Momentum is one of the strongest investing factors, but is often overlooked by investors relative to other factors like value. Momentum refers to buying stocks that have performed well in the recent past and avoiding stocks that have performed poorly. The idea is that stocks that have outperformed recently tend to continue outperforming in the near term. While the concept seems almost too simple to be effective, momentum is one of the most well-documented factors that has historically generated excess returns, or alpha.
Studies on momentum go back to the 1990s, when Jegadeesh and Titman published a seminal academic paper documenting the momentum effect. Since then, the factor has been confirmed across time periods, countries, and even asset classes. Researchers believe momentum works due to persistent behavioral biases – investors tend to underreact to positive information in the short run, and chase performance over the longer run. This creates a sweet spot for momentum to be effective over the intermediate term of 6-12 months.
Wes Gray’s Quantitative Momentum Strategy
In his book Quantitative Momentum, Wes Gray and co-author Jack Vogel set out to develop a systematic momentum strategy built upon a strong academic foundation. They examined momentum with “extreme rigor” to determine what really works. Some of the key conclusions that shaped their ultimate model:
- Momentum works best over an intermediate time frame. Short-term momentum of 1-3 months tends to invert, while momentum over 3-5 years is not effective. The sweet spot is around the 12 month mark.
- Excluding the most recent month is important. This avoids the short-term reversal effect and much of the negative impact from bid-ask bounce.
- Momentum is further enhanced when it is consistent. Stocks with steady and consistent outperformance are more reliable than those with streakier big gains.
- Combining momentum with other factors like value and quality can improve risk-adjusted returns.
Based on this research, Gray and Vogel set out a clear 3-step process to build a momentum portfolio:
- Exclude small and illiquid stocks to ensure sufficient capacity.
- Buy stocks with the highest “twelve minus one” momentum – total return over the past 12 months excluding the most recent month.
- Of the high momentum stocks, select those with the most consistent performance, as measured by volatility.
The resulting portfolio provides concentrated exposure to stocks with high and stable intermediate-term momentum, while maintaining sufficient diversification and capacity.
Validea’s Quantitative Momentum Model
Based on our interpretation of Gray’s book, here are the key criteria in Validea’s Quantitative Momentum model:
- Universe: Select liquid stocks with market caps over $150 million and daily dollar volume over $2 million. This focuses the model on larger stocks and avoids illiquid names.
- Twelve Minus One Momentum: Measure each stock’s momentum based on its total return over the past 12 months excluding the most recent month. Select the top 10% of stocks based on this criterion.
- Consistency of Momentum: For the high momentum stocks, calculate the consistency of momentum by looking at streaks of positive and negative daily returns. Consistent winners receive a better score. Select the top 5% of stocks based on the combo of 12-1 momentum and consistency.
The strategy is rebalanced periodically to maintain exposure to the top ranking momentum stocks. This disciplined, unemotional approach aims to harness the momentum factor while avoiding some of the pitfalls that have tripped up other momentum models.
5 Stocks Scoring Well on Validea’s Quantitative Momentum Model
As of May 2024, here are five stocks that score well based on Validea’s Quantitative Momentum model.
- Abercrombie & Fitch Co (ANF): Abercrombie & Fitch Co. operates as a specialty retailer of apparel and accessories. The company’s 12-1 momentum ranks in the top 1% of all stocks in Validea’s database over the past year. It also receives a perfect consistency score based on having positive streaks that significantly outweigh its negative daily moves. The stock exhibits the strong and steady momentum the model looks for.
- GoDaddy Inc (GDDY): GoDaddy is a domain registrar and web hosting company. It ranks in the top 9% based on 12-1 momentum and also receives a perfect consistency score, placing it in the top 1% based on the combination of the two factors. The strong recent momentum and steady outperformance make it a top pick for the model.
- Toyota Motor Corp (TM): Toyota is a leading global auto manufacturer. The stock’s 12-1 momentum ranks in the top 10% of the market and it also receives a very high consistency score. Despite being in a fairly cyclical industry, Toyota’s momentum has been impressive and steady.
- Spotify Technology (SPOT): Spotify is a leading audio streaming service. The stock’s 12-1 momentum ranks in the top 6% of the market, and it also receives a high consistency score. The strong price appreciation and steady outperformance make it another top momentum pick.
- KKR & Co Inc (KKR): KKR is a leading global investment firm that manages multiple alternative asset classes. The stock has been one of the top momentum performers over the past year, ranking in the top 6% based on 12-1 returns. It also scores in the top 1% based on the consistency of those gains.
Conclusion
Wes Gray’s research provides a compelling case for momentum investing and maps out a clear framework for how to harness the momentum factor. By focusing on the past 12 months excluding the most recent month, targeting stocks with consistent momentum, and concentrating the portfolio on the top performers, the quantitative momentum model aims to deliver strong returns for investors. For investors looking to tilt their portfolio toward momentum, Gray’s approach is one of the most compelling we have come across.
Further Research
