By Michael Brush, MarketWatch
Ryan Kelley’s name was misspelled in an earlier version of this article. It has been corrected.
Momentum has been the sweet spot for much of this bull market.
Since the start of 2014, momentum stocks in the Russell 1000 index /zigman2/quotes/210598144/delayed RUI +0.48% are up 187% compared to 166% for the index, according to T. Rowe Price chief investment officer John Linehan.
So it’s tempting to jump on board. The problem is, mo-mo stocks look richly valued. The price-earnings multiples of high momentum stocks are now almost 2.2 times as high as low momentum stocks. The gap has never been this wide in the past 16 years. The ratio is typically more like 1.2, according to Linehan.
But there’s a fix for this problem: Go with momentum stocks that have reasonable valuations. They’re out there. For help finding them, let’s turn to Ryan Kelley who manages the Hennessy Cornerstone Mid Cap 30 Fund /zigman2/quotes/210510882/realtime HFMDX +0.28% .
This quant fund screens for U.S.-listed midcaps that combine momentum, earnings growth and cheap valuations. For valuation, companies have to trade for a price-to-sales ratio below 1.5 to make the cut.
It makes sense to focus on value names in the mo-mo arena for a simple reason: Value is really out of favor. It looks like a good contrarian bet and a way to profit from the “reversion to the mean” tactic which helped make Ray Dalio of Bridgewater a billionaire.
Consider this remarkable datapoint, again courtesy of Linehan at T. Rowe Price. The market’s cheapest stocks (the bottom 20% by forward price-earnings multiples) now make up less than 5% of the top 20% of momentum names. This, too, is a rare event. The percentage has narrowed this much only six times in the past 30 years. Each time, value went on to post a remarkable rally for at least a year or more.
“When value underperforms to the extent we’re seeing now, there historically has been a sharp reversal,” says Linehan.
That’s not a guarantee it will happen again this time. But I sure like the odds. If value does come screaming back, the cheap momentum stocks in Kelly’s quant fund should outperform.
After all, Kelly’s system is pretty good at finding discounted momentum names. The fund has posted a respectable 10% annual gains since it launched 16 years ago. Part of the reason for the success is that the fund fishes in what I consider to be the best part of the market — midcaps. This means names with a stock-market value of $1 billion to $10 billion. Over the past 15 years, says Kelly, midcaps have outperformed small-cap Russell 2000 /zigman2/quotes/210598147/delayed RUT +0.32% names by 21%, and large-caps like those in the Russell 1000 or S&P 500 /zigman2/quotes/210599714/realtime SPX +0.45% by 10%.
Why midcaps rock
There are several reasons midcaps do well. Midcaps tend to have faster growth rates than large-caps, which at some point just get too big to keep up the rapid pace. Midcaps are a bit safer than small-caps.
Midcaps are also less followed by analysts, which means you are more likely to find companies with bullish trends that aren’t yet priced in. This is one of the main reasons I focus on midcaps in my stock letter Brush Up on Stocks , where I let insider buying lead me to promising companies, as a starting point for research.
Midcaps are also prime buyout candidates, notes Neil Hennessy, chief investment officer at Hennessy Funds. To this point, two names from my letter just got taken out for decent premiums: Tiffany /zigman2/quotes/209249105/composite TIF -0.0082% and Medicines Co..