10 top shares that will shock value investors

Have you ever sold a winning share and then lived to regret it? If you have, there's an interesting comment in Terry Smith's latest letter to shareholders of his Fundsmith Equity fund. It's one that many individuals will take comfort in.

Back in 2015, Fundsmith sold out of its position in Domino's Pizza. This was eye-catching because Smith has a policy of "buying good companies, trying not to over-pay and then doing nothing". To be fair, he explained that Domino's had reached a valuation which was only justifiable if its rapid rate of growth was sustainable, which he doubted.

The agonising result was that shares in Domino's went on to rise by more than 45% in 2016.

Since 2010, Fundsmith Equity has generated a near 200% cumulative return, or 19% annualised. So it's not as if Smith has much to apologise for. But he conceded to being fallible and offered the whole Domino's episode as a cautionary tale about the merits of doing nothing.

Grabbing a pizza the action

In broader terms, Domino's Pizza is an interesting case study into the challenge of tackling good companies on racy valuations. On a lot of valuation measures, Domino's has been an expensive share to buy for more than 10 years. But that hasn't made it a bad investment - far from it.

Domino's has arguably been one of the biggest reasons why investors have come to love (and seek out) so-called 'roll-outs'. It took a winning format with its fast food delivery stores and opened them across the country. In the process, it made a fortune for those investors who were prepared to stomach a price/earnings (PE) ratio usually well in excess of 20 times.

Domino's fits the profile of a classic 'high-flyer'. It's been a consistently high-quality business matched by relentlessly strong price momentum. The big fear with this type of company is that growth slows and the momentum reverses. But, as Terry Smith found, these types of investment can run and run.

Signposts to quality and momentum

To find companies with strong quality and momentum, there are some straightforward places to start. Generally a quality company is one that's highly profitable with high industry-leading margins, stable, growing and ideally accelerating sales and earnings. It will have a strong and improving financial track record, a robust dividend yield and no signs of accountancy or bankruptcy risk.

In turn, strong momentum will show up in stocks trading at, or above, their 52-week highest prices and performing strongly against the rest of the market. These companies will often be beating broker estimates and seeing estimate upgrades and recommendation changes.

Screening the market for high-flyers

These measures offer a useful starting point in screening for stock market high-flyers. To simplify things, Stockopedia created a screen for Interactive Investor using StockRanks, which score companies based on the strength of their quality, value and momentum. In this case we looked for companies that rank among the highest in the market for their quality and momentum, but remain expensively priced.

There is no doubt that the racy earnings multiples on some of these stocks will be enough to have value investors running for the hills. But this is precisely the point of a 'high-flyers' strategy. Companies like JD Sports, Boohoo.com, Burberry and Fevertree Drinks have become compelling investments in the eyes of many investors.

These stocks have consistently looked expensive. Yet their strong quality and momentum characteristics have contributed to a strong performance. They are evidence that under certain circumstances, ignoring PE ratios can be a completely rational thing to do with a high chance of favourable outcome.

Shying away from expensive-looking valuations does risk overlooking some of the best companies in the market. But, as Terry Smith feared with Domino's Pizza, momentum can suddenly turn and quality can deteriorate. Expensive shares are risky because the market has high expectations for them, but their quality can take them a very long way.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.