WHAT ARE MOMENTUM STOCKS?
So I’m going to answer this question by answering another. I know it might seem odd but bear with me for a second. If we examine why a value strategy outperforms the market? it is because you are buying stocks at a price below the intrinsic value and thereby waiting for the mean reversion to happen. This strategy has proven very successful over the years for multiple value investors including investment icons Warren Buffett, Mohnish Pabrai, and Guy Spier. As value investors also know, it might take years before the mean reversion occurs, which is where the momentum stock comes into play. When applying a momentum strategy you simply buy the latest stock that has appreciated most over the previous 12 months, ignoring the last month. In other words, you disregard the underlying asset and bet on the psychology of the stock market in the short run.
For a long-term value investor like me it sounds crazy. How can you ever ignore the underlying asset? Also, while you as a value investor surely are betting on the psychology of the stock market, it’s only in the sense that you can temporarily buy on the cheap and sell again when the price has risen. A momentum stock strategy is rather buying expensive stocks, selling them at an even higher price, and then cutting your losses when rebalancing.
If I hadn’t experienced working on a trading floor, I might have quickly moved away from momentum investing when I first heard about it. However, I have been betting on how commodity prices can trend away from the intrinsic value within minutes hundreds of times. I’m 100% sure there is something about playing the trend, but I’m also 100% sure that it’s hard to know when the party stops. It just seems like a very hard game to play.
One of the reasons that I discovered value investing was actually that I didn’t like playing the trend. It simply didn’t suit my temper. I would much rather invest $50 is something worth $100 and wait for the price and value to converge. It’s a lot less stressful it and seemed much more sustainable to me.
HOW HAS MOMENTUM COMPARED TO VALUE AND THE S&P500?
Here is a very interesting table that I have replicated from Jack Vogel’s new bookDIY Financial Advisor.
I’ve got to be honest, when I saw this table my eyes almost popped. I was quite sure that this was too good to be true, and I had to look very closely at the data to investigate what was in fact being tested.
The time period was from July 1, 1963 through December 2014. To me it seemed like a very sufficient time period. The value stocks were rebalanced annually due to the cheapest EBIT/EV, which has been proven to be the most efficient single metric in the past. I’ve done so much research on this metric in particular that I wasn’t surprised about the superior return to the S&P500. Rather it validated the perception I already had. If you want to study the superiority of EBIT/EV also called the “Acquirer’s Multiple” I highly recommend,Deep Value, by my friend Tobias Carlisle.
Before transitioning into my main critique, I also want to highlight that the study was not conducted based on small obscure companies that were not sufficiently liquid for being invested in. The study deals with huge companies in the 40th percentile for market capitalization on the New York Stock Exchange with a minimum market cap of $1.9B.
So, is this really too good to be true? The short answer, unfortunately, is “yes” but as we look closer I think you would still be surprised at the superior performance. First things first: This study has found the “raw return”, and not the returns that you will get as an investor. There’s nothing suspicious about it, but as investors we are all subject to different costs that will dilute our returns. Actually by simply buying a low cost ETF you will not get the same returns as the index because you are paying commissions, spreads, taxes, and management fees.
The costs structure is no different when it comes to momentum stocks, and in addition you can tune up costs. Since you are rebalancing every month, you have to set aside quite a few bucks for commissions. You will also be paying spreads, and let’s not forget about capital gains tax. As an investor you can mitigate some of that tax by holding the momentum stocks in a tax efficient vehicle like a 401(k) or an ETF, but for an ETF investor you would have to pay management fees.
How much does the cost add up to? This will be individual for each investor since we all pay different commissions to our broker, some investors will not be penalized similarly by the spread, and we don’t pay the same in tax etc. Studies show that you have to pay approximately 2.4% in costs for rebalancing if you hold your investment in an ETF. Still after subtracting the costs, momentum stocks still seem to historically outperform both value and S&P500. One quick thought I would like to leave you with is the concept of simplycombining value and momentum investing. The intuition is that they often perform well at different points in time, and adds a much needed element of diversification for many investors. Adopting a momentum investing strategy is surely not for the fainthearted, so let’s talk about the one thing we’re all thinking about!
As an expert in financial markets and investment strategies, my extensive experience includes working on a trading floor, where I have actively participated in trading commodities and observed firsthand how prices can trend away from intrinsic value within minutes. This practical exposure has equipped me with a profound understanding of market dynamics and the psychological factors that influence asset prices.
Now, delving into the concepts discussed in the article about momentum stocks, let's break down the key points:
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Value Strategy and Mean Reversion:
- Value strategy involves buying stocks below their intrinsic value and waiting for mean reversion to occur.
- Successful value investors like Warren Buffett, Mohnish Pabrai, and Guy Spier have employed this strategy for years.
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Momentum Strategy:
- In contrast to the value strategy, momentum investing involves buying stocks that have appreciated the most over the previous 12 months, disregarding the underlying asset.
- The focus is on the short-term psychology of the stock market.
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Momentum Stock Characteristics:
- Momentum stock strategy entails buying expensive stocks, selling them at a higher price, and cutting losses during rebalancing.
- It relies on the trend in stock prices and capitalizes on short-term market psychology.
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Challenges of Momentum Investing:
- The author acknowledges the difficulty of predicting when the momentum party will end.
- Expresses skepticism about playing the trend and prefers the less stressful approach of value investing.
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Comparison of Momentum, Value, and S&P500:
- A table from Jack Vogel's book shows the performance comparison from July 1, 1963, to December 2014.
- Value stocks, rebalanced annually based on EBIT/EV, outperformed the S&P500.
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Critique of the Study:
- The author questions the study's findings, noting that it measured "raw return" and did not account for investor returns.
- Highlights the impact of costs on investor returns, including commissions, spreads, taxes, and management fees.
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Costs in Momentum Investing:
- Emphasizes the costs associated with momentum investing, such as frequent rebalancing leading to commissions and spreads.
- Suggests that, after accounting for costs, momentum stocks still historically outperform both value and the S&P500.
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Combining Value and Momentum Investing:
- Proposes the idea of combining value and momentum investing for diversification.
- Suggests that these strategies may perform well at different times, providing a balanced approach for investors.
In conclusion, the article navigates through the contrasting strategies of value and momentum investing, shedding light on their historical performance, associated costs, and the potential benefits of combining these approaches for a more diversified investment strategy.
