Momentum Investing: Picking Top Stocks and ETFs (2024)

Quantitative analysis for stocks involves using mathematical and statistical techniques to evaluate investment opportunities and forecast stock performance. Seeking Alpha’s Quant mission is to uncover top stocks with data-driven tactics and to eliminate emotional investing. Holding true to this strategy, Seeking Alpha scores and grades each stock by five “factors” -- Value, Growth, Profitability, Momentum and EPS Revisions. To do this, we compare hundreds of underlying metrics for the respective factors (P/E, ROIC, ROE, etc…) to the same metric for the other stocks in its sector. This computational analysis helps to separate the strong metrics from the weak.

Quant Ratings are an objective, unemotional evaluation of each stock based on a data-driven approach to investing. After extensive back-testing and reviewing numerous independent research studies over a prolonged period, the five aforementioned factors have been identified as a robust basis for systematically evaluating stocks utilized by Seeking Alpha’s Quant team. However, it's crucial to acknowledge that these factors don't hold equal significance in terms of their predictive power for forecasting stock performance. Most Quants know that Momentum is the king of factors.

What is Momentum?

Let’s define momentum so we are all on the same page.

There are two main types of momentum: Time-Series Momentum and Cross-Sectional Momentum.

1. Time Series Momentum looks at a stock's performance relative to its own price history and typically buys stocks that have broken through technical indicators like a 200-day moving average. Our model does not consider Time Series momentum as this is typically a more frequently used factor for technical analysts.

2. Cross-sectional momentum looks at a stock’s performance versus its peers and can be used to help forecast its future relative performance.

Seeking Alpha’s Quant model uses cross-sectional momentum. We define momentum as the phenomenon where securities that have performed well/poorly relative to peers on average continue to outperform/underperform. Furthermore, Momentum is categorized as a persistence factor and tends to benefit from continued market trends.

Why Momentum Investing Works

Fear – sentiment – moves the markets. At one point or another, we’ve all experienced a time when we’ve made an investment decision based on our emotions. In a groundbreaking paper, Kahneman et al. suggested that stock prices overreact or underreact to information. The return premium of Momentum has been studied for a long time. Narasimhan Jegadeesh and Sheridan Titman first documented it in an academic paper published in 1993 titled Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. The study found that buying past winners and selling past losers realize significant abnormal returns over the time period they studied. Many others have looked into this and confirmed these findings. For example:

1. Geczy and Samonov (2016) found that the momentum phenomenon has been persistent and significant since at least 1801!
2. Fama and French (2008) found that momentum trading strategies are profitable even after adjusting for market capitalization and book ratio.

3. Asness et al. 2014 found that momentum strategies are still profitable even after adjusting for transaction costs.

The Momentum factor continues to be studied and is still a strong factor correlating with equity’s future returns.

So why does this momentum premium exist? One umbrella concept that contributes to the momentum premium is the study of behavioral finance. Behavioral finance helps to explain why profitable trading strategies that select stocks based on past returns exist. Two of the main biases attributed to Momentum strategies’ profitability are:

1. Anchoring Bias is Investors’ reliance on the first piece of information they receive, like an initial stock price or value. By envisioning some initial default number or “anchor”— regardless of how the initial anchor was chosen – people tend to adjust their anchors insufficiently and produce approximations that are, consequently, biased.

• In summary, this bias states that individuals are influenced (anchored) by the original lower price, and then when new information is introduced, like improving fundamentals, investors still consider the stock a poor investment because its price has increased.

2. Prospect Theory: In a critical study,

Kahneman and Tversky (1979) discovered that investors display a disposition to sell winners and ride losers when standard theory says otherwise.

• Prospect theory further reinforces why the momentum premium exists, as investors will sell stocks after they have appreciated, not considering the possibility that it could be a better investment even after it has risen in price.

For example, in January 2021, GameStop (GME) rose ~1800%. Momentum investing is a strategy focused on capitalizing on continuing market trends, yet Seeking Alpha’s Quant Rating system did not rate GameStop as a strong buy stock. GameStop maintained a Hold rating. Why? Because momentum investing alone does not comprise Seeking Alpha’s Quant methodology. As indicated by the quantitative ratings, poor fundamentals didn’t support GameStop's price rise, so our stock selection model did not assign GME a Strong Buy rating or highlight it as a good investment.

GameStop vs. Super Micro Computer’s momentum since 2021 can’t compare

Of course, we all know that GameStop’s trajectory reversed course from its January 2021 high of $483 back down to its current level of $16. For GameStop, the Quant system assigned a low score for long-term momentum, resulting in this factor receiving a relatively modest rating. Hence, the stock never had a Strong Buy rating.

In contrast, Super Micro Computer (SMCI) saw its stock value rise steadily over an extended period, leading to a high momentum grade. This performance was in stark contrast to GameStop, whose momentum was more short-lived and less consistent. GameStop proved to be just a flash in the pan.

Often, when we write an analysis focusing on stocks that Seeking Alpha’s Quantitative algorithm rates a Strong Buy, we often receive feedback stating something like, “This stock is no longer a good buy because it has already surged to a 52-week high.”

Therefore, we wanted to write an article defending Momentum with empirical evidence showing that it boasts an impressive long-term track record and is valuable in identifying compelling investments. Let’s start by defining momentum.

Unwarranted Disdain for Momentum

Now that we’ve discussed reasons why the momentum premium exists, let’s dive into some of the most common feedback points we see after highlighting stocks with a high momentum grade.

1. “Once a stock’s price has appreciated, it is no longer a good buy”

Investors tend to underreact to new information and are anchored to former prices. The chart above is a great visual that shows that even after stocks have risen, they might continue to rise. Furthermore, this type of feedback only considers the past price of a stock and ignores other information, like improving fundamentals or favorable economics. When investors don’t react to this new information and consider price as their sole reason for investment, they perceive the stock as riskier or too expensive when the opposite may be true.

For example, when Alpha Picks selected Powell Industries, Inc. (POWL) on 5/15/2023, the stock had appreciated 56% YTD. However, on the selection date, it traded at a lower earnings multiple (screenshot below) because although the price had increased, earnings had increased more.

Powell Industries (POWL) Price-to-Earnings Decreases Amid Stock Price Surge

Many are not considering the new information about increased earnings and the company's earnings momentum. Seeking Alpha’s Quant system is designed to look at new information daily and doesn’t have behavioral biases because it removes emotion from investing. Since being selected by Alpha Picks, POWL has a total return of 54.11% as of 11/30/2023. If used correctly, Momentum investing works, and it is this very point that we want to highlight.

2. “Momentum Strategies are Too Risky”

Like any investment factor, momentum is not perfect. It has gone through a period of underperformance and has experienced crashes. Momentum has been well observed and compared to the market, value, or size risk factors, momentum has offered investors the highest Sharpe ratio, according to Kenneth French’s website and affirmed in Asness et al. 2014.

Sharpe ratio is a measure of return per unit of risk, so we think it’s unfair to classify Momentum Strategies as too risky.

Additionally,

Daniel and Moskowitz (2013) found that momentum crashes typically happen after long bear markets and mostly affect the short side of the trade (shorting the biggest losers), stating:

“Consequently, the expected returns of the past losers are very high, and the momentum effect is reversed during these times. However, this feature does not apply equally to winners during good times, resulting in an asymmetry in the winner and loser exposure to market returns during extreme times.”

Furthermore, “The Devil in HML’s Details” shows that if you combine the value and momentum factor, you can effectively eliminate these crashes. As a bonus, the momentum factor also helped mitigate crashes in the value factor!

3. “I prefer value investing.”

The interaction that value and momentum have with each other is extremely important to the success of the Quant System. Specifically, value is extremely important and helpful when momentum is underperforming, a relationship perfectly summarized in Fact, Fiction, and Value Investing.

“Value and momentum are best thought of as a system. They are both strong alone, but are much stronger together due to their negative correlation, which shows up most clearly when value is defined with timely prices”.

Again, as mentioned, momentum has had periods of underperformance, but look at value (IUSV). It has significantly underperformed growth, momentum, and the S&P 500 over the last 10 years.

Value has underperformed growth, momentum, and the S&P 500 over 10-yrs

That said, just because a factor has experienced underperformance doesn’t mean it can’t be helpful. In fact, Value is another factor that is used in the quant system.

Momentum & Quant

Lastly, we wanted to talk about how the Seeking Alpha Quant system uses momentum as a factor and how it can help with stock selection. As shown in the GameStop example, Momentum alone cannot qualify a stock for a Strong Buy rating. We’ve studied, researched, and tested hundreds of different factors, and the result has culminated in the quantitative model you see on Seeking Alpha. The model identifies stocks that are collectively strong based on value, growth, profitability, and revisions.

Momentum is one of our system's most important composite factors, but we validate it by verifying that the company possesses solid fundamentals. This includes achieving high-value grades, promising future growth prospects, sustained profitability, and positive forward-looking earnings revisions. To reiterate, the model’s stock selection benefits from using many factors as it will not solely select stocks with positive momentum.

A perfect example is Super Micro Computer Inc. (SMCI), selected by Alpha Picks on 12/15/2022. As of the selection date, SMCI had a YTD return of ~81%. We nailed the stock’s Strong Buy Quant Rating because SMCI possessed tremendous fundamentals based on the five Factor Grades: Valuation, Growth, Profitability, Momentum, and EPS Revisions. Since being selected to Alpha Picks, SMCI has appreciated 220.79%!

While no factor or model is flawless, this article presents empirical evidence supporting Momentum, highlighting its remarkable long-term success and its effectiveness in pinpointing attractive investment opportunities.

Conclusion

Seeking Alpha's Quant mission is dedicated to identifying top-performing stocks using a data-driven approach, thereby eliminating emotional biases in investment decisions. The system evaluates stocks based on five key factors: Value, Growth, Profitability, Momentum, and EPS Revisions, comparing relevant metrics against those of sector peers to discern strong from weak metrics. Our unemotional assessment is grounded in a data-centric investment philosophy. Through extensive back-testing and independent research, these five factors have been established as a reliable foundation for stock evaluation, with Momentum often playing a key and pivotal role. Momentum is a useful signal when combined with the other factors in our Quant system. This article should help you understand why Momentum is an important factor and how it helps us in our investment processes.

Good luck with your future investments!

I work on the quant team at Seeking Alpha.