. ABCD is composed of four business units: Voyager Sopris Learning, Learning A–Z , ExploreLearning and Kurzweil Education Together. These business units provide gold-standard professional development and school-improvement services; breakthrough technology solutions for online learning and professional support. ABCD also offers literacy and learning solutions, including Kurzweil 3000+firefly that provides literacy support for students; and Kurzweil 1000, a scan and read software that makes printed or electronic text accessible to people who are blind or visually impaired. The ExploreLearning segment develops online solutions to enhance student learning in math and science. Its products include Gizmos, a library of online simulations for math and science in grades 3-12; and Reflex, an online system for math fact fluency development for grades 2-8.

    The stock chart shows investors recognized the potential in these businesses and pushed the stock price up. A recent consolidation appears to offer a buying opportunity.

    The company has turned profitable in the past twelve months and the stock price could break higher as profits continue.

    Zix Corporation (Nasdaq: ZIXI) provides email encryption, data loss prevention (DLP), and Bring-Your-Own-Device solutions to the healthcare, financial services, insurance, and government sectors in the United States. The company’s client base includes divisions of the U.S. Treasury, all U.S. Federal Financial Institutions Examination Council (FFIEC) regulators, the U.S. Securities and Exchange Commission, 30 percent of U.S. banks, over 1,200 U.S. hospitals and more than 30 Blue Cross Blue Shield organizations. ZIXI also offers ZixDLP, an email-specific data loss prevention solution that reduces deployment time from months to hours and minimizes impact on customer resources and workflow; and ZixOne, a mobile email app, which provides access to corporate email while never allowing that data to be persistently stored on the device where it is vulnerable to loss or theft. It sells its email encryption, DLP, and ZixOne services through a direct sales force, and a network of resellers and other distribution partners.

    ZIXI is more than 50% above it 2016 low but remains well below its all-time highs.

    The company is expected to report earnings per share (EPS) of $0.25 for 2016 and $0.28 for 2017. At 20 times earnings, a reasonable P/E ratio for a small growth company, the stock could be worth more than $5.60 a share.

    Two Harbors Investment Corp. (NYSE: TWO) operates as a real estate investment trust (REIT) that focuses on investing in, financing, and managing residential mortgage-backed securities (RMBS), residential mortgage loans, mortgage servicing rights, commercial real estate and other financial assets. The company’s target assets include agency RMBS collateralized by fixed rate mortgage loans, adjustable rate mortgage loans, hybrid mortgage loans, or derivatives; and non-agency RMBS collateralized by prime mortgage loans, Alt-A mortgage loans, pay-option ARM mortgage loans, and subprime mortgage loans. Its target assets also comprise prime nonconforming and credit sensitive residential mortgage loans; floating and fixed rate commercial real estate loans; CMBS collateralized by commercial real estate loans; and other assets, such as asset backed securities and certain non-hedging transactions.

    As a REIT, TWO is required to distribute substantially all of its earnings to investors. The stock currently yields about 11% and the current distribution is covered by expected earnings for the next two years. This indicates TWO is substantially undervalued.

    TransAlta Corporation (NYSE: TAC) is a non-regulated electricity generation and energy marketing company. TAC operates through Canadian Coal, U.S. Coal, Gas, Wind and Solar, Hydro, and Energy Marketing segments. It engages in generating and marketing electricity through various generation facilities. TAC has approximately $1.7 billion in annual revenue, more than $9 billion in assets, and power plants in Canada, the United States and Australia.

    The stock chart shows significant potential for TAC with a short-term price target more than 10% above the current price. The stock could gain more than 50% in the long run.

    TAC trades at about 90% of its book value. The long-term industry average P/B ratio for electric utilities is 1.6, indicating TAC is substantially undervalued.

    Pacific Mercantile Bancorp (Nasdaq: PMBC) provides a wide range of commercial banking services to businesses, business owners and business professionals through its combination of traditional banking offices and comprehensive, sophisticated electronic banking services. Pacific Mercantile Bank operates a total of eight banking offices in Southern California, located in Orange, Los Angeles, San Diego, and San Bernardino counties. PMBC offers deposit products that include noninterest-bearing and interest-bearing checking accounts, interest-bearing term deposit accounts, money market and savings deposits, and certificates of deposit. It also offers various loans, such as commercial loans and credit lines, accounts receivable and inventory financing, small business administration guaranteed business loans, owner-occupied commercial real estate loans, working capital lines of credit and asset based lending, growth capital loans, equipment financing, letters of credit, and corporate credit cards. In addition, the company provides cash and treasury management solutions, automated clearinghouse payment and wire solutions, fraud protection services, remote deposit capture services, courier services, and online banking services.

    PMBC is trading near the upper edge of a multiyear trading range.

    The company is expected to report earnings of $0.50 per share this year and its small size could make PMBC attractive as an acquisition.

    These five stocks provide investors with potential growth and income. The upside potential for the stocks is significant and research shows that investors shouldn’t be concerned that the stocks are trading significantly above their price of a year ago. Momentum stocks like these could be the biggest winners in the short term.

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