Big Mo' And Your Portfolio

For a dyed-in-the-wool value investor, the idea of buying a red-hot stock is probably anathema. After all, value investors try to buy stocks that are cheap compared to business fundamentals like earnings, sales and book value. They get excited when a stock of a good company is falling in price, because it means that, all things being equal, they can get a better deal. In fact, John Neff—one of the most successful value investors of all- time—said scouring the financial pages for stocks making new 52-week lows was one way he found investment ideas.

But remember, "cheap" and "falling" are two separate concepts (just as "expensive" and "rising" are). Sometimes a stock is so cheap that it can go on a tear and still be undervalued. Other times, a firm's business will excel as the shares surge, and earnings, sales and/or book values keep up with (or outpace) the stock's price gain. That keeps valuations low.

In those situations, having strong momentum behind a stock isn't a negative—it's actually an added boost. Some of history's best stock-pickers have found that stocks with strong momentum are often good bets to continue rising —if they're still attractively valued. While buying a hot stock with an exorbitant valuation can be the equivalent of jumping on a rocket ship that's almost out of gas and is about to plummet back to Earth, buying a hot stock that's still cheap is like jumping on a ship that has plenty of fuel left in the tank.

So, while commentators often try to play them off as opposites, momentum and value can—and do— peacefully coexist. Several of my Guru Strategies (each of which is inspired by a different investing great) use both momentum and value metrics in choosing stocks. For example, the growth model I base on the writings of James O'Shaughnessy (whose study of quantitative investing approaches may be the most extensive ever performed) looks for stocks that have market capitalizations of at least $150 million; increased earnings per share in each year of the past half-decade; and price/sales ratios under 1.5. It then takes all stocks that pass those tests and ranks them by their 12-year relative strength—a measure of how they've performed compared to all stocks in the market over the last year. Those with the highest relative strengths are then chosen.

My Motley Fool-inspired model, meanwhile, has an even tougher momentum criterion. It targets stocks with 12-month relative strengths of at least 90, meaning that they have outperformed at least 90% of all other stocks over that period. The Fool strategy (which is based on an approach laid out by Fool co-creators Tom and David Gardner) also uses a key valuation criterion: the PE-to-growth ratio, which mutual fund legend Peter Lynch pioneered. The "PEG" divides a firm's price/ earnings ratio by its historical earnings growth rate; the Fool-based model looks for PEGs of 0.6 or below. This strategy has been my top US performer over the long haul—a 10-stock portfolio picked using the approach has averaged annualized returns of 16.4% since its mid2003 inception. Over the same stretch, the S&P 500 has returned 6.6% annualized.

A third strategy that uses momentum is my (aptly named) Momentum Investor approach, which targets stocks that have 12-month relative strengths of at least 80. It also looks for strong earnings growth in both the most recent quarter and the long term, a high return on equity, and a low or declining debt/equity ratio. While this strategy does not include a valuation metric, many of its holdings tend to be reasonably priced. And it's been my best performer in Canada -- since I started tracking it in August 2010, a 10-stock portfolio picked using the approach has posted annualized returns of 18.5%, compared to just 5.7% for the S&P/TSX Composite.

So, what stocks currently have the key combination of momentum and value? Here is a look at four Canadian stocks and four US stocks that currently fit the bill, and get high marks from one of the models I discussed above. (Keep in mind that I invest in baskets of stocks picked using my strategies to diversify away stock-specific risk. You should invest in stocks like these as part of a broader, well-diversified portfolio.)

Linamar Corporation (LNR.TO): Ontario-based Linamar is a diversified global manufacturing company of highly engineered products. It makes precision metallic components, modules and systems for global vehicle markets, as well as mobile industrial products. Linamar gets strong interest from my Momentum Investor approach, which likes its strong 54% EPS growth last quarter and a stellar 97 relative strength. The strategy also likes the firm's reasonable 29% debt/equity ratio and 20% return on equity. Linamar shares trade for just 16 times EPS and 1.25 times sales.

Zumiez (ZUMZ.US): This Washington State-based retailer sells skateboards, snowboards, and a variety of other "action sports" clothing and accessories. It has a market cap of about $1 billion. My O'Shaughnessybased growth model has strong interest in the stock in part because of its combination of a low PSR (0.84) and a high relative strength of 86. The strategy also likes that Zumiez has upped earnings per share in each year of the past five-year period.

Magna International (MG.TO): Magna is a global automotive supplier with manufacturing operations in 29 countries. It produces bodies, chassis, interiors and exteriors, seating, powertrain, electronics, vision, closure & roof systems and modules. Magna is another favorite of my Momentum Investor model. The strategy likes the firm's 57% EPS growth last quarter and its annual earnings growth of 85% over the past five years. It also likes Magna's 89 relative strength and 20% return on equity. Magna shares trade for 14 times earnings and 0.75 times sales.

Jones Lang LaSalle (JLL.US): Chicago-based JLL is a financial and professional services firm specializing in real estate. It has over 200 corporate offices worldwide and operations in more than 1000 locations in 70 countries, offering integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients. JLL ($7.4 billion market cap) gets strong interest from my O'Shaughnessybased strategy. The stock has strong momentum, with a relative strength of 85, but it remains reasonably priced, with a price/sales ratio of 1.36.

Lannett Company, Inc. (LCI.US): This 73-yearold Philadelphia-based firm ($2.3 billion market cap) makes generic prescription pharmaceutical products for customers throughout the United States. Lannett markets its products primarily to drug wholesalers, retail drug chains, distributors, and government agencies.

Lannett gets strong interest from my Momentum Investor approach. One reason: the stock's 89 relative strength. The strategy also likes Lannett's tremendous growth last quarter (147%) and strong return on equity (41%). While its fundamentals are quite strong, Lannett shares remain reasonably priced, at less than 19 times earnings and with a PE-to-Growth ratio of just 0.4.

WestJet Airlines (WJA.TO): WestJet offers service to more than 90 destinations in North America, Central America, the Caribbean and Europe. It also has a regional airline, WestJet Encore, and partnerships with airlines representing every major region of the world. The $4-billion-market-cap firm is a favorite of my O'Shaughnessy growth approach, thanks in large part to its combination of a high relative strength (82) and low price/sales ratio (1.0).

Federated National Holding Co. (FNHC.US): Formerly known as 21st Century Holding Company, FNHC is an insurance holding company that writes homeowners’, commercial general liability, federal flood, personal auto and other lines of insurance in Florida and various other states. It's a favorite of my Fool-based model, in part because of its impressive 96 relative strength. The strategy also likes its 17% profit margin and strong growth last quarter (44% for EPS and 34% for sales). FNHC trades for just 10.5 times earnings.

I'm long FNHC, LCI, JLL & ZUMZ.

John Reese is founder and CEO of Validea.com and Validea. ca. He is also portfolio manager on the National Bank Consensus funds.