By Jack Forehand, CFA, CFP® (@practicalquant) —
Momentum can be one of the more challenging factors for investors to understand. Since we are investing in businesses when we buy a stock, we are inclined as investors to want to relate our reason for investing to what is going on in that business. Value investing meets that requirement since it involves looking for companies that are cheap relative to their earnings and cash flows. Quality does too since it involves looking for good, profitable companies with solid balance sheets and consistent earnings.
Momentum is different, though. While the fact that a stock is going up is typically related indirectly to what is going on in its business, the direct reason for buying a stock using momentum is just that it is going up. The fact that a fundamental explanation isn’t required can make the factor difficult to follow and believe in for many investors.
But don’t let the lack of direct fundamental tie in fool you. The academic evidence supporting momentum is probably as strong as any factor out there.
What is Momentum?
There are two types of momentum that are typically used in investment strategies. The first is time series momentum. Time series momentum involves comparing the price of an asset to its own history. Trend following is a good example of this. For example, a trend follower might buy an asset when it is above its 200-day moving average and sell it when it falls below it.
In this article, I am going to discuss cross sectional momentum, which is the other major type. Cross sectional momentum involves comparing an asset to other assets instead of to itself. With a cross sectional momentum strategy, I want to buy the assets that are going up the most relative to the other assets in the universe I am looking at. In the world of stock selection, momentum is investing in securities with the strongest relative price performance in the intermediate-term.
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.
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 momentum is about buying stocks that are going up and not caring about why.
Why Does Momentum Work?
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 years before its recent decline. 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. 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 (until it doesn’t like we have seen in the past year). 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. Most researchers either dismiss this argument entirely, though, in the case of momentum or think it is only a small portion of the story. Academics typically believe the behavioral argument is much stronger.
Potential Supplements to a Momentum Strategy
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. This type of approach can also have behavioral advantages. The reason gets back to what I talked about before. As investors, we seek a fundamental reason for investing in a company. And sometimes having that fundamental reason will allow us to stay the course when things get rough. If adding in fundamental momentum to a price momentum strategy does that, it doesn’t really matter whether it enhances the return because the behavioral component will likely trump any return differences.
Momentum also works well when combined with other factors, It works particularly well with value since their excess returns tend to be negatively correlated and so investors who combine them can typically get comparable returns to the individual factors with less risk.
The Downsides 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.
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 Factor That Gets No Respect
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. 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 to play a significant role.
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.