How to find value shares that are about to fly

When it comes to stock market strategies, few would argue against the power of value investing. Decades of research kicked off by Benjamin Graham in the 1930s, shows that on average "cheap" beats "expensive" fairly consistently over the long term. But there are flaws. Value investing can suffer miserable periods of underperformance, which makes it difficult to stick with. So it's no surprise that efforts have been made to improve on it. One way has been to combine value with another key driver of stock market returns - the power of persisting trends that's known as momentum.

The odd couple

At first sight, value and momentum are styles that seem incompatible. After all, value investing purists look for shares that are mispriced because they are misunderstood. So chasing rising prices is at odds with that approach. Meanwhile, momentum investors have little interest in buying cheap shares in the hope that they'll recover. They prefer to catch a wave of rising prices in increasingly popular stocks over the short term.

But the merits of combining these strategies are actually well known. Academic studies have long shown that when one style is working the other tends to lag. Over time, that has the effect of smoothing returns whilst capturing the power of each style in turn.

These findings have naturally led to strategies that aim to find shares which are both undervalued and showing the early signs of positive momentum. It's a hallmark of fund managers like Josef Lakonishok. He was a major contributor to the academic work on momentum, and now runs a $90 billion fund management business that specifically looks for undervalued shares just at the moment the market is starting to warm to them.

Another research-driven quant fund manager is Cliff Asness at AQR Capital. Research carried out by his team more recently has reiterated that the negative correlation between value and momentum means that when one falters the other will fly. And that means a smoother, less-volatile performance than you get from either factor on its own.

Screening for value and momentum

To identify companies which currently have the best combination of value and momentum, Stockopedia created a screen for Interactive Investor. It scores and ranks firms according to a range of valuation ratios, including the price-to-earnings (P/E) ratio, as well as momentum factors like relative price strength against the market and positive trends in earnings forecasts.

Top value and momentum shares

Among the highest ranking value and momentum shares currently is LSE:INDV:Indivior, the pharma company that was spun-out of Reckitt Benckiser last year. This business looks potentially cheap on several measures despite a strong price performance in 2015. Earnings forecasts have also been upgraded in recent months.

Lloyds' insurance group LSE:NVA:Novae also ranks highly. It recently reported a better than expected first quarter trading performance and, again, brokers have been revising their earnings forecasts accordingly.

Logistics company LSE:WIN:Wincanton has encountered criticism for weaknesses in its balance sheet and that uncertainty may be contributing to it appearing cheap on a number of measures. Its shares have nonetheless seen strong momentum, and have all but recovered from a dip during the spring.

The largest company on the list is LSE:RMG:Royal Mail, which has seen an uptrend in its share price recently. Competitive pressure has been a concern and brokers have been bearish on the stock for some time. However, earnings forecasts were upgraded slightly in May.

Among the mid-caps are insurance underwriter LSE:PHNX:Phoenix, retail group LSE:DEB:Debenhams and motor retailer LSE:PDG:Pendragon.

The smallest companies by capitalisation include the £41m airline brokerage LSE:AIP:Air Partner, gift packaging and stationery distributor, LSE:IGR:International Greetings, valued at £75m, and marketing consultancy LSE:CRE:Creston, valued at £79m.

With the benefit of hindsight, this portfolio of shares would have produced a 25.6% returns so far this year compared to 4.3% from the FTSE All-Share.

Individually, value and momentum have long been shown to be two of the most powerful drivers of stock market returns. Yet in combination the evidence suggests that they can work together to reduce volatility at the same time as maximising the effects of each strategy. Of course, with any strategy detailed research is essential, and it's important to assess the quality of the companies in question. Value and momentum stocks may well be previously misunderstood or recovering shares that still carry an air of suspicion. But they'll also be showing the signs that the market is beginning to notice them.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

● Interactive Investor readers can enjoy a two week free trial and £50 discount to Stockopedia using the coupon code iii014 - click here.

● To learn more about Ben Graham and his deep value investing strategies, you can download the free Stockopedia book, How to Make Money in Value Stocks.

It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"