Good stocks hitting new highs: A set of rules to pinpoint market leaders

Momentum investing strategies have a natural dislike for bearish, unsettled conditions. So it’s no surprise that some of them have been on the ropes this year. But with the market clawing its way back from the summer slump, one of our most beloved momentum screens - the 52 week highs list - is starting to look a bit healthier. It comes as new research shows that a simple addition to this strategy could improve its returns. 

New ideas from new highs

Momentum - arguably one of the market’s most powerful profit drivers - has been the name of the game in the stock market over the past decade. Value strategies have suffered at the hands of popular growth stocks, which have been on a relentless march, notching up multibagger-like returns.

But over the past year or so, the tables have shifted. Strategies that surf the upward price drift caused by momentum catalysts like earnings surprises and broker upgrades have struggled to find shares. In the past, this has signalled the start of a change in market direction. A different view might be that momentum has just hit a bump in the road, rather than completely crashed.

One of the most popular momentum strategies is the 52 week high, which is an approach I often pick up on, with good reason. For a start it brings together a very simple, accessible data-point with some intriguing academic research into the way investors think and behave...

The idea is that stocks at new highs are prone to being priced incorrectly. Holders who have ‘anchored’ at a previous price may be slow to buy at the new high (and may even sell to lock in profits). Meanwhile, others may be hesitant to buy stocks that have already risen sharply. Over time, this fog of uncertainty clears and the price of 52 week high stocks can drift higher.

But the 52 week highs list is interesting for other reasons, too. It’s like the stock market’s gossip column. It’s the list that everyone likes to look at, whether or not they act on it. It’s a window into the market’s latest big winners, recent takeover targets and the sectors and industries that could be on the up. For technical traders, the 52 week high is like an age-old friend - always there to offer new ideas.

Quality and momentum join forces

New research this summer casts a slightly different light on the 52 week highs strategy by introducing ‘fundamental quality’ as an extra filter. The paper (which you can find here) pairs up new highs with companies that score well against the all-weather nine-point checklist of fundamental strength: Joseph Piotroski’s F-Score. 

This combination of factors turns what was a momentum-only strategy into something that resembles much more of a quality & momentum ‘High Flyer’ approach. 

The F-Score itself was originally conceived back in 2000 by Piotroski (an accounting professor) as a way of rooting out value stocks with the potential strength to re-rate. It works by looking for an improving health trend across areas like profitability, operating efficiency, and leverage. Its popularity means that it’s now a go-to quality benchmark for just about any strategy. 

In this new paper, the researchers (Zhu, Sun and Chen) wanted a better way of measuring the degree of investor underreaction to fundamental news about stocks trading close to new highs. To do it, they used the F-Score as the measure of a firm’s fundamental strength. Those with F-Scores of 7, 8 and 9 were classified as “high F-Score” stocks.

Ultimately, the research found that stocks with high F-Scores that were trading at new highs went on to deliver superior returns. In fact, they apparently saw nearly double the average returns of portfolios that were sorted only by 52 week highs. The findings confirmed the view of the researchers that investor ‘anchoring’ is a big driver of the 52 week high anomaly. 

So what kinds of stocks pass these rules? Here’s a revised take on the 52 Week Highs approach, sorted for stocks with the highest F-Scores (you can find the screen here). 

As it stands, high F-Score stocks trading close to new highs come from right across the market-cap range and from across industry sectors.

For investors looking for a barometer of market sentiment and a sense of where investor excitement is focused, the 52 week highs strategy is an interesting source of ideas. In buoyant conditions, as we’ve seen in recent years, the momentum in a strategy like this can be powerful and predictive. But in less certain conditions, where investor sentiment can turn very quickly, momentum needs to be watched closely. 

Adding the F-Score as a quality checklist to focus on stocks with the strongest trends in improving fundamentals could be a useful way of reinforcing the strategy and defending it from the risks of sudden disappointments.