By Jack Forehand, CFA, CFP® (@practicalquant) —
I have probably talked too exhaustively now in my articles about my natural preference for value investing. Feeling like I am buying something for less than it is worth has always resonated with me, even if value works for completely different reasons than that and that premise isn’t even true. But I have learned over my career that investing solely in value (or any other factor for that matter) is typically not a good idea. Not only does it involve long periods of underperformance, but a single factor portfolio like that is also not an optimal one and takes on excess risk with getting any excess return for doing it.
But if using value alone isn’t optimal, the big question faced by value investors is what to complement it with. There are many options an investor could look at to answer that. Looking for high quality companies that are also cheap can work. Or at least filtering out the lowest quality ones is typically a good idea. Other factors like low volatility can also help improve the risk-adjusted returns of a value strategy.
But to me there is one factor that can do the most to improve the risk and return characteristics of a value strategy. That factor is momentum.
Using momentum with value isn’t as straightforward as many think, though. There are a variety of ways to do it, and each one of them can yield very different results.
Here are the four ways I have found most helpful to use momentum to enhance a value strategy.
[1] The Full Monty
The most integrated way to use value and momentum together is also probably the best in my opinion. Combining them together into a multi-factor portfolio generates something very close to a free lunch. The reason is that both factors have similar long-term data supporting them, but they both also work best in different types of market environments. As a result, the combination of them generates similar returns to each factor on its own, but with less volatility and more consistent outperformance.
Value and momentum can be combined in a couple of different ways in an approach like this. One method, which I like to call the sleeve method, involves just buying an equal number of stocks with each factor. If I am building a 20-stock portfolio, I would just buy 10 value stocks and 10 momentum stocks. The other method, which I like to call the consensus method, involves looking for stocks that simultaneously have both value and momentum. In this method, you are sacrificing some on the individual factor exposure in order to get a better blend of the two factors. Your value stocks won’t be as cheap, and your momentum stocks won’t have as much momentum, but you will get stocks with a better combination of both.
Although the data shows an integrated multi-factor approach is probably the best way to use value and momentum together, many value investors will prefer something less aggressive that maintains a primary value approach and uses momentum as a supplement.
This brings me to my next method.
[2] Improve the Entry
We are all taught in investing to avoid trying to catch a falling knife. But as value investors, we often don’t heed that advice and buy stocks in freefall because they are cheap.
We don’t have to do that, though. One great way to use momentum to improve a value strategy is just to wait to buy a value stock until it shows some signs of improvement. That doesn’t mean that momentum has to be strong. If you wait too long, you can miss a lot of the return in a value stock as it bounces back. But at least looking for stabilization and improving momentum can help to avoid trying to catch a falling knife.
[3] Avoiding Value Traps
Value traps are the bane of a value investor’s existence. We are buying cheap stocks with the hope that the market has overestimated how bad things are. But sometimes things are actually worse. These situations are often referred to as value traps. While value traps can’t be avoided, there is some evidence that their impact on a portfolio can be reduced. When we tested the criteria for our negative quality screen that we use to try to limit value traps, we found some fundamental tests that helped. But we also found that avoiding stocks with strong negative momentum also worked very well. And if you think about it, that makes a lot of sense. If a stock’s momentum is among the worst stocks in the market, the odds are higher that something has gone horribly wrong with the business, and the chances that these problems are worse than market expectations are elevated. We have found excluding the absolute lowest momentum stocks (the bottom 5% of our database) can help with this problem.
[4] Honor the Trend
The last option is the most extreme and probably not a fit for many investors, but one way to limit the impact of the underperforming periods of value is to try to sidestep them. That obviously can’t be done entirely, but there is research that shows that momentum works not just on a stock level, but on a factor level as well. AQR looked at this idea in their paper Factor Momentum Everywhere. Reducing exposure to value when it has poor momentum can be a viable strategy. It is important to keep in mind, though, that the evidence on whether factor timing works is mixed and it is not possible to get the timing exactly right, so making it work will require sitting through periods where things are going against you.
Two is Better Than One
None of these approaches are a panacea. None of them will change the fact that value strategies will go through long periods where they struggle. But incremental improvement is crucial to building investment strategies that last, and that investors can stick with. To accomplish that goal with a value strategy, there is probably no better tool to keep in your toolbox than momentum.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
