This Style of Investing Is Delivering 9 Times the Performance of the S&P 500

Francisco Bermea's picture

Monday, August 11, 2014 - 4:15pm

by Francisco Bermea

There's a group of stocks currently trouncing the S&P 500. In just a few months, they've generated 44.8%, 58.1%, 74.8% and even 137.7%. And I expect this elite club of stocks to continue moving higher for two reasons.

For one, each of these stocks sports an abnormally high Alpha Score.

Every stock has an Alpha Score, and it can range from 0 to 200. It is derived by combining two of the market's most effective triggers -- relative strength (RS), our technical trigger, and a fundamental trigger. The higher the score, the more likely a stock is to move higher in the coming weeks and months.

On top of having high Alpha Scores, these stocks are also deeply undervalued. In our experience, undervalued stocks with high Alpha Scores outperform the market in a big way.

In my premium newsletter, Alpha Trader, we have a section dedicated to finding the market's most undervalued stocks with high Alpha Scores. It's called the Half-Priced Stocks Portfolio, and below is snapshot of its performance. (To be fair to my subscribers, I can't reveal the tickers of all our open positions).

All but one of holdings is currently outperforming the S&P 500. And on average, our "Half-Priced" stocks have returned 35% since being added to the portfolio. By comparison, the average performance of the S&P 500 over these respective time periods is 4%. That means these stocks have outperformed the S&P by a margin of nearly 9 to 1.

Our biggest winner in the Half-Priced Stocks Portfolio is Hi-Crush Partners (NYSE: HCLP). The company produces a specialized mineral known as proppant, which is critical to the fracking process. The ongoing U.S. energy boom has created a tailwind for shares, but that's not why we recommended them.

In October 2013, HCLP flashed an Alpha Score of 165. Only a few dozen stocks in the entire market have a score that high at any given time. That alone made HCLP an attractive stock, but not necessarily a candidate for our Half-Priced Stocks Portfolio. To make the cut, a stock also needs to be extremely undervalued.

Here's what we had to say about HCLP's valuation at the time:

       "The company is expected to deliver EPS growth averaging 33% a year over the next five years yet is trading at a price-to-earnings (P/E) ratio under 10 based on next year's estimated earnings... the stock could double from the current price               and still be undervalued."

The stock bounced 32% higher within three months and has more than doubled since publishing our alert. Not every undervalued stock with a high Alpha Score does this well, but it has been one of our best performing portfolios as a whole.

And although I prefer stocks that offer value, I am by no means a value investor.

You see, with traditional value investing, the point is to find stocks that are trading below what they should be trading at -- a price level often referred to as a stock's "fair value." The belief is that the market sometimes misprices stocks and that this leads to situations where the price of a stock doesn't accurately reflect its long-term fundamentals.

In order to find stocks that are trading below their intrinsic value, most value investors rely on financial ratios like the price-to-book ratio (P/B), the price-to-earnings ratio (P/E), and the less-known (but extremely effective) price/earnings to growth (PEG) ratio.

But while these ratios provide a good starting point, it's also where many value investors stop. Since most of these investors are only concerned with finding the market's "cheapest" stocks, they usually make their decisions based on these metrics alone.

That is a problem, because you often get what you pay for. After all, you wouldn't pay $4 for a bottle of Andre expecting it to taste like a $150 glass of Dom Perignon.

The same idea applies in investing. When a stock is cheap, there's likely an explanation. Case and point: specialty retail shops like Bed Bath & Beyond (NASDAQ: BBBY), The Buckle (NYSE: BKE) and Staples (NASDAQ: SPLS).

Take a look at the chart below...

As you can see, based on traditional valuation metrics, specialty retail stores across the board look "cheap." Two that we looked at, The Buckle and Bed Bath & Beyond, are even sporting price-to-earnings ratios below 13 -- a full 28% below the S&Ps P/E of 18.2.

To some value investors, these stocks might look like bargains. But chances are that's not the case.

What's far more likely is that the valuations these stocks are sporting are warranted. Why? Because their business models are in trouble. With online retailers like Amazon.com (NASDAQ: AMZN) and Overstock.com (NASDAQ: OSTK) continually stealing market share in the retail space, traditional brick-and-mortar stores are having a hard time staying economically competitive. As a result, the market is deeply discounting their shares...

Of course, that's not to say fundamental indicators like the P/E ratio and the P/B ratio aren't useful. The trick is to find companies that are not only cheap, but also possess the technicals and fundamentals needed to make strong upward moves. And this is where our Half-Priced Stocks Portfolio differs from traditional value investing. We combine valuation metrics with our two Alpha Score triggers -- relative strength (RS) and a fundamental indicator -- to find stocks that are both cheap and fundamentally attractive.

The Alpha Score has had success uncovering undervalued stocks, but it can also be used to find blue-chip stocks, high-yield stocks, international stocks, even stocks that are likely to double in the next 12 months. In fact, two of the stocks in our "Doublers" Portfolio have done just that, and are well on their way toward 200% returns.

To learn more about the Alpha Score, including the name of a stock signaling "buy," follow this link.

Francisco Bermea does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.