Combining Value and Momentum
Kevin Truitt illustrates how investors can benefit by combining traditional value and price momentum filters in his July 2013 AAII Journal article “Investing’s Odd Couple: Value and Momentum.” Research cited by Truitt highlights fundamental and technical factors that can be combined to help avoid both value traps and overvalued momentum stocks. It is possible to combine growth and value approaches with good track records into a combined approach with high expected return, but even lower expected volatility. Growth and value approaches tend to shine in different market environments, providing diversification benefits.
This issue’s First Cut applies the key factors highlighted in the article using AAII’s stock screening and fundamental database, Stock Investor Pro.
The starting universe of 4,953 stocks consisted of exchange-listed companies. The First Cut first looked for companies with price-earnings ratios (price divided by trailing 12-month earnings per share) lower than the median industry ratio in which the company is classified. This type of relative comparison adjusts automatically to industry prospects and overall market conditions. The First Cut then filtered for companies with a PEG ratio (price-earnings ratio divided by five-year historical growth rate) to be either below the industry median or below 1.0. The screen’s final fundamental test required that the ratio of enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization) be 10 or smaller. Enterprise value is calculated by adding market capitalization, preferred stock and total debt, and reducing this sum by the amount of cash held by the firm. The enterprise value to EBITDA ratio relates a firm’s takeover cost to its earnings potential. The lower the ratio, the more attractive the firm. A total of 362 exchange-listed stocks passed all of the value filters.
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