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Price momentum as a stock performance predictor is often scoffed at by fundamental value investors and "efficient market" academics. Momentum, they will tell you, has nothing to do with the fundamental factors that drive revenue, profit, and book value growth - the ultimate factors that determine the value of a business and, hence, the price of a stock. No less an authority than Warren Buffett has said that past prices are only good at predicting past returns! Many value investors even believe that the stocks that have been the most beaten down make the best investments because the stock price is logically closer to the bottom.

On the other hand, there are armies of technically-oriented traders that use nothing other than price charts to make investment decisions!

So, who is correct?

Believe it or not, there is pretty convincing research that price momentum *does* make a difference over a one-year investment horizon, the period targeted by Magic Formula Investing (MFI). The most convincing study can be found in James O'Shaughnessy's book What Works on Wall Street (Kindle version is under $6), in which the author back-tests a number of mechanical investing strategies over a 42-year period, re-balancing annually.

O'Shaughnessy's study confirmed some things that we already believe. Stocks with low valuations - low price/earnings ratios, low price/cash flow ratios, low price/book, and low price/sales - outperformed the S&P 500 over his sample period. The inverse (high p/e, p/b, etc.) all underperformed the market. Additionally, he found that stocks with high returns on equity (ROE) also trounced the S&P, giving further support to the MFI strategy, which focuses solely on high earnings yields (equivalent to low p/e) and high returns on capital (i.e., high ROE).

What was more surprising were his findings on price momentum, defined in the book as high trailing twelve month stock price appreciation. The stocks with the best price momentum greatly outperformed the market, although doing so with high volatility. On the other hand, buying the stocks with the worst price momentum was a sure path to disaster. It was the *worst* performing mechanical strategy, returning just 3.3% compound a year vs. the S&P's 11.51%.

The best strategies combined both value and momentum to deliver really excellent returns. All of the top 10 performing strategies used price momentum as a filtering component, and 4 of the top 6 combined price momentum with one of the value ratios listed above. Look at how adding price momentum influenced already good value screening strategies (compound annual returns, the S&P returned 11.51%):

  • Low price/sales: 15.54%. With high price momentum: 18.62% (this was the best performing screen).

  • Low price/book: 14.80%. With high price momentum: 17.95%.

  • Low price/earnings: 12.07%. With high price momentum: 18.52%.

  • High ROE: 12.52%. With high price momentum: 17.10%.

With these results in mind, perhaps price momentum is an important thing to consider when choosing Magic Formula stocks for your portfolio? Here are the 5 MFI stocks with the best trailing twelve month returns:

  1. Power-One (NASDAQ:PWER): 196.7%

  2. InterDigital (NASDAQ:IDCC): 87.3%

  3. GT Solar (SOLR): 78.9%

  4. Impax Labs (NASDAQ:IPXL): 75.0%

  5. SanDisk (NASDAQ:SNDK): 66.4%

On the other hand, here are the 5 MFI stocks with the *worst* price momentum:

  1. Strayer Education (NASDAQ:STRA): -45.3%

  2. Amedisys (NASDAQ:AMED): -41.4%

  3. H&R Block (NYSE:HRB): -38.7%

  4. China North East Petroleum (NYSE:NEP): -34.6%

  5. Argan (NYSE:AGX): -33.5%

In the short run, the price of a stock is determined by people, and people are more inclined to let emotion, not logic, dictate their decisions. Emotions run high for stocks that go up, and run low for stocks that have gone down. Momentum is important over short holding periods, and MagicDiligence uses it as a factor in choosing Top Buy picks.

Disclosure: Steve owns IDCC, SOLR, SNDK