Value Investing vs. Momentum Investing: Where Do You Stand?

by: Bill Gunderson

As a professional money manager and stock market radio talk-show host over the last 18 years, it has always been interesting to observe the value vs. momentum debate that takes place in the market. Most of us, whether we are professional investors or individual investors, usually align ourselves with one camp or the other.

Value investors can often times be seen wearing bow-ties or inexpensive suits, and talking at length about stocks trading below their intrinsic value. Value investors probably drive cars that get good mileage and are not afraid to use coupons at the local diner.

Most so-called value investors would recognize the late Benjamin Graham as the "father of value investing." Benjamin Graham was a U.S. economist, professional investor, and professor at the Columbia Business School. Graham also co-wrote the book Security Analysis, which is considered by many to be the bible for serious value investors.

Graham, also wrote the book The Intelligent Investor, which Warren Buffett called the best book about investing ever written. Buffett also called Graham the second most influential person in his life, right behind his father. It should also be noted that Warren Buffett named his son Howard Graham Buffett.

Value investors generally search out stocks with low valuation ratios. Another well-known, present day value investor is David Dreman. In his book, Contrarian Investment Strategies, Dreman did extensive studies that showed over the long haul, stocks with valuation ratios in the bottom quintile far outperformed stocks in the upper valuation ranges.

In other words, his studies showed that the stocks with lowest PE ratios, lowest price to book value ratios, and lowest price to cash flow ratios far outperformed those with highest ratios by a wide margin.

In his book What Works on Wall Street, another well known value investor, James O"Shaugnessy showed that stocks with the lowest price to sales ratios were the best investments over the long haul.

Without a doubt, there is much to be said about true "value disciples" who have racked up some very impressive results over the years. Warren Buffett did not become the richest man in the world by "paying up" for stocks.

Having said this, I have found many flaws in value investing. Many value investors got "their clocks cleaned" during the 2008 financial crisis. A lot of the so-called value stocks at that time were stocks from the financial sector, which absolutely got clobbered that year.

Value investors basically cast a blind eye on performance or momentum. More on value investing later in this article.

Momentum investors, on the other hand, tend to be a little bit more flamboyant. Fast cars, sushi bars and Tommy Bahama are more their style. Instead of Barron's, and Forbes, they read Investors Business Daily. Instead of buying low and selling high, momentum investors buy high and hopefully sell much higher.

Richard Driehaus is widely considered as the "father of momentum investing." William J. O'Neil has also done much to advance the cause of momentum investing with his newspaper, Investor's Business Daily and with his books on investing.

Momentum investing is all about performance, strong technical patterns, and relative strength. O'Neil coined the term "CANSLIM" to sum up the characteristics that he likes to see in a stock:

"C" stands for outstanding current or quarterly earnings comparisons, many times 100% or better.

"A" stands for outstanding annual earning growth, usually in the range of 25% or better. CSCO just does not cut it any more.

"N" stand for something new like a new product, new management, or new high. Sorry Research In Motion (RIMM).

"S" stand for a limited amount of shares outstanding and for those shares available to be in heavy demand. GE would have a hard time making the cut here.

"L" stands for the stock being a leader in their sector or in the market.

"I" stands for heavy institutional ownership. The theory is that it takes heavy institutional demand to drive stock prices higher.

"M" stands for market. Without the cooperation of the market all of the above basically go out the window.

Momentum investing basically closes a blind eye to value. For this reason, momentum investors got killed during the 2000-2002 thrashing that the Nasdaq took. At the Nasdaq peak of April 2000, I remember many, many stocks trading at PE ratios of 100-300 or above. The Nasdaq was at a gaudy 5,300 at that time and now here we are 11 years later and we a little above 2,800.

It has been my observation over the last 18 years in the business that both value and momentum investing have their strong points and their shortcomings. Many times, low PE stocks are nothing more than value traps.

Looking at some of the low forward PE stocks of today, I see a lot of bad stocks:

Microsoft (NASDAQ:MSFT) - 9.4
J P Morgan (NYSE:JPM) - 7.4
Pfizer (NYSE:PFE) - 9.1
Citigroup (NYSE:C) - 8.1
Bank of America (NYSE:BAC) - 6.6
Merck (NYSE:MRK) - 9.3
Cisco (NASDAQ:CSCO) - 9.3
Goldman Sachs (NYSE:GS) - 7.4
UBS (NYSE:UBS) - 7.3
Deutsche Bank (NYSE:DB) - 6.6
AIG (NYSE:AIG) - 9.3
General Motors - 6.3

Why do I call them bad stocks? These are some of the absolute worst performers in the market. Investors have fared very poorly with them for the last decade.

Here is their respective average annual returns over the last ten years:

Microsoft -(0.4%)
J P Morgan +2.2%
Pfizer -(3.0%)
Citigroup -(19.5%)
Bank of America -(6.3%)
Merck -(0.5%)
Cisco -(1.0%)
Goldman Sach +5.9%
U B S (-2.0%)
Deutsche Bank (-0.7)
A I G (-21.6%)
General Motors (Starting over!)

Yecch, what a lousy bunch of stocks! If I hear one more so-called analyst on CNBC recommend Cisco, I am going to puke. Oh, I know, the market has basically gone sideways for the last 10 years, but many stocks have excelled during that same period of time. More on this later.

As I stated earlier, I have observed shortcomings in value investing over the years. It is my opinion that many of them deserve to be trading at the low multiples that they currently garner.

It has also been my observation that momentum investing has its flaws. I was there in 2000 when the high-priced momentum darlings got crushed. We found out then that value does matter. Home buyers that were chasing single family homes in 2006 also found out that value does matter, as it may take years for home prices to get back to their 2006 peak.

As I look at some of the highest forward PE stocks at the current time, I can't help but flashback to the year 2000:

Netsuite (NYSE:N) (136)
Lululemon (NASDAQ:LULU) (85.6)
Clean Energy Fuels (NASDAQ:CLNE) (83.2) (NYSE:CRM) (79.9)
Sinacorp (NASDAQ:SINA) (59.4)
China Eastern Airlines (NYSE:CEA) (58.3) (NASDAQ:AMZN) (54.8)
Open Table (NASDAQ:OPEN) (49.1)

These are some very high multiples and they must have fantastic growth to justify such high valuations.

Again, I find big faults with both value and momentum investing.

What is wrong with combining the best attributes of value investing and the best attributes of momentum investing?

What is wrong with buying stocks that still make sense from a value perspective that also are some of the top performers in the market today? Is this possible?

I have developed my own grading system, called the Gunderson Grading System. It assigns a letter grade to 2,700 stocks in the market.

In order for a stock to achieve a Gunderson Grade of "A," it must possess the following attributes:

It must have superior short-term, intermediate-term, and where possible long-term performance on a relative basis against the other 2,700 stock in the market.

It must have a five-year target price that still offers substantial five year upside potential (usually 80% or more).

In determining five-year target prices, I use a very common five-year valuation formula that I used in my days as a securities analyst for many years. The valuation formula begins with next year's consensus EPS estimate (I used to calculate my own on stocks that I followed). Next year's consensus EPS estimate is readily available from many sources. I use Yahoo's website.

I next apply the consensus analyst five-year growth estimate. For an analyst, this growth estimate generally comes from talking with management or by doing your own research on potential market share penetration and the overall size of that market. The five-year consensus growth rate is also readily available from many websites. Here again, I use Yahoo.

I then extrapolate next year's EPS estimate by the five-year growth rate and come up with an EPS estimate for five years down the road. Here is an example of what I mean: Let's assume that stock ABC has a consensus next year EPS estimate of $1.00. Let's also assume that the consensus five-year growth rate from the analyst community is 10%. If everything goes as projected, the earnings over the next five years would look like this:

2015= $1.33

In other words, if the company meets next years EPS estimate of $1.00 per share and it does indeed grow at the consensus five-year growth rate of 10% per year, the company would be making $1.46 five years from now.

Now comes the hard part. As a stock analyst, I have to apply a multiple that I think the stock will deserve five years down the road. Another way of saying this would be: "what PE ratio do I think that the stock will be trading at five years from now?"

I wish that there was an easy formula to apply here, but the experience that I have gained by having studied stocks over the last 20 years is invaluable. Nevertheless, here are some tips. A market multiple is generally in the 15 area. This is a good starting point. A superior growth stock can trade at much higher than market multiples however. Consider Netflix (NASDAQ:NFLX) or Baidu (NASDAQ:BIDU). Netflix currently has a PE ratio of 77, while Baidu has a PE ratio of 79. Also consider, however, that Netflix has been growing its earnings at a 41% clip over the last five years, while Baidu has been growing its earnings by a whopping 93% per year over the last five years.

By comparison, Cisco has been growing its earnings by a very tepid 7% per year over the last five years, while Microsoft checks in at just 13%. No wonder these stocks are trading at such low PE ratios currently. The growth has slowed to a crawl.

Various sectors in the market also trade at different multiples. Technology stocks generally trade at much higher multiples than deep cyclicals. Consumer stocks tend to trade at very close to market multiples, while commodity related stocks tend to trade in the low teens. One can also look at a multiple history or average PE ratio of a stock over the last many years for guidance. This information is also readily available from a variety of sources. Lastly, a look at the current forward PE of a stock, as it can also be a good clue at what multiple a stock deserves.

Once I have the five years from now EPS estimate, I multiply it by the multiple that I think is appropriate for the stock. Let's go back to our $1.46 example. Let's assume that I deem a multiple of 20X to be appropriate for the stock. The stock would therefore have a five year target price of $29.20.

I would only be interested in buying the stock at less than $15 or so. I like to have as close to 100% upside potential over the next five years as possible. The upside potential goes into determining my value grade.

Lastly, I look at how well the stock held up in the year 2008 when the market was under its own stress test. I calculate a safety grade for the stock. I then take into account the short-term performance grade, the intermediate term performance grade, the long term performance grade, the valuation grade, and the safety grade. I also apply a proprietary weighting to each of these grades to come up with an overall Gunderson Grade.

I have been using this grading system for the last several years and could not be happier with the results. I find that "A" rated stocks can remain at the top of the heap for a long time. If their grade starts falling, it may be time to move on. I also find that the grades are a reflection of the current economy. I call my "A" rated stocks the Best Stocks Now. I have also developed a smart phone app and written a book by the same name.

Here are some examples of A rated stocks at the current time:

Green Mountain Coffee (NASDAQ:GMCR) - This stock has more than doubled since I bought it. I still have a five-year target price of $175 and the stock has returned an amazing 97.9% average over the last five years and it is still hitting new highs. Without question, it is still a stock of today.

Ezcorp Inc. (NASDAQ:EZPW) - There are currently three red-hot pawnshop stocks and EZPW is one of them. In my opinion, this is a reflection on our current economy. I have a five-year target price on EZPW of $68 and the stock has averaged an amazing 47.0% return over the last 10 years.

Tractor Supply (NASDAQ:TSCO) - I had the CEO, Jim Wright, on my radio show a several weeks ago, and I can see why this stock has been such an amazing performer. The stock has averaged an amazing 42.4% over the last 10 years and still has roughly 95% upside potential, according to my calculations, over the next five years.

Carbo Ceramics (NYSE:CRR) - With all of the "fracking" going on across the U.S., it is no surprise that CRR is such a good stock right now. I still calculate almost 90% upside potential over the next five years and the stock has delivered an average return of 22.1% over the last 10 years to its investors.

First Cash Financial (NASDAQ:FCFS) - Another pawn shop stock that is running wild right now. Forward PE ratio is just 16.1 and I calculate upside potential of 93% over the next five years. The stocks returned an average of 34% to its investors over the last 10 years.

These are just five examples of stocks that have grades of "A" right now. At any given time roughly 8%-10% or about 200 stocks meet my stringent criteria.

I will write more articles from time to time on stocks that currently have "A" grades in the future.

What are you? A value investor or a momentum investor?

I like them both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.