Buying stocks near their 52-week highs can pay off

Stocks trading near their yearly high tend to continue to perform very well, and vice-versa.

Michael Leonard 19 October, 2015 | 5:00PM
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If you were offered a choice of buying one of two Canadian stocks, and the only information available to you is that Stock A is trading close to its high of the past 12 months while Stock B is trading near its low, which would you choose?

The value-conscious side of your intuition may well have you selecting the presumably cheap Stock B. If so, you would probably have made the wrong choice. The reason: Stocks trading near their high for the past year tend to continue to perform very well, and stocks trading near their low tend to continue to perform poorly.

Using proprietary software and a database of Canadian stocks with almost three decades of historic data, Morningstar's CPMS division can run single or multivariate tests to determine those metrics that do and do not add alpha to the equity investment process.

Since Jan. 1, 1992, there have been 95 calendar quarters. The S&P/TSX Composite Total Return Index had positive returns in 64 of those quarters. A single-variable test, holding the 40 Canadian stocks trading closest to their 12-month high (which CPMS calls "price change from 12-month high" or PCHGHI) at the beginning of each quarter, produced an annualized return more than 1,000 basis points higher than the benchmark.

If you are thinking that there must be significant volatility associated with owning this quarterly-reconstituted portfolio, you would be wrong again. In fact both the standard deviation of monthly returns and the downside deviation percentage come in significantly lower than those of the benchmark. The Sharpe Ratio, which measures risk-adjusted returns, was 1.2 versus 0.4 for the benchmark.

Another misconception is that stocks trading near their 12-month highs tend to do better in rising markets than in falling ones. The PCHGHI-selected portfolio beat the S&P/TSX Composite Total Return in 67 of 95 quarters, for a 71% success ratio. Since these 67 outperforming quarters closely resembles the number of positive quarters for the benchmark (64), you might conclude there's a close correlation between positive market returns and positive returns for stocks trading near their 12-month highs.

If so, you would be wrong. The single-variable test of PCHGHI beat the index in 41 of those 64 positive market quarters, for a very respectable success ratio of 64%. However, owning those 40 stocks trading the nearest to their 12-month highs led to outperformance in fully 26 of the market's 31 negative quarters since 1992, for an 84% success rate! This includes the recently concluded third quarter of 2015.

So in fact, over time, not only is owning stocks trading near their year-high prices a great way to add alpha, it's also a great defensive strategy. In the current market environment, with equities experiencing significantly more volatility than normal, look for stocks trading near their 12-month high -- not their 12-month low -- if you are particularly concerned about equity market weakness.

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Michael Leonard

Michael Leonard  Michael Leonard, CFA, is chief equity strategist at Morningstar Canada.

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