by Kevin Truitt

For value investors, the sweet spot in investing is being able to buy an undervalued stock right before its value is recognized by the market and just before its stock price begins to take off.

But how can a value investor tell when a stock is in the sweet spot? The answer, according to Brian Nelson, president of investment research company Valuentum Securities, is to identify stocks with good value that are just starting to exhibit good technical/momentum characteristics.

Doing so helps an investor avoid:

• value traps: stocks whose prices continue to fallso-called falling knivesor stocks whose value will never be recognized by the market,
• underperformance due to the opportunity cost associated with holding a stock with great potential, but whose value takes an inordinate amount of time to be recognized by the market and
• speculative momentum or irrational high-yielding stocks whose technicals are unsupported by their fundamental valuation (greater fool stocks).

Many investors often base their investment decision on whether a stock is undervalued or overvalued or whether it has excellent competitive advantages or other qualitative measures. Nelson believes this a great start but its an incomplete assessment, as stocks can stay undervalued or overvalued for decades (and some stocks may never converge to an estimated intrinsic value). Only when there is buying or selling in the stock based on its overvalued or undervalued state does a stock actually converge to its intrinsic value. Investors are highly dependent on other investors actions (buying a stock drives its price higher, all else equal).

This core market dynamic is why Nelson looks for undervalued stocks that are just starting to be bought by other investors, the latter evidenced by a stocks positive technical/momentum considerations. He does not believe it is enough for a stock just to be undervalued. When it takes too long for a stocks value to be recognized by the market, both the power of compounding and the stocks annualized rate of return are adversely affected. A 30% return in nine months, for example, is far better than a 30% return over five years. Investors who focus only on value, growth or competitive-advantage analysis may not be using everything in their tool kit to maximize returns.

The value school of investing has seen this happen before. For a long time, value investing and growth investing were mistakenly viewed as separate and incompatible styles of investing. Legendary investor Warren Buffett debunked this myth when he said, Growth and value investing are joined at the hip. Value is the discounted present value of an investments future cash flow; growth is simply a calculation used to determine value. Similarly, some value investors have viewed value and momentum as being likewise incompatible investment strategies, even though there is a benefit to combining them.

As a common example, value investors have traditionally been conditioned not to accept technical/momentum analysis. Price movement strategies have often been dismissed as a self-fulfilling prophecy, the belief that they only work because other investors are buying and selling based on technical/momentum indicators. Nelson argues that this isnt a balanced view of the markets. Value investing works sometimes because people buy or sell based on value principles, driving a stock higher or lower, respectively. An understanding of these market dynamics helps investors relate to the theory behind why stocks admired by both value (inclusive of growth) and technical/momentum investors can be attractive. The possibility of price-to-fair-value convergence for this cohort of stocks is enhanced.

Research Says Combine Value With Momentum

Several research studiesmost notably a study done by Cliff Asness of AQR Capital, Tobias Moskowitz of the University of Chicago and Lasse H. Pedersen at the New York University in their paper Value and Momentum Everywheremake the argument that value and momentum strategies work well together. In their research, Asness, et al. show that over time combining value and momentum strategies across diverse markets and asset classes results in significantly higher risk-adjusted rates of returns.

Modern portfolio theory indicates that when you combine assets that are not perfectly correlated, or move in opposite directions, both portfolio volatility and overall risk are reduced. By applying this same sort of thinking to combining the best elements of two seemingly incompatible investment strategiesvalue and momentumAsness, Moskowitz and Pedersen found that an investor can garner significant benefits of diversification by combining the best elements of value and momentum strategies. In their research, Asness, et al. found that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes.