By Jack Forehand, CFA (@practicalquant)
We often write about factor investing on our blog. We talk about factors like value, momentum, quality and low volatility and their practical use in the real world. But the articles we write often unfairly assume that everyone reading them understands some of the basics of factor investing.
Given that factors can be a complicated topic, I thought it would be a good idea to take a step back and to look at the basics of the major investing factors. So over the course of the next few months, I am going to write a series of articles to look at the major factors, why they work, and how they are typically used in the real world.
This week, I will start by looking at momentum investing.
What is Momentum?
My natural inclination has always led me toward value investing. I like the idea of trying to buy businesses for less than I think they are worth. One of the negative effects of that over my investment career is that it has led me to focus more on value than I should have and to not give sufficient emphasis to momentum.
The reality is that when you look at the academic data, the support for momentum is every bit as strong as it is for value. And given that the excess returns of the two factors exhibit low levels of correlation, the case for using both of them is a very strong one.
One of the reasons I haven’t used momentum as much as I should have is one that typically affects many investors – it just doesn’t make as much intuitive sense as a factor like value.
To understand why, let’s look at an example. Take the stock market out of the equation for a minute and consider how you would look at the situation if I was asking you to invest in a small business in your local area. If you are like most investors, the first thing you would do is ask me to provide you with some data that supports why you should invest. What if my response was that you should invest for one reason and one reason only: because the price has gone up a lot recently?
You would likely decline my offer very quickly. You would ask for evidence that the business’s sales and earnings are growing. You would probably ask what its valuation is and the amount of earnings and cash flow you are getting for each dollar you are paying for the business. But you certainly wouldn’t invest just because the price keeps getting higher.
But with momentum investing in publicly traded companies, that is exactly what we are asking you to do. There has been some research that combining fundamental momentum with price momentum, like this paper that we use as inspiration for our Twin Momentum model on Validea, can enhance returns, but in general price momentum is about buying stocks that are going up and not caring about why.
So moving back to our initial question, what is momentum? In the world of stock selection, momentum is investing in securities with the strongest relative price performance in the intermediate-term. In practical application, this typically means buying stocks that are up the most in the most recent year.
Momentum was first identified in academic research in 1993, when Narasimhan Jegadeesh and Sheridan Titman published their paper, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”. The researchers showed that excess returns could be generated by investing in the stocks that have performed best over the past 3-12 months.
The majority of the academic research measures momentum using a variable called twelve minus one momentum. This refers to the price performance of a stock in the past year, excluding the performance in the most recent month. The reason that the most recent month is excluded is that short-term price performance tends to reverse itself. Excluding the most recent month leads to a stronger signal.
Why Does Momentum Work?
Getting back to our example of the local business that I was asking you to invest in, the next question you might be asking is “If I wouldn’t invest in a private company just because its price has gone up, why would I invest in a public company for that same reason?”.
There is some debate as to why momentum works in public companies, but the most popular reason relates to the fact that public companies have prices that are regularly quoted and many investors buying and selling them. This introduces all the biases we all suffer from as human beings into the process. I won’t get into all the details here, but the end result is that we often tend to underestimate the good news with companies that have performed well in the intermediate term. That obviously won’t be true for every company, but it is true for a group of them. By investing in a basket of these companies, an investor can benefit from this mispricing and generate an excess return. This is what is often referred to as the behavioral explanation for momentum.
Another potential explanation for momentum’s outperformance is based around the idea of reflexivity. In a nutshell, reflexivity refers to the idea that when good things happen, it can lead to a cycle where more good things will follow. The best example I can think of for this concept in what has happened with Tesla in the past couple of years. By Elon Musk’s own admission, there was a period where the future of Tesla was in question. But it had one really positive thing going for it – its stock price kept going up. The fact that the stock price kept going up allowed it to issue stock and raise capital. That capital allowed it to get through a period it otherwise might not have. It has also allowed it to continue to sell more stock as the price has skyrocketed this year. The high stock price also gives the company the opportunity to attract and retain good talent through stock compensation. And that cycle keeps feeding on itself. Although ultimately the value of a business determines its stock price, in situations like this, a rising stock price can have a major positive effect on a business.
The other reason that some argue that momentum stocks outperform is a risk-based one. This argument is a pretty simple one. If momentum stocks are riskier than the market in general and that risk is rewarded, then investors would get compensation for it in the firm of excess returns.
Potential Enhancements to Price Momentum
Although much of the academic research into momentum relies on nothing but price performance, there has been research that has looked at other things that can enhance the momentum signal.
In their book Quantitative Momentum, Wes Gray and Jack Vogel found that momentum works best when it is consistent. So if two companies have the same return, but one took a slow and steady path to get there, and one had wild fluctuations along the way, we can rely on the past performance of the first one more than the second. As I mentioned earlier, Dashan Huang and his co-authors also found that when price momentum is coupled with fundamental momentum (fundamentals are getting better as the price goes up), the excess return of a momentum strategy received a boost.
Momentum also works well when combined with other factors like value, but we will cover that in a future article where we look at combining factors.
Critiques of Momentum
Like all factors, momentum also has some weaknesses to go along with its strengths.
First, momentum typically requires more turnover than the other factors. In order for a portfolio to benefit from exposure to momentum, it needs to contain high momentum stocks. But momentum can change much more rapidly than other factors like value or quality. And when momentum breaks down, it is important to remove those stocks from a portfolio and replace them with new stocks exhibiting strong momentum. So momentum is more difficult to implement in taxable accounts and trading costs can be a drag.
Dimensional Fund Advisors looked at the performance of real-world momentum funds in 2018 and found that “Most of the funds’ managers were able to actually capitalize on the momentum premium, but they incurred trading costs that wiped out the benefits.”. Although there is debate as to the validity of their study, it does illustrate the point that the high turnover required by momentum can make real world implementation difficult.
Momentum also struggles at market turning points. For example, 2009 was not a great year for momentum, even though the market had a strong year bouncing back from the financial crisis. The reason is that it takes time for momentum to pick up a change in market leadership, and it will continue to hold the best performers from the previous regime for a period of time.
The Role of Momentum in a Portfolio
If you were to look at all the major investing factors and rank them based on their historical performance, value and momentum would likely lead the way. But value is clearly much more popular in terms of the number of investors and investment products that use it. The historical data doesn’t justify that, though. Like me, most investors don’t give momentum the credit it deserves. For investors who use factors in their investment strategy, momentum has clearly shown that it deserves a seat at the table.
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.