Momentum Investing - the What, the Why, the How and the Risks

By Justin Carbonneau (@jjcarbonneau)

At the most basic level, momentum investing in the context of security selection can be defined as buying securities that have done the best over the past 12 months and selling those that have done the worst. While there are multiple methods and timeframes used to measure momentum, which we’ll get into below, the idea of buying based on price strength and selling based on price weakness is at the core of momentum investing.

One thing is clear so far in 2019: stocks with strong price momentum are leading the way. Of the top 10 performing model portfolios we run, 6 of them have a strong momentum component as part of the stock selection process. And the recent performance is a continuation of the last few years, where momentum has been robust and other investing styles, like value, have struggled.

No active quantitative strategy works all the time or stays on top forever, but since 2003 some of the very best performing models we track have a momentum criteria baked into them. We couldn’t have predicted that then, nor can we predict whether it will continue going forward, but the recent performance of momentum gives us an opportunity to talk about this style of investing, the theories behind why momentum has the potential to work, how momentum can be measured, the risks of momentum (and there are plenty), and how momentum can be combined with other fundamental factors to aid in stock selection.

Momentum Model Portfolios on Validea – YTD Returns

Guru Based on	Portfolio	YTD Return	Includes Momentum Criteria
Wesley Gray	Quantitative Momentum Investor	48.3%	Yes
Dashan Huang	Twin Momentum Investor	25.5%	Yes
Warren Buffett	Patient Investor	24.8%	No
Motley Fool	Small-Cap Growth Investor	20.4%	Yes
Partha Mohanram	P/B Growth Investor	18.6%	No
Pim van Vliet	Multi-Factor Investor	18.1%	Yes
Kenneth Fisher	Price/Sales Investor	16.7%	No
Validea	Momentum Investor	15.1%	Yes
Meb Faber	Shareholder Yield Investor	14.8%	Yes
Wayne Thorp	Earnings Revision Investor	14.4%	No

The table above lists focused 10 stock model portfolios run on Validea. The returns in the table don’t represent actual returns. These portfolios are not endorsed or approved by the individuals in the table. All of our models are based on publicly disclosed strategies outlined by these individuals in books or academic papers.

For many investors, particularly fundamentalists that look to buy good companies at attractive prices, momentum-based investing can be difficult to comprehend because it lacks a clear connection to the ultimate value of the underlying business and the economic drivers of value.

However, momentum tends to be one of the most robust market anomalies and has been verified over the long term academically. As Eugene Fama, “father of modern finance”, outlined in this paper, which highlights past research and his own findings …

“stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns.”
Dissecting Anomalies, THE JOURNAL OF FINANCE • VOL. LXIII, NO. 4 • AUGUST 2008

Asking “Why” is Paramount

To understand momentum, let’s start by learning from others who’ve studied the factor extensively and who have implemented it themselves.

In the Curious Investor podcast with Cliff Asness, co-founder and Managing Principal at AQR, and Wes Gray, CEO of the quantitative investment firm Alpha Architect, we get some very valuable insights on momentum. Asness and Gray are considered authorities on investment factors such as momentum and value.

As they pointed out, thinking about the “why” behind momentum — whether it’s risk-based, behavioral or some combination of the two — is an important exercise.

The risk-based theory would say momentum is riskier and therefore in order to compensate investors for that risk, momentum stocks need to present a higher return. Ok, that makes sense.

But as the two practitioners discuss in the podcast, the behavior explanations tend to be a little deeper and perhaps offer better explanations about the drivers of momentum.

Possible Drivers of Momentum Premium …

Under-reaction: Investors tend to under-react to good news. So for instance, if a company increases earnings guidance it takes time for that positive development to be totally embraced by the market. As a result, a stock may exhibit an upward move and continue upward as the market and investors digest the good news.
Over-reaction: Another is somewhat the opposite of the above. As a stocks exhibit positive price increases, investors look at that and buy more, this creating an almost herding like effect based on strong recent price movement.
Disposition Effect: Investors tend to hang onto losing positions and sell winners prematurely. Known in behavioral finance as the “disposition effect”, this is theorized to have a positive impact for stocks with momentum. Larry Swedroe’s piece on ETF.com has more on this.
Theory of Reflexivity: In the podcast, Dr. Gray mentions one other reason, which is an interesting idea, where he suggests you invert the problem. Rather than momentum reflecting positive future outcomes for the company, what if momentum in and of itself drove those positive outcomes. For example, if a company’s stock price doubles that company may be able to attract the best employees with stock options, have more optionality to use its stock for acquisitions or have more leeway to make bold and innovative bets that another company with a lagging stock price may not.

How to Measure It

Now that we have some of the theories on why momentum may work, let’s looks at how momentum is measured.

Relative Strength: Relative strength is simply a measure, on a scale of 0-100, of a stock’s relative price strength compared to all other stocks. You can measure relative strength over any period of time, say 3 months, 6 months or 12 months. Our models such as the Small Cap Growth, Momentum, Growth/Value (based on Jim O’Shaughnessy’s Cornerstone Growth model), Millennial and Shareholder Yield use a 12 month relative strength rating and stocks generally have to obtain a score of 90 or better to obtain 100% from either model.

Industry Relative Strength: This metric uses relative strength at an industry level to identify those industries exhibiting strong price performance. Validea’s Momentum model uses this.

Twelve Month Minus One Month Momentum: Most tests on momentum show the factor is not persistent in the very short term or in periods of greater than a year. This measure takes that into consideration by looking at a stock’s return over the past 12 months while at the same time excluding the most recent month. In the Validea system, stocks are then percentile ranked as a way to identify those names with the highest momentum. Our strategies that use this include Twin Momentum, Quantitative Momentum and the Multi-Factor model.

There are other ways to screen for momentum as well, including percent above or below 52-week highs and percent above or below 200 or 50 day moving averages. These are included in Validea’s stock screening application under the Momentum and Price Criteria filter.

Combining Momentum with Fundamental Factors

The majority of models captured by Validea utilize momentum in combination with other investment criteria. The one model that may be considered pure momentum is the Quantitative momentum model, based on Dr. Gray’s book, Quantitative Momentum, but even that model uses the consistency of returns as a way to reward stocks with more price return consistency.

A good example of a model that uses momentum along with a host of other factors is our Small Cap Growth model based on investment strategy outlined in the book, The Motley Fool Investment Guide. This model looks for small cap growth stocks with solid fundamentals and strong price performance. To obtain 100% based on the model, stocks need to pass all of the hurdles mentioned below, which include a relative strength minimum of at least 90. What is interesting about this particular model is that it has shown the most consistency in terms of outperformance vs. many of our other models. In my opinion, part of that has to do with the momentum or relative strength component, which has tended to keep the model from picking stocks that go on to see large declines.

Here are the criteria in the Small Cap Growth Investor Model

Profit Margin
Relative Strength – 90% or higher needed in order to get 100% score from the model
Compare Sales And Eps Growth To The Same Period Last Year
Insider Holdings
Cash Flow From Operations
Profit Margin Consistency
Cash And Cash Equivalents
Long Term Debt/Equity Ratio
P/E To Growth Ratio

Other criteria in the model include: Inventory to Sales, R&D As A Percentage Of Sales, Accounts Receivable To Sales, Average Shares Outstanding, Sales, Daily Dollar Volume, Price, Income Tax Percentage

The Risk of Momentum

Now, before you go all in on the next momentum strategy you read about, it’s important to understand the downside of momentum investing, and there are many.

Turnover: Momentum strategies typically have a high degree of turnover, which has multiple implications. For one, high turnover strategies have higher direct and indirect trading costs.
Taxes: Because of the high turnover, momentum strategies are very tax inefficient. This is why deploying them in things like an ETF wrapper can make sense.
Implementation Risk: Anyone who has followed a model knows that the more touches you have, the more chances of screwing things up. Because of the high amount of turnover, there is more chances of this.
Market Transitions: When the market transitions from one leadership group to another, momentum strategies don’t turn on a dime, so the strategies often struggle in periods of changing market leadership.
Momentum Crashes: If the floor drops out of momentum stocks, watch out. If you go back to the late 90s/early 2000s, all the momentum was in the high flying, overvalued technology stocks and when the air pocket came out, we know what happened.

Rob Arnott and researchers at Research Affiliates published a paper in 2017 that looked at the actual performance of mutual funds that appeared to use momentum as part of their investment approach. Anyone interested in much deeper research on momentum should read this research, but one conclusion they found was clear:

Momentum is a popular and seductive strategy. Human nature conditions us to want more of whatever has given us joy and profit and to get rid of anything that has inflicted pain and losses. Momentum delivers exactly this, as a formal strategy! It tells us to buy what’s hot and sell what’s not. On paper, this is associated with superior performance, all over the world, over long periods of time. Alas, momentum fares far worse on live assets than on paper. Historically, momentum funds—whether self-identifying as such, or objectively showing a strong momentum loading—have failed to beat the market, on average, even during extended periods when momentum factor paper portfolios were delivering outstanding performance.
Can Momentum Investing Be Saved?, Research Affiliates, OCTOBER 2017

Parting Thoughts on Momentum

Like any investment strategy that attempts to outperform, there are always pluses and minuses. We have certainly seen that with all of the models run on Validea. One of the most important aspects of momentum investing (like any investment strategy) is asking, and trying to understand, the “why” behind it, while also internalizing the reasons it may not work. In today’s market, momentum investing has worked very well this year and also has worked over the long-term, but like any strategy, it will go through periods of struggle. The ability to stay the course during them is the key to success.