How to Find Stocks Ready to Breakout, and What This Indicator Says Now

Value investors are familiar with a problem most experienced investors have faced. Identifying value stocks to buy is relatively easy to do but the problem is that stocks can remain undervalued for extended periods of time, years in some cases. That means they buy an undervalued stock and then wait for it to move higher. Sometimes, they wait for months or even years before other investors discover their undervalued gem.

There are a number of ways to deal with this problem but one of the simplest could be to combine value investing with relative strength analysis. This is the approach taken by James O’Shaughnessy in his popular book, What Works on Wall Street.

Relative strength (RS) is an indicator that compares the performance of a stock to the performance of all other stocks. It is usually reported as a percentile value so that a stock with an RS rank of 70 would mean the stock is outperforming 70% of all other stocks. An RS rank of 90 would indicate the stock is performing better than 90% of all other stocks. Higher values are used to find buys.

RS strategies have been studied extensively and dozens of research papers have demonstrated these strategies outperform the market in the long run. The research has conclusively shown that stocks tend to move in trends for months at a time. If stocks are in an up trend, they will have a high RS rank and that indicates the trend is likely to continue for at least the next three to six months. When stocks are in down trends, they will have low RS readings and that indicates they are likely to lag the market for the next three to six months.

But, RS strategies can lose much more than the market averages on the downside. This is the biggest risk investors face when using the strategies. If they can accept the fact that losses will be large in bear markets, they can beat the market by wide margins in bull markets and usually, this makes up for the steep drawdowns.

O’Shaughnessy’s idea was to combine value and RS. His logic was that value stocks have often already suffered steep drops and they should have little downside left. That makes value a possible way to reduce risk. He then added RS to his strategy to find stocks that are moving higher and could deliver large returns.

Buying high RS stocks might be uncomfortable to some investors. These are stocks that have already been moving higher. Many investors prefer buying stocks near their lows. But, research shows a high RS strategy works in the long run.

For individual investors, finding RS has been a problem. The indicator is usually only available through expensive subscription services or it can be calculated with expensive software programs. It can be calculated in a spreadsheet using free data but the amount of work requires is extensive. There is a way investors can use RS for free.

Before describing how to implement an RS strategy at no cost, we need to review how RS is calculated.

There are dozens of ways to calculate this indicator but they all involve comparing the performance of an individual stocks with the performance of the stock market. Much of the variation in the calculation is in how the stock’s performance is calculated. Weighted moving averages (MAs) are popular.

An MA, or a simple MA, sums up all the day and then divides by the number of items that were summed. A 20-day MA, for example, adds up the last 20 closing prices and then divides by 20. In this calculation, each day’s close is equally weighted. A weighted MA assigns different weights to each data point used in the sum.

A front-weighted MA might count the most recent closing twice as much as the earlier data. A back-weighted average emphasizes the earlier data and underweights more recent data. There are pros and cons to each technique. Back testing shows the extra work associated with more complex calculations is usually not worth the effort. Over the long run, the simplest RS calculation works just as well as the most complex calculations.

The simplest calculation compares the price of today with an earlier price, usually the price three or six months ago. This is the rate of change (ROC) indicator. This calculation is completed for all stocks and the ROC is divided by a broad marker average like the S&P 500 index to form a ratio. Ratios above 1 indicate the stock performed better than average while ratios below 1 show the stock lagged the broad market. Stocks are then sorted by the ratio from highest to lowest and the highest stocks are considered buy candidates.

Mathematically, there is no reason to divide the ROC by the S&P 500. Since all of the calculations include the same denominator, this step can be eliminated. That means we can sort stocks by ROC and we will come up with the same order when ranked from high to low. This means sorting stocks by ROC will provide us with an RS ranking system.

Many free stock screeners provide the ability to complete this sort. At FinViz.com, for example, the ROC indicator is available as performance. The screen shot below shows one way to follow the strategy O’Shaughnessy found to be among the best long term performers.

In the screen above, we have restricted the list of stocks to consider to those in the S&P 500 index. This was done by selecting the S&P 500 from the Index pull-down menu and is highlighted in yellow. This limits our potential buys to the most liquid stocks and opens up the possibility of using options with this strategy. Instead of buying stocks, call options with an expiration date three to six months in the future could be used. (For those who aren’t familiar with options or if you are an options trader looking for new ideas, consider the Options Insider service.)

O’Shaughnessy cited the price-to-sales (P/S) ratio as one of the best performing fundamental indicators. In the screen above, we have followed his method and included only stocks with a P/S ratio less than one. This is a low reading for the indicator and indicates the stock is potentially undervalued based on its fundamentals.

We then sorted by performance over the past year, from highest to lowest. The five stocks at the top pf the list are:

  1. Quanta Services, Inc. (NYSE: PWR), a company that provides specialty contracting services to the electric power, and oil and gas industries in North America and internationally.
  1. Chesapeake Energy Corporation (NYSE: CHK), an oil and gas producer.
  1. Hewlett Packard Enterprise Company (NYSE: HPE), a computer services provider.
  1. Best Buy Co., Inc. (NYSE: BBY), the electronics and appliances retailer.
  1. Ryder System, Inc. (NYSE: R), a national trucking and logistics company.

These five companies could be expected to be among the stock market’s winners over the next six months. They are also a reasonably diversified group of stocks that could reduce risks of a market crash since they are all value stocks.

Using performance or the ROC indicator to identify potential buys is one way to implement an RS-based investment strategy. This technique offers high potential rewards but does carry a high level of risk. To reduce the risk, RS can be combined with value. This article described just one way to do that and with a stock screener, many individual investors should be able to find a strategy that incorporates their favorite fundamental indicators.