How I Trade My IRA

I measure momentum by looking at the actual price change of every stock over the past year, six months and three months. I restrict my universe to those stocks that have performed much better than the universe over these time periods. For example, the price change over the last year must be in the top 30% of all stocks.

It seems counterintuitive to buy stocks at or near their highs for the last year. After all, haven't we all been told to "buy low, sell high"? Actually, as James P. O'Shaughnessy showed in What Works on Wall Street, winners continue to win. Why? Because when things are changing in an industry or within a company, the market often underestimates the scope of those changes. So a true turnaround story, for example, isn't really believed at first.

There are many measures of value in a common stock. O'Shaughnessy came to the conclusion, based on his statistical analysis, that the price/sales ratio was the best measurement of value. This metric does, indeed, seem attractive, because sales data are much more reliable than earnings or cash flow. However, low price/sales ratios unfairly punish those companies that have high profit margins, since price/sales ratios and margins are so positively correlated.

After reading The Little Book That Beats The Market, I came to be impressed with the metric used there: Enterprise Value/EBIT. Enterprise value adds total market capitalization to long-term debt and preferred stock and then subtracts cash on hand. Then, enterprise value is divided by earnings before interest and taxes to arrive at the ratio.