NEW YORK ( MagicDiligence.com) -- Price momentum as a stock performance predictor is often scoffed at by fundamental value investors and "efficient market" academics.

Momentum, they will tell you, has nothing to do with the fundamental factors that drive growth in revenue, profits and book value -- the ultimate factors that determine the value of a business and, hence, the price of a stock.

No less an authority than Warren Buffett has said that past prices are only good at predicting past returns! Many value investors even believe that the stocks that have been the most beaten down make the best investments because the stock price is logically closer to the bottom.

On the other hand, there are armies of technically oriented traders that use nothing except than price charts to make investment decisions!

So who is correct?

Believe it or not, there is pretty convincing research that price momentum does make a difference over a 1-year investment horizon, the period targeted by Magic Formula Investing (MFI).

The most convincing study can be found in James O'Shaughnessy's book What Works on Wall Street (the Kindle version costs less than $6), in which the author back-tests a number of mechanical investing strategies over a 42-year period, rebalancing annually.

O'Shaughnessy's study confirmed some things that we already believe. Stocks with low valuations -- low price-to-earnings ratios, low price-to-cash flow ratios, low price-to-book ratios and low price-to-sales ratios -- outperformed the S&P 500 over his sample period. Stocks with the inverse (high P/E, etc.) all underperformed the market.

Additionally, O'Shaughnessy found that stocks with high returns on equity (ROE) also trounced the S&P, giving further support to the MFI strategy, which focuses solely on high earnings yields (equivalent to low P/E) and high returns on capital (i.e., high ROE).

What was more surprising were his findings on price momentum, defined in the book as high trailing 12-month stock price appreciation. The stocks with the best price momentum greatly outperformed the market, although they did so with high volatility.

On the other hand, buying the stocks with the worst price momentum was a sure path to disaster. It was the worst performing mechanical strategy, returning just 3.3% on a compounded annual basis vs. the S&P's 11.51%.

The best strategies combined both value and momentum to deliver really excellent returns. All of the top 10 performing strategies used price momentum as a filtering component, and four of the top six combined price momentum with one of the value ratios listed above. Look at how adding price momentum influenced already good value screening strategies. These are compounded annual returns, vs. 11.51% for the S&P.

Low price-to-sales ratio: 15.54%. With high price momentum: 18.62% (this was the best performing screen).

Low price-to-book ratio: 14.80%. With high price momentum: 17.95%.

Low P/E: 12.07%. With high price momentum: 18.52%.

High ROE: 12.52%. With high price momentum: 17.10%.

With these results in mind, perhaps price momentum is an important thing to consider when choosing Magic Formula stocks for your portfolio?

Here are the five MFI stocks with the best trailing 12-month returns:
  • Power-One (PWER): 196.7%
  • InterDigital (IDCC): 87.3%
  • GT Solar (SOLR): 78.9%
  • Impax Laboratories (IPXL): 75.0%
  • SanDisk (SNDK): 66.4%

On the other hand, here are the five MFI stocks with the worst price momentum:
  • Strayer Education (STRA): -45.3%
  • Amedisys (AMED): -41.4%
  • H&R Block (HRB): -38.7%
  • China North East Petroleum (NEP): -34.6%
  • Argan (AGX): -33.5%

In the short run, the price of a stock is determined by people, and people are more inclined to let emotion, not logic, dictate their decisions. Emotions run high for stocks that go up, and run low for stocks that have gone down. Momentum is important over short holding periods, and MagicDiligence.com uses it as a factor in choosing Top Buy picks.

At the time of publication, Alexander owned shares of IDCC, SOLR and SNDK.

--Written by Steve Alexander.

>To contact the staff member responsible for this article, click here: Ross Snel.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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