Now's the time to bet on momentum

In most of my columns, I focus on the importance of finding value when examining stocks, whether it's by looking at share prices in relation to earnings or in comparison to some other yardstick of intrinsic value. I believe gurus like Warren Buffett and Peter Lynch have shown that buying shares of good companies on the cheap is a timeless formula for investment success.

Usually that means avoiding high-flying shares and focusing instead on good, solid companies that have taken recent hits. But that's not always the case. In fact, looking for stocks with good price momentum can be a big boost to returns – particularly during certain market conditions.

James O'Shaughnessy, one of the gurus upon whose writings I base my Guru Strategies, has researched how the market's affection for momentum varies over time. He emphasizes relative strength – which measures on a scale of 1 to 99 how a stock has performed, price-wise, compared to all other stocks in an index over a specific period. His firm's research has shown that momentum-type strategies tend to fare well in the second years of bull markets, and that the third year of a bull – which we are now in the middle of – tends to be "much friendlier to trend-following and high-yield strategies than to value."

I've found that to be the case over the past year or so. Since I started tracking them on my Validea Canada website in August 2010, my three top-performing guru-inspired portfolios have all included relative strength criteria. My O'Shaughnessy-based portfolio is up 4.2 per cent, my Momentum Investor portfolio is up 13.4 per cent, and the portfolio I base on the writings of Motley Fool creators Tom and David Gardner is up 19.2 per cent (all through Oct. 20). The S&P/TSX Composite is up just 0.3 per cent over that period.

Here's the critical thing to remember, however: These and other successful momentum-focused strategies don't look at relative strength in a vacuum; they use it as part of a broader approach that also examines fundamental and financial criteria. In doing so, they look for stocks that have the wind in their sails for a reason.

What stocks currently have a lot of momentum and solid fundamentals to boot? Here are three picks from the Canadian market.

Metro Inc. : Montreal-based Metro operates more than 600 food stores and more than 250 drugstores. It has a red-hot 12-month relative strength of 94, part of the reason it gets a 100 per cent score from my O'Shaughnessy-based model.

Relative strength was one-half of a key tandem of characteristics Mr. O'Shaughnessy used to find strong growth plays. The other half: a low price/sales ratio. That combination helps you find stocks that the market is embracing, but which haven't gotten too pricey. Metro's P/S ratio: 0.43, well under this model's 1.5 upper limit.

The O'Shaughnessy-based model also likes companies that have shown persistent earnings growth. Metro has upped earnings per share in each year of the past half-decade, a great sign.

Artis Real Estate Investment Trust : This Winnipeg-based firm has had very choppy earnings in recent years, but it has performed quite well this year, a big reason my Momentum Investor model gives it a solid 87 per cent score. This model looks for companies that have grown their earnings per share by at least 18 per cent from the same quarter a year before; at 35.1 per cent Artis easily passes.

This model also looks for 12-month relative strengths that are at least 80 – and which have been on the rise over the past four weeks. Artis, with an RS of 88, passes both tests.

The Momentum Investor model also looks at a firm's return on equity, which should be at least 17 per cent, and the long-term debt/equity ratio, which should be less than 200 per cent or have been declining over the past three years. Artis has an 18.1 per cent ROE and has decreased its long-term debt/equity ratio from 201 per cent to 180 per cent over the past three fiscal years.

Dundee Corp. : This Toronto-based asset management firm is involved in private wealth management, real estate investment, and resource investment. It has about $65-billion under management and administration.

My Motley Fool-inspired model likes to see stocks have 12-month relative strengths of 90 or higher; Dundee falls just short at 89. But that and its other fundamentals are enough to earn a solid overall score of 86 per cent from the model. The strategy likes Dundee's very high, expanding profit margins and its very low 0.17 P/E-to-growth ratio.

Keep in mind that there's risk in stocks like these because you never know exactly when the market will shift from momentum back toward value. But with these three, both fundamentals and financials indicate good reasons for the recent gains, and that makes them worth a good, hard look for long-term investors.