Jack Hough: How to Find Great Stocks That Pay Off Fast

You can search for bargain stocks to hold for the next five years while increasing the chances that they'll pay off over the next five months. To do so, simply run a screen for companies that display two key attributes. First, they have modest share prices based on some valuation measure. Second, their share prices are hitting new highs.

That might sound contradictory. Value stocks, after all, are ones whose share prices have been beaten down to the point where they look attractive relative to measures of income (sales, earnings) or company worth (book value). Price momentum suggests just the opposite: a popular company whose share price is being bid higher. But an Impatient Value screen, as I call it, tends to turn up two kinds of stocks. The first is a company that's not only due for a turnaround, but whose turnaround has already started. The second is a company with a rising share price that still looks cheap.

Let's review the evidence on our two clues. Low price/earnings ratios have been widely understood to predict market-beating performance since Benjamin Graham (the man Warren Buffett says taught him how to buy stocks) published "Securities Analysis" in 1934. And they've been proven to do so ever since computers were first employed to scan decades of financial and trading data. A finance professor named Sanjoy Basu published the first such convincing argument in 1977, showing that among 1,400 companies during the 14 years ended 1971, low-P/E ones beat high-P/E ones by seven percentage points a year. Plenty of other researchers have reported similar findings since.

The case for price momentum wasn't as clear until recently. Though researchers have studied its predictive power since at least the 1960s, early results were confusing. Studies showed that past winners were indeed more likely than not to outperform the broad market. But at the same time other studies showed that contrarian strategies worked, too. That is, past losers also tended to outperform the market. Both, of course, can't be true. Much depends on timing, it was determined. The past year's gainers tend to keep rising, but only for another year, and then they reverse.

In a 2004 study titled "The 52-Week High and Momentum Investing" and published in the Journal of Finance, Thomas George of the University of Houston and Chuan-Yang Hwang of Hong Kong University of Science and Technology cracked the code of price momentum. What's important, they found, isn't how far a stock has risen in recent months, but how close it is to its 52-week high price. After all, a stock that's still up 80% for the year, despite having slid 20% in the past two months, doesn't exactly have great price momentum.

George and Hwang looked at stock prices between 1963 and 2001, and created two portfolios, one that simulated buying big gainers and shorting big losers, and another that did the same with stocks that were within 5% of their 52-week high and low prices, both of which rebalanced monthly. The gainer/loser portfolio beat the market by an annualized margin of 4.5 percentage points a year, but held that pace for only about six months after each rebalancing. The 52-week high/low portfolio beat the market by 7.8 percentage points a year. Remarkably, the returns stayed strong for more than five years.

Stocks that are hitting new highs might be bargains, ironically, because few investors believe that they are. No one wants to be the last one to buy shares of a soaring stock before it turns around. But that thinking isn't entirely rational. Stock valuations should be based on fundamental merits like earnings, not past performance. After all, if stocks prices climbed in a straight-line progression rather than an erratic one, they'd hit new highs every day. Anything that keeps investors unduly biased against great stocks serves as a bargain opportunity for those in the know.

There's a trade-off involved with my Impatient Value screen, but it's a pretty attractive one. The stocks that turn up on it won't be sitting at the lowest prices they've seen in recent months. But if the research holds, they'll be far more likely than traditional value stocks to head higher in coming months.

Note that for the screen I use a modified version of the P/E ratio called the PEG ratio. It simply divides a company's P/E by the rate at which its earnings are projected to grow over the next several years. So a company with a P/E of 12 and a projected growth rate of 10% will have a PEG ratio of 1.2, as will one with a P/E of 24 and a growth rate of 20%. That helps to normalize for the difference in growth rates among industries. I search for PEGs below 1.5 to find companies that are cheaper than the broad market relative to their growth rates. And of course, I look for share prices that are within 5% of their 52-week highs. Beyond those two key demands, you can add any you like to shorten your list of screen survivors, like a requirement that a company earns an ample return on the capital it invests, or one that its earnings estimates have been boosted in recent weeks.

To run my Impatient Value screen for yourself anytime for free, see the preprogrammed version I've added to my book page. If you want to tinker with the inputs, you'll need access to a stock screener like the one offered on SmartMoney Select.

Reprinted by permission of the publisher, John Wiley & Sons, Inc., from "Your Next Great Stock: How to Screen the Market for Tomorrow's Top Performers." Copyright (c) 2008 by Jack Hough. All rights reserved.