Today I want to tell you about an investing strategy that defies logic. It shouldn't work based on everything we've learned about the stock market.
Yet it does. In fact, for more than half a century, investors and traders have used this strategy to produce unparalleled results.
And no, for those of you who may be wondering, this strategy doesn't involve options, derivatives or any other obscure financial product.
What's more, what I'm about to show you can be used as part of any general investing strategy -- regardless of whether you're focusing on income, growth, blue chips, small caps or even commodities.
Specifically, I'm talking about relative-strength investing.
Relative strength investing is simply a type of momentum investing. It involves buying the best-performing stocks (relative to the market) and holding them until their momentum changes course.
To most investors, especially those considered value investors, this strategy probably sounds ridiculous. After all, most people have heard the phrase "buy low, sell high." Since relative strength investors buy stocks that are already outperforming today, many view this style of investing as counterintuitive.
But that's a mistake... and it's one many people make whenever they approach a stock pick.
That's because most investors have been trained to think that "undervalued" stocks have the most upside potential. The definition of undervalued varies by investor, but normally people use metrics like low price-to-earnings ratios, price-to-book ratios or price-to-sales values, to describe it.
The problem is that this approach leads investors to often overlook the market's best-performing stocks in favor of the ones doing the worst. Since underperforming investments usually sport the lower valuations, investors tend to think these stocks are the more attractive buys.
Metaphorically speaking, this is like abandoning a luxury yacht in favor of sailing around the world in a leaky shrimp boat because buying a ticket on the shrimp boat can save you half the cost of your trip. Don't get me wrong, I like saving money, but I'll gladly take the yacht if it means I'm going to enjoy my vacation and get back home alive.
Unfortunately, when it comes to investing, most people don't look at stocks like that. They see a great-performing company with an average or premium valuation (the yacht) as riskier than a stock that is underperforming and has a low valuation (the leaky shrimp boat).
Research has proven that this is a terrible fallacy. It turns out that the best-performing stocks, the ones already beating the market today, are in fact the best investments to own... at least in the medium term.
One of the best studies on this phenomenon was done by AQR Capital Management. They looked at U.S. stocks going all the way back to 1927. What they found was that at any given time, the stocks that were outperforming 80% of the market continued to outperform for at least the next 12 months. The same thing goes for the underperforming stocks. The bottom 20% of performers continued to underperform over the same period.
This idea is essentially the central concept underpinning relative strength investing. Relative strength investors will rank stocks based on performance, then buy the ones that are performing the best. They will sell that stock when the momentum changes course.
If it sounds too easy, that's because it is. Yet despite its simplicity, this strategy has been executed with staggering results.
For example, AQR found that using a relative-strength strategy, the asset-management firm was able to outperform their benchmarks in nearly every investing category (including mid-cap, blue-chip and small-cap stocks). What's more, James P. O'Shaughnessy, author of What Works on Wall Street, discovered that using a relative strength based system would have beaten the market by an average of 3.7 percentage points per year over the last 83 years.
With that kind of track record, it's hard to deny the benefits of relative strength investing. Yet as good as relative strength is by itself, it's been taken to another level by Profitable Trading's premium newsletter Alpha Trader .
Alpha Trader uses a unique investment system to leverage the powerful forces behind the relative-strength metric. He does so by combining a stock's relative-strength rating ( RS ) with a proprietary fundamental indicator. The combined values of these two numbers yield a stock's "Alpha Score." From what we've seen, the higher a stock's alpha score, the better its chance of delivering blockbuster gains.
Take Electronic Arts (Nasdaq: EA ) for example. Alpha Trader originally tagged Electronic Arts as a buy in early October 2014, when the stock was sporting an Alpha Score rating of 183. Part of that Alpha Score was based on the stock's relative strength rating, which at the time was 91. The other piece of EA's Alpha Score comes from the system's proprietary fundamental indicator, which was at 92.
Since Alpha Trader made that recommendation nearly a year ago, EA has returned a total of 78% -- outperforming the S&P 500, which has actually dropped in price.
That's incredible... and it speaks volumes to the power of the system's Alpha Score rating.
Of course, not all stocks with a high Alpha Score rating will jump this much. But nonetheless, on top of Electronic Arts, the system has still highlighted tons of stocks right before they delivered double-digit gains in a month... including several that went on to deliver gains well over 100%.
If you'd like to learn more about the Alpha Score, I urge you to take a minute to watch my brand-new presentation . It shows exactly how the Alpha Score works, and even reveals the name and ticker symbol of a top-rated Alpha Score stock flashing "buy." This presentation is coming down soon, so follow this link now if you have any interest in learning more.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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