Using a Valuation and Momentum Strategy to Pick Interesting Stocks From Three Major Asian Indices

by: Value Expectations

Typically, long-term valuation is the main driver of stock performance, as shares of companies that are trading at a discount to their intrinsic values tend to go up over time (on the opposite end, shares of companies that are trading above their intrinsic values will migrate down over time). If we were to attempt to quantify this, it appears that aggregate stock movement can be explained by long-term valuation adjustments roughly 75% of the time. The remaining 25% are best identified as momentum markets, which simply implies that a short-term event has created an environment that makes investors less concerned with long-term value and more focused on short-term issues.

This shift in investor preference often leads to a move towards quality or “safe” stocks, and it is in these markets that we witness outperformance from a momentum-based strategy, which can be based on the momentum of price changes or earnings forecasts.

Due to its significant overall outperformance, we believe utilizing a trust-worthy valuation metric is of utmost importance in stock screening. The chart below highlights the performance of our valuation metric across the globe.

Table 1: International Valuation Performance: 12/31/1991 – 10/31/2009 (Percent to Target)

With that said, a simple valuation-only strategy can hinder the performance of your portfolio when momentum-driven markets are at play. Therefore, it is also important to consider the performance of momentum stocks. The chart below highlights the performance of our momentum metric across the globe.

Table 2: International Momentum Performance: 12/31/1991 – 10/31/2009 (EM Momentum)

Taking this one step further, we observed that over the long term, performance is significantly improved with the momentum overlay. In valuation periods, the overlay slightly lowered the outperformance when compared to the valuation-only strategy, but in momentum years, it significantly improved the performance. The table below highlights the performance when combining both the AFG valuation variable and EM Momentum variables.

Table 3: International Combination Performance: 12/31/1991 – 10/31/2009

We believe that a valuation framework is a tremendously effective starting point for your stock selection criteria. But because markets do not always act rationally with valuation in mind, it is important to protect your clients' assets in these periods of distress or uncertainty. Adding a momentum-based variable to your selection criteria not only improves the overall performance, based on our analysis, but also helps eliminate the underperformance for periods of time when valuation alone does not work as well.

Today we will implement this valuation plus EM Momentum strategy to pick stocks from the three main Asian indices (Nikkei 225, Hang Seng, Straits Times) that rank in the top half of both metrics. The chart below illustrates how each long and short strategy based on these two variables works across each country, with the three Asian markets highlighted.

The companies listed below all rank in the top half of valuation attractiveness and EM Momentum within their respective countries.

The data tables provided above highlight the benefit of a Valuation/Momentum hybrid strategy.